Options trading meaning

What is Options Trading?

When most people think of investment, they think of buying stocks on the stock market, and many are probably completely unaware of terms like options trading. Buying stocks and holding on to them with a view to making long term gains is after all, one of the more common investment strategies. It's also a perfectly sensible to way invest, providing you have some idea about which stocks you should be buying or use a broker that can offer you advice and guidance on such matters.

This approach is known as a buy and hold strategy and can help you increase your wealth in the long run, but it doesn’t provide much, if anything, in the way of short term gains. These days, many investors are choosing to use a more active investment style in order to try and make more immediate returns.

Thanks to the range of online brokers that enable investors to make transactions on the stock exchanges with just a few clicks of their mouse, it's relatively straightforward for investors to be more active if they wish to. There are many people that trade online on either a part time or a full time basis; buying and selling regularly to try and take advantage of shorter term price fluctuations and often holding on to their purchases for just a few weeks or days, or even just a couple of hours.

There are plenty of financial instruments that can be actively traded. Options, in particular have proved to be very popular among traders and options trading is becoming more and more common. On this page we have provided some useful information on what is involved in options trading and how it works.

What Does Options Trading Involve?

In very simple terms options trading involves buying and selling options contracts on the public exchanges and, broadly speaking, it's very similar to stock trading. Whereas stock traders aim to make profits through buying stocks and selling them at a higher price, options traders can make profits through buying options contracts and selling them at a higher price. Also, in the same way that stock traders can take a short position on stock that they believe will go down in value, options traders can do the same with options contracts.

In practice however, this form of trading is far more versatile than stock trading. For one thing, the fact that options contracts can be based on wide variety of underlying securities means that there is plenty of scope when it comes to deciding how and where to invest. Traders can use options to speculate on the price movement of individual stocks, indices, foreign currencies, and commodities among other things and this obviously presents far more opportunities for potential profits.

The real versatility, though, is in the various options types that can be traded and the range of different orders that can be placed.

When trading stocks you basically have two main ways of making money, through taking either a long position or a short position on a specific stock. If you expected a particular stock to go up in value, then you would take a long position by buying that stock with a view to selling it later at a higher price. If you expected a particular stock to go down in value, then you would take a short position by short selling that stock with a hope to buying it back later at a lower price.

In options trading, there's more choice in the way trades can be executed and many more ways to make money.

It should be made clear that options trading is a much more complicated subject than stock trading and the whole concept of what is involved can seem very daunting to beginners. There is certainly a lot you should learn before you actually get started and invest your money. With that being said, however, most of the fundamentals aren't actually that difficult to comprehend. Once you have grasped the basics, it becomes much easier to understand exactly what options trading is all about.

Below we explain in more detail all the various processes involved.

Buying Options.

Buying an options contract is in practice no different to buying stock. You are basically taking a long position on that option, expecting it to go up in value. You can buy options contracts by simply choosing exactly what you wish to buy and how many, and then placing a buy to open order with a broker. This order was named as such because you are opening a position through buying options.

If your options do go up in value, then you can either sell them or exercise your option depending on what suits you best. We provide more information on selling and exercising options later.

One of the big advantages of options contracts is that you can buy them in situations when you expect the underlying asset to go up in value and also in situations when you expect the underlying asset to go down.

If you were expecting an underlying asset to go up in value, then you would buy call options, which gives you the right to buy the underlying asset at a fixed price. If you were expecting an underlying asset to go down in value, then you would buy put options, which gives you the right to sell the underlying asset at a fixed price. This is just one example of the flexibility on these contracts; there are several more.

If you have previously opened a short position on options contracts by writing them, then you can also buy those contracts back to close that position. To close a position by buying contracts you would place a buy to close order with your broker.

Selling & Writing Options.

There are basically two ways in which you can sell options contracts. First, if you have previously bought contracts and wish to realize your profits, or cut your losses, then you would sell them by placing a sell to close order. The order is named as such because you are closing your position by selling options contracts.

You would usually use that order if the options you owned had gone up in value and you wanted to take your profits at that point, or if the options you owned had fallen in value and you wanted to exit your position before incurring any other losses.

The other way you can sell options is by opening a short position and short selling them. This is also known as writing options, because the process actually involves you writing new contracts to be sold in the market. When you do this you are taking on the obligation in the contract i. e. if the holder chooses to exercise their option then you would have to sell them the underlying security at the strike price (if a call option) or buy the underlying security from them at the strike price (if a put option).

Writing options is done by using the sell to open order, and you would receive a payment at the time of placing such an order. This is generally riskier than trading through buying and then selling, but there are profits to be made if you know what you are doing. You would usually place such an order if you believed the relevant underlying security would not move in such a way that the holder would be able to exercise their option for a profit.

For example, if you believed that a particular stock was going to either remain static or fall in value, then you could choose to write and sell call options based on that stock. You would be liable to potential losses if the stock did go up in value, but if it failed to do so by the time the options expired you would keep the payment you received for writing them.

