The Fundamentals of Options Trading:
Options are a type of derivative security, meaning their price is directly linked to the price of an underlying security (typically a stock or index). In options trading, there are two basic types of contracts known as Calls and Puts. Calls increase in value as the price of the underlying goes up and decrease in value as the price of the underlying goes down. Puts are just the opposite. They decrease in value as the underlying goes up and increase in value as it goes down. 1 option contract is typically equal to 100 shares of the underlying stock or index. The total cost of an option contract, also known as the Premium, is based on the underlying security price, Strike Price, Expiration Date, and volatility. The most you can lose when buying a call or put option is the premium spent. It’s important to note that traders can also sell calls and puts, but we won’t dive too deep into that right now for the sake of simplicity. Option buyers are often referred to as holders and option sellers are often referred to as writers.
One of the main reasons traders are attracted to options is for the versatility. In short, options give you options. You can choose from a large number of underlying securities, strike prices, premiums, etc. They can also provide quite a bit of leverage. For example, stocks trading at $100-200 per share could potentially have options available at only a few dollars or less. So instead of buying 100 shares of the stock for $12,500, you can buy just 1 contract for a $100 premium and essentially control 100 shares of the stock. In buying the stock you have $12,500 at risk, but only $100 with the option. The option also has the capability of delivering a much higher percentage return based on the price movements of the underlying stock. A mere 1% move in the stock can potentially equal a 5, 10, 20 or 50%+ move in the price of the option depending on the Delta, or rate of change, associated with that particular option. One of the major obstacles options traders have to contend with, however, is time decay since options are Wasting-Assets. Overall, the direction, timing, and magnitude of the movement in the underlying security are critical in options trading.
Related Post: What is Compound Interest? The Eighth Wonder of the World
Leave a Reply