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Options

WHAT IS OPTIONS TRADING?

 An image of a stock options process chart.

 

If you have been thinking of investing in the stock market, options are a good choice. An option is a type of contract which gives the buyer the right to buy or sell an underlying asset at a specific price (strike price) prior to or on a particular date which is referred to as the expiration date. Options are securities, just like stocks and bonds, and come with terms and properties that are strictly defined. The buyer of an option has the privilege to exercise their option before or on the expiry date but is not obligated to.

Stock options are contracts between two parties: buyers and sellers. The people who buy options are called the holders and the ones who sell options are the writers. It gives the stockholder the option to buy or sell shares at or before a specific date. When you buy an option, you have the right, but not the obligation to buy or sell shares. This contract has very strict terms and conditions that must be followed by both parties.

Options give holders the ability to adjust or adapt their position when certain situations arise. However, it is important to understand that options have costs, they can be very risky and are quite complex in nature. They may not be suitable for all shareholders. Options trading can also be speculative in the sense that you expect certain movements on the market or index in order for you to make profits.

IF YOU WISH UNDERSTAND THE CONCEPT BEHIND OPTIONS THEN CONSIDER THIS EXAMPLE:

You are interested in buying something, maybe a second-hand luxury car or a valuable piece of artwork. Unfortunately, you do not have the entire amount required to pay for this right away. So you strike a deal with the seller, who agrees to sell the car or artwork to you after six months at a price of $40,000, provided you pay him $4,000 right now.

Now, suppose later on it is discovered that the artwork is much more valuable than you had initially appraised it to be; the owner is still obligated to sell it to you at the agreed upon price, regardless of this new value of the piece of art. On the other hand, if you decide that you do not wish to buy the car or the artwork (for whatever reason), you don’t have to, but you will not get the $4,000 you paid back. Buying an option places you under no obligation to go through with the sale.

Evidently, options are contracts that deal with underlying assets, meaning, they derive their value from something else. That’s why options are called derivatives. Going by the illustration given above, the underlying asset is the car or the artwork. Usually, stocks and indexes are the preferred underlying assets when it comes to options.