Exercising Options.

Options traders tend to make their profits through the buying, selling, and writing of options rather than ever actually exercising them. However, depending on the strategies you are using and the reasons you have bought certain contracts, there may be occasions when you choose to exercise your options to buy or sell the underlying security.

The simple fact that you can potentially make money out of exercising as well as buying and selling them further serves to illustrate just how much flexibility and versatility this form of trading offers.

Options Spreads.

What really makes trading options such an interesting way to invest is the ability to create options spreads. You can certainly make money trading by buying options and then selling them if you make a profit, but it's the spreads that are the seriously powerful tools in trading. A spread is quite simply when you enter a position on two or more options contracts based on the same underlying security; for example, buying options on a specific stock and also writing contracts on the same stock.

There are many different types of spreads that you can create, and they can be used for many different reasons. Most commonly, they are used to either limit the risk involved with taking a position or reducing the financial outlay required with taking a position. Most options trading strategies involve the use of spreads. Some strategies can be very complicated, but there are also a number of fairly basic strategies that are easy to understand.

You can read more about all the different types of spreads here.

Benefits of Trading Options.

There are actually a number of benefits this form of trading offers, plus the versatility that we have referred to above. It's continuing to grow in popularity, not just with professional traders but also with more casual traders as well. To find out just what it is that makes it so appealing, please read the next page in this section – Why Trade Options?

Options Defined.

Options are contracts through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.

Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products. Stock options contracts are for 100 shares of the underlying stock - an exception would be when there are adjustments for stock splits or mergers.

Options are traded on securities marketplaces among institutional investors, individual investors, and professional traders and trades can be for one contract or for many. Fractional contracts are not traded.

An option contract is defined by the following elements: type (Put or Call), underlying security, unit of trade (number of shares), strike price and expiration date.

Options Symbology.

All option contracts that are of the same type and style and cover the same underlying security are referred to as a class of options. All options of the same class that also have the same unit of trade at the same strike price and expiration date are referred to as an option series.

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Option.

What is an 'Option'

An option is a financial derivative that represents a contract sold by one party (the option writer) to another party (the option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

BREAKING DOWN 'Option'

Call Option.

Call options give the option to buy at certain price, so the buyer would want the stock to go up. Conversely, the option writer needs to provide the underlying shares in the event that the stock's market price exceeds the strike due to the contractual obligation. An option writer who sells a call option believes that the underlying stock's price will drop relative to the option's strike price during the life of the option, as that is how he will reap maximum profit.

This is exactly the opposite outlook of the option buyer. The buyer believes that the underlying stock will rise; if this happens, the buyer will be able to acquire the stock for a lower price and then sell it for a profit. However, if the underlying stock does not close above the strike price on the expiration date, the option buyer would lose the premium paid for the call option.

Put Option.

Put options give the option to sell at a certain price, so the buyer would want the stock to go down. The opposite is true for put option writers. For example, a put option buyer is bearish on the underlying stock and believes its market price will fall below the specified strike price on or before a specified date. On the other hand, an option writer who shorts a put option believes the underlying stock's price will increase about a specified price on or before the expiration date.

If the underlying stock's price closes above the specified strike price on the expiration date, the put option writer's maximum profit is achieved. Conversely, a put option holder would only benefit from a fall in the underlying stock's price below the strike price. If the underlying stock's price falls below the strike price, the put option writer is obligated to purchase shares of the underlying stock at the strike price.

Option Trading Definition.

Option trading is one of the fastest growing areas in the financial industry. The option exchanges have consistently reported record option trading activity year-after-year. Speculators leverage stock positions by trading options while investors hedge risk through option trading.

When you purchase a call option on a stock you have the right to buy shares at a specified price (the strike price) within a specified period of time (expiration date). When you purchase a put option, you have the right to sell shares at a specified price (the strike price) within a specified period of time (expiration date). The key concept is that you have the right, but not the obligation to take action. Some options expire worthless while others are exercised. However, the vast majority of option contracts are traded.

As the price of the stock fluctuates, the bid/ask of the option changes. There is a pricing relationship between the stock and the option. Market Makers use sophisticated auto-quote systems to dynamically update the bid/ask. Serious option trading requires real-time quotes and split second executions. They are available through most online brokerage firms. Longer-term option trading can be attempted using delayed quotes.

Options are a derivative of the underlying stock and the pricing concepts and strategies are complex. Before you attempt option trading, you should know option trading definitions. I divide them into 3 categories.

Basic Option Trading Definitions - call, put, strike price, expiration date, exercise, assignment, contract, bid, ask, premium, intrinsic value, time decay.

Strategic Option Trading Definitions - long, short, premium buying, spread, debit spread, credit spread, margin requirement, breakeven, diagonal spread, condor, back spread, butterfly, naked, covered call, strangle, straddle.

Advanced Option Trading Definitions - implied volatility, delta, gamma, vega, theta, rho, Black-Scholes pricing model.

Categories.

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