Are you looking for a primer on options? If so, you’ve come to the right place. You can think of this as a sort of “options trading for dummies” article as we’ll go over the basics of options trading. We’re going to focus mostly on stock options trading. The basic ideas and principles explained here though can be used for other types of options trading too.
So What Is Options Trading?
Options are one of the more difficult financial instruments to explain. Once you get the hang of them though, the concept is actually pretty easy to understand. Before we get started, however, we should warn you that option trading is a high-risk, high-reward type of investment vehicle.
Anyways, option trading allows you to purchase the right to buy or sell a particular asset within a given time frame (or on a certain date) at a predetermined price. A call option gives you the right to buy a financial asset, whereas a put option will give you the right to sell a certain asset. You buy call options when you expect prices to go up, and put options when you expect prices to go down.
How Options Trading Works
Right now, option trading probably sounds a little confusing, so let’s use an example to illustrate. Let’s say you have $1,000 dollars. Right now, Acme Motors stocks are selling for $10 dollars. However, you are convinced that stock prices will rise in the near future. You’re very confident that stock prices will rise to $15 dollars within the next six months.
You could buy 100 shares of Acme Motors with your thousand dollars, or you could buy call options with a strike price of $10.00 dollars. These options will almost certainly cost much less per option than would stocks. Option prices will depend on outlook, volatility, and other things but they’ll most likely cost a few dollars, or even less than a dollar.
Let’s assume that options to buy Acme Motors at $10 dollars a share at some point within the next 3 months are selling for $1. Instead of buying 100 shares you decide to buy 1,000 options. Your insights turn out to be correct and over the following 3 months Acme Motor’s stock rises to $15 dollars per share.
If you have bought 100 shares you would have made $500 dollars off of your investment, which certainly counts as a good return. Instead, you bought options and made $5 dollars per option (because you were able to buy shares at $10 dollars due to the strike price, but current market prices for shares are $15 dollars). That means you would have made $5,000 dollars.
How’s that for returns?
Where There is Reward There is Risk
Making $5,000 dollars off of a thousand dollar investment is certainly a great return. In fact, it might even sound too good to be true. But here’s the thing with options: they are high risk investments. If you don’t exercise your option within the given time frame or on the specified date, you lose all of your money.
Stock options trading and every other type of options trading is a “go big or go home” type of ordeal. If you trade in options you stand to make a lot of money, but you could also end up losing all of the money you invested.
We hope our options primer answered the question of “what is option trading?”. Yes, the concept can be a bit confusing at first, but if you’re still having trouble just reread this article again and think on the concept a bit more. You’ll get the hang of it in no time!