Options Trading 101

Options trading is a strategy that some investors use as a way to hedge against a decrease in the value of an asset they own shares in, such as a stock.  Having an option contract in place can help limit your losses in the event your stock loses value, however, there are also risks involved with trading options since you’re speculating as to the future direction and timing of the stock movement.

What are Options?

An option is a contract that gives you the right to buy or sell an asset at a specific price until a certain time. There are two types of options:

1. Call: This is a “buy” option, allowing you to buy the underlying asset in question, at a certain price.
2. Put: This is a “sell” option, providing you the right to sell the underlying asset at a certain price. If the option is exercised by the option holder, the seller is obligated to sell the underlying asset.

It is important that you understand that, as a buyer, you do not have to buy the asset the option contract is based on. You are simply purchasing the right to buy it at a specific price. Anytime until the option expires, you can buy it at the price specified. If asset prices rise, you can make money because you have the right to purchase the asset at a lower price than the current market value and then turn around and sell it for more.

If you do decide to exercise the option, you’ll need to have the money available to buy the stock.  Options contracts typically start off at 100 shares so even at the lower price, you’ll need a chunk of change to make the purchase.  Another alternative you have is to sell the option itself rather than exercising it and actually buying the shares.

While you can buy or sell options, many beginners prefer to start out with call options since they are a little simpler way to understand the options market.

Basic Options Definitions

Here are some basic definitions to understand before you begin options trading:

• Underlying Asset: This is the the security that the contract is based on. If you are trading stock options, it is the stock you are considering. If you want an option on Citi (C), then you purchase the right to exercise 100 shares of C.
• Premium: This is the price of the options contract.
• Expiration: The final date at which the option can be exercised.
• Strike Price: Using the market price of the underlying asset, a key price level is determined. This is the strike price. At expiry, if the underlying share price has moved below the strike price, it is worthless on a call option. For a call, you want the underlying security to expire above the strike price. The opposite is true of a put option. With a put option, it is worthless if the underlying asset ends up with a price above the strike.

Remember that the buyer has control of the transaction. An options buyer can choose to exercise the option, or allow it to expire. Sellers, in most situations, can only wait for a buyer decision.

Options Trading Advantages

The main advantage to buying options is that you do not have to actually own the underlying asset in order to participate. When buying options you have leverage working on your side.  You can control 100 shares of an asset without having to pay the price to purchase them at market value.

As mentioned earlier, one of the benefits of buying an option is to hedge your risk against a big drop in the value of an asset that you own.

Options Trading Disadvantages

The main drawback to options trading is, as you might imagine, the potential for loss. If the option expires without being executed, you lose money. Unlike buying a share of stock, whose value is based on the underlying assets and performance of the company, an options value is based only on your right to buy.

Indeed, since you purchased the right to buy an asset at a specific price, if you don’t buy it, you are still out what you paid for the option. Also, if you are selling an option, and someone buys it, and the price has increased, you have no choice but to accept the lower price.

Options Trading Training

More online brokerages these days are offering the ability to trade options.  Before you begin, it is important to make sure you fully understand how option contracts work, as well the potential downsides. Hopefully this gave you a decent overview of why people buy and sell options and some of the advatages and risks.

Some options brokers offer extensive training on the basics of options as well as the various options trading strategies.  If you’re interested in pursuing options trading I suggest you go through some of this training to see if it’s a good fit for you.

Miranda writes about personal finance almost every day. An experienced freelance writer, she's covered your money online and in print from every angle and is always looking for new ones.

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