April 19, 2011 10:19 pm

What Is Options Trading

 
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People who are learning about investing may think about stocks but may not know about options. Like stocks, options are used by investors to make a profit. What is options trading?

Though both stocks and options can be used by investors to make money based on the movement of the stock market, stocks and options are quite different. Stocks have value as shares of the company.
Stockholders have rights associated with stock ownership like the ability to vote in shareholder meetings. Options do not convey any such rights.

The value of an option is based on the underlying asset or security and the time left on the option. As the option nears its expiration date, the value of the option based on time decreases.

The volatility of the underlying security is considered to increase the value of the option. The more volatile the stock is, the more likely the stock option may move in-the-money and therefore be valuable to the buyer.

Like stocks, investing in options can be risky. Someone new to options may want to make use of educational tools that teach how to trade options. Some options trading strategies carry more risk than others. New investors may want to use options strategies with limited risk of loss.

When trading options, the investor either buys or sells an option. The option quote must be multiplied by one hundred since one option is based on one hundred shares of the stock or other underlying security. Calls and puts are the two types of options that are traded.

It may be easier to think of an option like a contract. A call gives the buyer of the call the right to purchase the underlying security at the strike price included in the option.

A put option gives the buyer of the put the right to sell the underlying security at the strike price. If a buyer chooses to exercise a call or put option, the buyer must do so before the option’s expiration date.

The buyer of the option is given the right to act on the option but is not required to do so. If the buyer chooses to exercise the option, the option exchange assigns the option to one of the brokerage firms that had investors sell that option.

The broker then assigns the option to one of the investors who sold that option. These assignments of the option are usually done randomly by both the option exchange and the broker though the broker may use a first in, first out method of assignment.

If the seller of the option is assigned, the seller must comply with the terms of the option. If the option is a call option, the seller must allow the buyer to purchase the underlying security at the strike price. If it’s a put option, the seller must buy the underlying security from the buyer at the strike price.

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Disclaimer: The risk of loss in trading any financial vehicles such as securities, options, futures and forex can be substantial. Members must consider all relevant risk factors, including their own individual financial situation, before going into trading. Options involve risk (as in trading with any other channels) and are not suitable for all investors. See Characteristics and Risks of Standardized Options. Past results of any individual trader or trading system published by us are not indicative of future returns by that trader or system, and are not indicative of guaranteed future returns which may be realized by members.

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