An Introduction to Trading Options
The world of options is an exciting one. Unfortunately, many stock market traders and investors miss out on trading options because they do not understand how they work. It is understandable. When someone explains options to you for the first time, you might shake your head and decide to stick with mutual funds. But like anything worth knowing, once you do the investigation, the reward far outweighs the effort.
So in an attempt to help people better understand options, we will present a series of articles starting from the beginning and covering many topics related to trading options. So check back regularly.
So to get started, what are options? The official definition of an option might go something like this:
The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time.
Wow, well that helps a lot. Okay, let's try to break that down into simpler terms. First, let's take the part about a given stock, commodity, currency, index, or debt. Let's simplify that by saying that we have the ability to buy and sell options for many things. You can buy an option for a stock such as IBM, a commodity such as gold, a currency such as the U.S. dollar, an index such as the S&P 500, or debt such as a bond. So for the purpose of finishing our description of an option, we will use...your car!
Next, "during a specific period of time". Let's describe this part by saying that options are contracts that expire. For example, say you told me that I could buy your car from you for the next two weeks at $500. If I wait longer than two weeks, well, I might have to pay more. So we have a contract that expires in two weeks. Simply enough, that contract I just described is an option! It is the option to buy your car from you at $500 for the next two weeks.
Said another way, I have the right, but not the obligation, to buy your car from you for the next two weeks. So why the right, but not the obligation? We signed a contract. That gives me the right to buy your car at $500. But If I choose not to, it is okay. I may have to pay more after two weeks, but I can also choose not to buy it at all.
An option is the right, but not the obligation, to buy something at a specific price for a specific amount of time. That "something" is called the underlying. Now you might ask yourself, "Why would I want to give you the right to buy my car at $500 for the next two weeks, if someone might come along and offer me $1000?". The answer, because I pay you! That is why it is called "buying the option". What I get out of buying that option is that I control that car for the next two weeks! I can find a buyer for $1000, buy it from you for $500, and sell it for a profit immediately.
In summary, an option is a contract to buy an underlying at a price for a certain amount of time. As you continue on in your options education, you can look into services that help you trade options such as http://www.5percentperweek.com. Until next time when we take another step into the realm of options, take care!
An Introduction to Trading Options
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