How Option Trading Works

Option trading is one of the more advanced and in many ways confusing forms of financial investments. While trading options can be difficult to grasp for beginners, learning more about these financial instruments is important because it can generate a lot of profits. As with any type of investment, however, option trading carries risks with it.

Option trading is one of the more advanced types of trading, so you should be cautious when getting involved. Before you engage in such trading, make sure you have a good grasp of how it works and understand all of the terms. In fact, many investment websites now offer simulators that will let you practice with trading, including options, before you do the real thing. This is always a good idea, especially if you are new to specific type of investment.

Defining terms and understanding what they mean

Let’s look at the term more closely. There are two words, options and trading. Trading is pretty straight forward, you give one thing in exchange for another. In this case, you are trading money for options or vice versa. So what then are options? Options give you the option to buy a specific financial instrument at a specified price within a defined time period.

That’s a mouthful isn’t it? Like we’ve said, options can be a bit difficult to grasp. If you got it on the first pass, good for you. If not, no worries. Sometimes these financial terms can take a minute or two (or three, or four) to get a good grasp on. But practice makes perfect, and repeated effort can make anything seem clear.

An Option Trading Example

Let’s use an example to demonstrate how an option works. Let’s say you are convinced that Microsoft’s stock is going to rise over the next six months. You could just buy Microsoft’s stock but you only have a thousand dollars to invest. Even if Microsoft’s stocks rise substantially, you’ll only make a few hundred dollars, at most.

Instead of buying stocks, you could buy an option for Microsoft’s stock. Let’s say that Microsoft’s stock currently costs $50 dollars but the company is launching a new operating system and you are convinced that prices will rise to $60 dollars or more within the next six months. You could buy 20 Microsoft stocks with your $1,000 dollars, but even if your tuition turns out to be correct, you’d only make $200 dollars.

Or you could buy a “call” option that will give you the option of buying Microsoft’s price at $40 dollars (there are many different price valuations) within the next six months. The options cost only $2 dollars per share so you will be able to buy 500 of them. In six months, however, the option will expire and you will lose your right to buy the stocks. If you don’t exercise your option, you’d end up losing all of your money.

Your intuition turns out to be correct, however, and Microsoft’s stocks rise to $60 dollars. You can then settle the difference on your options, which would be $19 dollars per option. And $10 dollars times 500 options is a whopping $10,000 dollars! Not a bad return for a $1,000 dollar investment, right?

Of course, like we said, if prices don’t rise within 6 months, you’ll lose all of your money. So what’s that mean? It means high risk, high reward. So if you are considering trading options always keep that in mind.

It’s never a good idea to put all of your eggs in one basket, and especially a high risk basket. As such, we recommend that you diversify your portfolio. Make sure you have several types of assets and that not all of them are high risk.