Understanding the Basics of Options Trading

Understanding the Basics of Options Trading

Options are flexible financial instrument. But they can also be risky and complicated. Apart from losing your entire investment, a number of strategies can expose you to unlimited loses. That is why you have to understand some basics and strategies for options that are appropriate for beginners.

What is an Option

Options are contacts that give the owner the right to purchase or sell an asset at a fixed price for a certain time period. This period could one day to two years, depending upon the option. The option contract’s seller is obligated to take the opposite side of the trade if and when the owner exercises the right to purchase or sell the underlying asset.

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Knowing the Options Lingo

Options trading can be a bit jargon-y so consider getting your definitions straight. Below are some of the terms that you will come across within the options field.

  • Puts and Calls. Standard options can be call options and put options. It is necessary to understand the difference between these to get started. For every call contract you purchase, you can buy 100 shares of a certain security at a particular price within a certain time frame. Meanwhile, for every put contract you purchase, you can sell 100 shares of a certain security at a specific price within a particular time frame.

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  • Long vs Short- In the money world, long does not have to do with the amount of time or distance you hang into security. Rather, it implies that own something. When you purchased a stock or a call or put, you are long in your account. Also, you can be short in your account. Thus, you have sold a stock or option without owning it.
  • Strike price. This is the pre-agreed price per share that stock is likely to be purchased or sold under an option contract’s terms. For a number of traders, this is the exercise price.

Understanding Volatility

  • Historical volatility-This is the amount of stock price that fluctuated over a period of one year. The figure refers to the past price data.
  • Implied volatility- This is determined through the use of an option pricing models. So even if the marketplace is likely to make use of implied volatility to expect a stock’s volatility in the future, there is no guarantee this projection is correct.

In case there will be a court decision or earnings announcement coming up, traders are expected to change trading patterns on some options. This drives options price down or up, independent of the movement of the stock price. The implied volatility is obtained from the options’ cost. Consider an options trading newsletter to learn more about this.

Speaking a Bit Greek

  • Delta-This is the amount an option moves based upon a dollar change in the underlying stock. In theory, when an option has .50 delta, when the stock moves $1, then the option must move about 50 cents.

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  • Theta-This refers to the measure of time decay or the amount the price of an option changes.
  • Vega- This is the amount of the price of an option will change in theory for a one-point change of the option contract’s implied volatility. 

Author Bio – Kim Klaiman is a full time options trader. He offers options trading newsletter to his avid readers.

Categories: Invest

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