The Ins and Outs of Option Trading

By: Robert Thomson

Option trading is a popular form of day trading, used by amateurs and professionals alike to make quick money on the stock, currency and commodity markets. Unlike buying and selling in the present, options trading is a form of buying and selling based on anticipated future prices. When you buy an option, you gain the right to buy or sell a particular asset at a particular price within a certain timeline. Options may be as short-term as one hour and as long-term as ten years or more, though the standard term of an options trade is one month to one year.

Calls and Puts

Call and put options are used by traders who try to predict prices on the market. For instance, you might purchase an option to buy 100 shares of stock for $2000 in two months based on the stock's current price of $20 per share. However, if the stock rises in value to $30 per share in those two months, you will effectively be using your $2000 to buy $3000 worth of goods. This type of option trading is known as a "call," and it is a popular beginning option trade.

However, you have to be relatively sure that the asset will rise in value over the option trading period. If the abovementioned stock's value were to fall to $10 per share, you will still be forced to pay $2000 for 100 shares. You will effectively be using your $2000 to buy $1000 worth of goods, which is a bad deal.

You can also place options to sell. These are known as "puts," and the strategy is slightly different. Let's say you already own 100 shares of the stock worth $20 per share. You can place a put to sell that stock for $2000 in two months if you believe that it is going to decrease in value. If it does decrease to $10 per share, you will effectively be selling $1000 worth of goods for $2000 - a good deal for you! Conversely, if it increases, you will be out of luck.

Generally speaking, you will have to spend a relatively small premium per share to place a call or put order. The current price plus the premium is known as the strike price. Therefore, your goal is for stocks to reach a price that a) pays you for the time you spent researching and placing your order and b) is higher or lower than the strike price, depending on whether you are placing a call or a put.

Types of Option Trading

There are two main option trades: American and European.

American option trades may be exercised at any time during their working lives. This means that with a two month call option, you may buy at any time for the duration of the option. If the price hits a high point within those two months and you think it's going down, you may choose to exercise your option.

European option trades may only be exercised at the end of their working lives. For instance, if a two month call option hits a high point one month in, but then drops down to its initial value one month later, you will be forced to take the lower trade value.

There are also a number of different types of exotic options such as binary options, Asian options, barrier options and compound options. However, these are best used by highly experienced trainers. It is best to cut your teeth with basic options trading if you are a beginner or intermediate training.

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