An option is a contract giving the investor the right to buy or sell an underlying security at a specific price on or before a specified date. The investor enjoys the right to exercise the option contract to obtain or liquidate the underlying asset but is not obligated to do so. As a matter of fact, most options are not exercised, but instead do expire worthless. The option is a binding contract with strictly predetermined terms of agreement and properties. Options are also known as derivatives, which means an option derives its value from something else. As an example, if you buy 1 contract of an IBM July 100 call, the value of the contract is partly based on its derived value from the underlying stock (i.e. in this case, it is IBM)
Options are very versatile securities that can be used in a number of different ways. Options can be used by traders as a speculative vehicle in betting on the direction of a stock, or traders can use options to hedge against loss of a stock price. In terms of speculation, the trader either buys or sells options depending on his/her believe of whether a stock will go up or down, respectively. So speculation is nothing more than betting on the direction of a stock. Using options as speculative vehicle is the reason why options have the reputation of being risky. This is because when an option is bought, the trader has already bet that the price of the stock is either going to go up ( in terms of buying a call option ), or the price will move lower ( in terms of buying a put option ). Also, the magnitude and the timing of the stock's price movement are also critical components of options trading. To succeed, the option trader must correctly predict whether a stock will move higher or lower and the trader must also be correct in terms of how much the price will change, as well as the time frame it will take for all of this to occur.
Options can also be used as a hedge to protect the investor from losing all of the value in the underlying stock. Hedging can be interpreted as an insurance policy against catastrophic events.
There are two main types of options: the American options and the European options. The American options can be exercised at any time between the date of purchase and the expiration date. Most exchange traded options belong to this type. The European version of options only allows the trader to exercise the options on the date of expiration. Options can also be characterized as short-term options or long term options. The long term options are also called LEAPS, which stands for "Long-Term Equity Anticipation Securities". While short-term options have expiration within one to 9-months, LEAPS are defined as those options that have hold dates for as long as one year to several years. Whether a trader participates in trading LEAPS or short-term options, or makes transactions using the American or European versions of options, the basic building blocks of options are the call and the put options. A call option allows the holder of the call to buy the underlying security at the predefined price within a specific period of time. For instance, an IBM July 100 call indicates that the holder can buy the IBM shares at $100 per share on or before the July expiration date ( which is typically, the third Friday in the specified month ). A put option allows the holder to sell the underlying security at the predetermined price within a specific period of time.
For an in-depth study on options and option related information, visit the
Options Industry Council
For an in-depth practical guide to learning how to trade options, visit the
tradingtrainer.com
options mentoring program.
For information on advanced options trading techniques, visit the
onlineoption.com website.
Readers may also be interested in the options trading advisory service
offered by MarketNeutralOptions.com.