Option trading demystified

You can enter the stock market with a minimum of investment and still get a bigger return on your investment if you go in for option trading. In option trading you pay a premium to give you the right to buy or sell some shares in the future. You can then buy or sell those shares within the time specified at the price decided. You are obliged to make the purchase or sale within the specified time or risk the forfeiture of the premium paid.

During that time you are free to complete the purchase or sale at the price decided initially. If you do not honor the contract the premium that you pay can be lost. Time period in option trading contracts are generally about a month and are settled at dates that are fixed by the stock exchanges that could be the third Saturday of the month. Once this period is over, as an option trader you have lost all rights to make the trade and your premium remains forfeit.

A broader look at option trading

Stock trading and option trading are quite dissimilar. Understand the ideas and the terms behind option trading if you choose that as the way to trade in the stock market. The words used are quite specific and may sound like Greek and Latin to the newcomer. As on option trader, you would have the right to buy or sell a particular stock in the volume agreed on at a fixed price, as long as you execute the trade within the time that has been specified.

The option trader who buys options has no obligation to act whatsoever, and is only obligated to pay the premium to buy the option in the first place. He retains the right to exercise his options in the future, should the opportunity arise and should he wish to do so. The option “exercise price” locks in the specified price at which the underlying stock can be bought or sold for the lifetime of the option. If you are the owner of a call option, giving you the right to buy stock at the exercise price, and the stock price rises above the exercise price during the lifetime of your call option, you can exercise your option to acquire the stock at that exercise price instead of the prevailing price in the market, which may be far higher. In other words, you are buying stock cheaper than the market value.

The stock price may drop or just remain lower the exercise price, the buyer of call option cannot use at all, but can also sell the option and in that way exit the position at a loss or breakeven. Instead, he can hold onto it with the hope that there will be rise in the option of the market value, by depending upon factors such as volatility, expiry time and much more.

When you know what you are doing, there are also far more trading opportunities with relatively lower risk compared to merely buying or selling the underlying. Usually, the options of leverage can control a bulk amount of the original stock for relatively small capital expenditure compared with buying or selling the underlying tool. This makes options more attractive because there exists higher profits on investment than just trading the original instrument.

Terminology

When you opt for option trading you trade in blocks of 100 shares.

The option giving the right to buy the underlying instrument at the strike price is called the “call” option.

Put option: The option giving the right to sell the underlying instrument at the strike price

The price that you agree to when the option trading contract is made is called the strike price.

In the money: When the strike price is below the existing price of the stock and you exercise a call option, and when the strike price is above the existing price of the stock and you exercise a put option.

You are considered to be “out of the money” if your strike price is more than the existing price at the time of the option and you put in a call option, or you put in a put option and the strike price is lower than the existing price.