Options Trading in a Nutshell: The General Idea behind Options Trading

by Tatya H.P.

Perhaps among the most complicated and possibly the riskiest type of trading is option trading. Most seasoned traders realize that option trading does not suit all traders. It selects its own type of people, usually the risk takers. And the trade itself requires skills and thinking unique only to people who could handle extreme risks. Most experts recommend this type of trading only to those people who have sufficient risk capital as it carries with it substantial risks.

By nature, it is also speculative. So if you are a person who doesn’t want to speculate too much, you might as well find another type of security which will work best for you. However, rejecting the idea of entering this trade right away is as risky as not knowing anything about it. It carries with it risks, that's true, but it is also a highly profitable venture. You might as well try to learn something on it such that you could decide whether to try you luck on options trading or not.

While it is inherently risky, option trading also offers advantages that may not be had with other types of trades. Among its premium advantages is the flexibility it lends its investors. Each lender has the option to trade at a specific price within a predetermined period.

It is also, by comparison, a more advantageous type of trade because of the high leverage it offers. Depending on the location, each option may cover a number of underlying assets. In the United States, for example, each option may represent for 100 underlying assets. Thus, this principle lends the holder the capacity to profit from several assets within a single option.

So what is an option?

An option is a type of security, perhaps closely comparable to bonds and stocks. It is, in itself, a binding contract, that is monitored by and through strict terms and conditions. In gist, options are contracts that owners could buy or sell at a certain price prior to or on a specific date. An option is typically an added price tag to a certain asset or item because it is a reservation for the purchase or sale of a certain asset.

Options are also sometimes called derivatives. This is due to the fact that the value of an option is derived from the value of the underlying asset.

To give light on this topic, consider the example below:

Say you have considered buying a real estate property which is worth several hundred thousand dollars. However, when you first negotiated with the owner, you did not have sufficient money to purchase the property right there and then. So you made a deal with the owner to pay an extra $5, 000 to reserve the deal for you for the duration of two months. The extra money you put in is called the options. In case you don’t want to pursue with the sale, the owner of the real estate can neither force you to buy the property nor can the law impose the sale on you. However, you would still have to pay the price of the option.

In summary, when considering buying a property with an enclosed option, you will have the right to pursue with the sale or to turn down the sale. You are not obligated to do either of the two. However, you may lose 100% of your total investment in options trading which is the value of the option itself.