What Is Options Trading?
Table of Contents
What Is Options Trading?
A savvy investor looks much further than Forex, stocks (including penny stocks), bonds, real estate and even mutual funds.
Now-a-days, more and more people are now looking at options trading as a way to earn some quick cash in very little time.
If you are willing to take calculated and EDUCATED risks, options trading presents an unlimited number of potentially lucrative opportunities. However, you have to understand that options are incredibly complex securities and hence they can be quite risky.
Often, options trades are accompanied by disclaimers such as – “only invest risk capital as options can be speculative in nature”. Well, the best thing about options is their amazing versatility and truth be told, options trading can be as speculative or as conservative as you want it to be. The only differentiating factor between other trades and options is the finality of the result.
For example: If you are trading a commodity such as gold or silver, you remain in possession of the commodity until you decide to sell it.
If the price falls down, you can wait till it rises again and still make a profit or sell at a loss and recover at least a part of your initial investment.
However, with options – things are radically different.
Take this for example: You bet on whether the price of gold will rise or fall within a certain (usually short) time frame. If you win the bet, you make money. If you do not – you lose your capital investment!
Yes, the risks are high but so is the reward. Of course, this is just one random example (of a binary option) out of a million different possibilities. Other examples are discussed further in the article.
The above mentioned example clearly elucidates that options trading can be extremely high risk! However, it is risky ONLY if you do not know what you are doing! If you understand the intricacies of the trade, you can actually make truckloads of cash in a matter of days or even hours!
Many people will tell you to avoid options trades altogether – these are the people who ventured into options without doing their homework. No wonder they failed miserably!
Note that not knowing about a certain type of investment makes you a weak investor. Sure, options are risky but so are many other things – like driving. Does that mean that you will sit at home and avoid traveling and/or driving altogether?
No, it means that you will learn all there is to know about driving and then use that knowledge to become a safe driver. Similarly, if you take time to learn about options trading – you can reap tremendous monetary benefits. You can practice with virtual money until you grow confident and begin winning consistently. Even if you do not invest in options, you should still take the time to learn about them. This will help you to gain an insight into the workings of major global corporations – you will be attuned to the thoughts of world leaders and CEOs. You will grow as an individual and become a smarter and wealthier individual.
Some basic topics about options trading are discussed below. Do not expect to become an expert immediately after reading this article. Just like any other field, it takes years of experience to become an expert in options. However, the information below will definitely get you started – ON THE RIGHT TRACK!
What exactly are options?Well, an option is a binding contract with properly defined terms and conditions. It gives the buyer the right to buy/sell a certain UNDERLYING asset at a set price, up to or on a specific date. However, the buyer is not obligated to buy or sell if he/she does not want to.
Get it? Probably not! Okay then!
Here is an example to help you understand better.
Say you come across a certain house that you would like to buy. After talking to the owner, you find out that the house costs 250,000 dollars. You do not have that kind of money right now, it will take you 2 months to gather the money – so you strike a deal with the owner. This deal gives you the OPTION to buy the house within 2 months at a price of 250,000 thousand dollars. You pay the owner a sum of $2,500 as part of the deal. Note that you are not obligated to buy the house.
Here are two possible outcomes that may arise out of this deal:
Scenario 1: Your local governing body may declare that an airport will be built near the house in question. This will draw a flurry of investments to that particular area and the prices of real estate will rise. So now, the house costs $350,000 instead of $250,000. However, the owner is obligated to sell you the house at the pre-set price of 250,000 dollars since you made a deal with him/her. Congratulations! You just made a profit of 97,500!
Scenario 2: It comes to your knowledge that in the past, someone committed suicide in this house and evil spirit haunts the place to this very day! Also, the house has other problems such as rat infestation, leakage, mold etc. On second thought, the value of the house is much less than the $250,000 quoted by the owner. It is actually just 160,000 dollars. Hence, you decide to NOT go through with the sale. Sure, you lose the $2,500 dollars that you gave the owner to hold the house for you. However, losing $2,500 is much better than losing 90,000 dollars!
Pretty Cool right?
Anyways – The above example taught you two very important things.
First, an option is just that – an OPTION. You are not obligated to take any action – you can simply let the option expire. However, you will lose ALL the money that you used to buy the option.
Secondly, an option is based on an UNDERLYING asset. In our case, the underlying asset is the house. The option derives its value from the underlying asset. Hence, an option is known as a derivative. In most cases, the underlying assets are stocks, commodities or indexes.
Here is some common lingo associated with options trading:
There are two types of options – Call and Puts.
What is a CALL? A call gives the holder to buy an asset at a specific price within a certain time frame. This is a long term option. Buyers hope that the value of the underlying asset increases as much as possible within the mentioned time frame!
What is a PUT? A put gives the holder the right to sell an asset at a certain price within a specific time frame. A put is like having a stock for a short term. Buyers of puts hope that the price of the underlying asset falls significantly before the expiration of the option.
Those who buy options are known as holders and people who sell them are known as writers. Put holders and call holders are not obligated to buy/sell. However, put writers and call writers are obligated to sell/buy. All this may seem a bit confusing – however, for the time being, you just need to know that there are two parties in any options contract. As you are a beginner, you should focus predominantly on buying options.
Selling options is way too risky for a person with a basic level of knowledge. Read this blog post I did on options trading strategies to find out more about how to make money through options!
2019 Update: I Highly Recommend Jason Bond Picks for ‘next level’ Options Trading Training, and Profits Unlimited if you’re looking for an epic Stock Newsletter by somebody who’s been in the game for quite some time.
I promise, it’s NOT as complex as you think IF you have the right knowledge and strategy! 🙂