Understanding options trading – what sophisticated investors should know

The world of financial investments has so much to offer. The choices are as extensive and as lucrative as the investors’ appetite for risk. But there’s one financial instrument that is never missing in every sophisticated investor’s portfolio – Options.

All sophisticated investors started the same way – by having the guts for risk and by understanding options trading. Learning the basic terms is a step towards advancing yourself as an investor. The risks may be overwhelming, but they can be managed with proper financial knowledge.

 

To gain an understanding of options trading, knowledge of the following points is vital:

 

  1. Option contracts

An option is a contract that gives its owner the right, but not an obligation, to specifically buy or sell the underlying security at a specific price and within a specific period.

An option contract is tradable and it derives its value from the underlying security such as a stock, index, commodity, or currency. An option contract can either be a call or a put.

understanding options trading
understanding options trading

 

 

 

  1. Buyer of Call or Put contracts

A buyer can either have a call (a right, but not an obligation, to buy) or a put (a right, but not an obligation, to sell) contract.

An example of a call option contract is this, “Call ABC Co. $33 100 shares November.” A buyer of this contract earns the right to buy 100 shares of ABC Co. on or before the expiration in November.

Likewise, if a put option contract says, “Put ABC Co. $33 100 shares November.” A buyer of this contract earns the right to sell 100 shares of ABC Co. on or before the expiration in November.

If the stock is trading in the market at a price higher or lower than $33, which is the price in the contract (or the strike price), this would signal an opportunity to either profit or lose for the buyer who has the right to buy (call contract) or sell (put contract) 100 shares of ABC Co.

 

  1. Seller of Call or Put contracts

A seller, also known as the option writer, earns the price of an option contract but receives no right to exercise it. A seller is only obliged to buy the security (put contract) or to sell the security (call contract) once the right of the owner is exercised.

 

  1. Premium

Premium is the price of an option contract. It is this amount multiplied by the number of shares, which represents what the buyer pays and the amount the seller receives. A premium fluctuates depending on the price movement of the underlying security, the rate of price volatility, the period before expiration, market conditions, and dividends, among others.

 

  1. Exercise, Trade, or Expire

It is primarily the buyer that moves the option trading with its choice on whether to exercise the contract (buy or sell), to trade it or to let it expire.

These choices are bound by how favorable the price of the underlying security in the market is compared to the strike price. The contract is exercised if the strike price is “In-the-money” or the call contract strike price is lower than the market. The contract can also be exercised even if its “Out-of-the-money”, as in the strike price is higher than the market, if the holder owns a put contract.

If the conditions don’t seem favorable to the buyer, there’s an option to trade the contract (to close the transaction) or allow it to expire (not do anything).

Trading options can help your portfolio in many ways. It allows you to leverage your investment by buying a “right” in an option contract instead of buying the actual security in the market. It limits the possibility of loss while offering unlimited gain. It can be used to hedge a position, protect your profit, or even cut a loss.

 

This flexibility is what makes options an inviting investment. And there’s so much more that can be gained by understanding options trading. Don’t allow the limits of your financial knowledge limit your investment options. A good return can be earned given the right understanding that sophisticated investors themselves have learned first before trading options.