An Introduction to Options Trading

Option trading is a way of trading which is speculative in nature and has a risk of element involved. An option can be defined as a contract under which the buyer has the right but not any obligation to buy or sell an underlying asset which could be stock, indices or currencies, at a specific predetermined price on or before a certain fixed date. An option is considered a security just like a stock or bond. The terms and properties under the trading options contract are properly defined and are binding.

Versatility is the power of options trading. Through this form of trading, the trader can adjust his position as per the situation. One can be as speculative or as conservative with options trading. This denotes that a trader can successfully protect his position from declining to bet on the movement of the index or the market to make a profit. However the versatility is not without costs. There is a certain element of risk involved and as these are complex securities care is to be taken .

Advantages of option trading

1. Cost effective: by trading options, a trader has great leveraging powers. This means that although the situation of holding a position can be similar to holding stocks, but in options trading the investment is far less. However this cost effectiveness depends on the careful selection of the right call option.

2. Less risk: at times an option trading is riskier than equity trading but at other times, it’s less risky than other forms of trading. It all really depends on how a trader puts his trade using the options. As options trading require lesser finance for trading, they are less risky for investors. Again options trading is the best strategy where hedging is concerned. In a similar situation with stocks, the trader has to put in a stop loss order which means that the stock is trading below the limit as indicated by the stop loss order.

3. Higher potential returns: trading options offers a high return to investors on their investments. If the trader makes the right selection in the option trading he may be able to generate returns on his investments to the tune of nearly 60 to 70%. Whereas on the other hand, even if the stock selection is correct, a trader may at the most make 10 to 15% returns. However one thing is to be remembered here and that is that if a trading option can give a high return of 60 to 70% in case of the proper selection, an improper selection can lead to a loss of the same amount. So the returns are good only if you are prepared to take calculated risks.

4. Strategic alternatives: provides more investment alternatives. Options can be used in various ways to make other positions which are called synthetics. This requires careful planning and good execution. Traders can use options to trade not only stock movements but also movements in the volatility and passage of time. Thus options trading provide strategic alternatives that can be used in every type of market to reap profits.

Thus with these advantages trading options market has become the center of attention in the financial circuit. Again with the introduction of online trading, the online brokerage houses and firms provide direct access to the options market. This has aided the investor highly as now he can use this powerful tool of the investment industry and trade like the professional do. Another advantage while trading online is the comfort of trading from the home and that too at unbelievable low commission costs. So it is a must for every trader to learn the working of the options carefully.

Option trading requires the knowledge of a few terms that are typical to its trading.

Strike price: this is the price at which the underlying stock or asset is purchased or sold. Again for a calls option, the stock price should go above this price and for a put option the stock price should be below the strike price to exercise a profit.

Expiration date: the pre determined date after which the changes in the strike price would not be considered for a given option.

In-the-money: if the stock price for a call option is above the strike price, the contract is considered in the money and for a put option the stock price should be below the strike price.

Types of options

Basically there are two types of options: calls and puts.

Call: just like having a long position on a stock, the call gives the buyer the right to buy the underlying asset at a certain pre determined price within a defined period of time.

Put: opposite to calls, the put gives the holder the right to sell the asset held at a certain pre determined price within a defined or specific period of time. Having a short position in a stock is similar to having puts.

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