Trading Options

Options are contracts that allow a person to buy or sell stock at a certain price. Although they are similar in nature to stocks, they tend to be more volatile than stocks and also carry an expiration date. The option establishes a specific price called the strike price at which the contract is carried out. Used to control certain amounts of shares in a stock, options trading can be one of the biggest earners of your portfolio if played well. Options are of two types – calls and puts. They serve to play different roles in different portfolios and depending on your intended goal, there are diverse options strategies to choose from.

Call – A call option allows a person to buy a number of shares of stock at a given strike price. Mostly, we never exercise the right to buy the stock, just trade in it. When you buy a call, you are predicting that the stock will go up and the option will rise.

Put – Put is the opposite of a call. Here you are betting that the stock will go down and thus the put increases in value if the stock goes down.

Once you have decided that you are ready to invest in options trading your first step would be to find a brokerage firm. A good brokerage firm will offer personalized service, advice on financial planning and risks and benefits of various transactions as well as execute trades. Based on the information you provide in the options agreement and your eligibility for risk, your brokerage firm will approve you for a specific level of options trading. With the advent of the Internet, online option trading has also become possible and convenient.

The next step is documentation. You need to fill out an options agreement form, the information on which brokerage firms use, to measure your knowledge of options and trading strategies, as well as your general investing experience. Also ensure that you have read the document titled ‘Characteristics and Risks of Standardized Options’, which your firm will distribute to all its customers, thoroughly.

Pricing of a trading option is based on these following criteria:

The price of the stock - A call will be more expensive to buy as the stock rises.

Volatility - Again if there is great fluctuation in price, the option becomes more expensive to buy.

The strike price – If the call’s strike price is increased, the price of the option will increase.

Expiration – It is an essential element as people will pay more for the option several months before its expiration and less as the time draws near.

Demand and Supply – The price of the stock is affected by the amount of people buying or selling it. If a large number of people buy a certain option, it will raise its price and vice versa.

The premium is the buying or selling price of an option. The premium is a flexible charge and changes constantly. This change reflects the give and take between what the buyers are willing to pay and what the sellers are willing to accept for the option. The point at which the trade is agreed upon becomes the price of that particular transaction.

Buying and Selling options - The worth of a particular options contract to a buyer or seller is measured by how likely it is to meet their expectations. A call option is in-the-money if the current market value of the underlying stock is above the exercise price of the option, and out-of-the-money if the stock is below the exercise price. A put option is in-the-money if the current market value of the underlying stock is below the exercise price and out-of-the-money if it is above it. If an option is not in-the-money at expiration, the option will become worthless.

Benefits and Risks – Most strategies used by options investors have limited risk leading to limited profit potential. Even those using speculative strategies do not have significant returns. The potential profit is limited to the premium received for the contract, and the potential loss is often unlimited. By leveraging your transactions, you could get higher returns, but the cash component may remain smaller than a similar stock options transaction. However, option trading remains the most flexible of investment choices and depending on the contract and strategies used, it can enhance the portfolio in any kind of market.

Reducing Risks – Options trading remains a tool for risk management as it acts like an insurance policy if prices should fall. For example if an investor fears a fall in price of a certain stock, all he has to do is purchase puts allowing him to sell the stock at the strike price, even in a falling market. At the cost of the option's premium, the investor has insured himself against losses below the strike price. This type of option practice is also known as hedging. Many options strategies are made to minimize risk by hedging existing portfolios. Although option trading is safe, it is not without risks. Since transactions usually open and close in the short term, the likelihood of both, huge gains and losses is possible. It's important to understand all the risks with options before you include them in your investment portfolio.