Some Fundamentals of Option Trading

Option trading is an ever increasingly popular form of investment. The wide spread use of online option trading has led to many newcomers to these risky, but potentially profitable opportunities. The following is a review of some of the fundamentals of Option Trading.

The Future

Options trading is sometimes known as "future trading". In the commodity market, for example, options are commonly called futures. This points up one of the basic fundamentals of the market. You are making an investment now, based on what you think will happen in the future. Furthermore, you are making a contract to perform an act such as buying or selling at a future date. When you make an options contract to buy stock, remember, you are not buying, or paying for the stock, you are merely buying and paying for the contract to buy or sell it at a later date.

An Option is a Choice

The name option comes from the concept that your contract is buying the RIGHT, but not the OBLIGATION, to buy or sell stock at a future date. You pay for that right, but you can exercise your option or choice, by deciding not to buy or sell the stock before the future date arrives. This future date is known as the expiration date, and it means just that. Your choice expires on that date, and you have to exercise it then if you have not done so before it arrives.

What Goes Up Can Also Come Down

There are two kinds of options contracts. One is to buy stock, called a call, and the other is to sell stock, called a put. In each case, you are making a decision and picking a certain price. This price is known as the strike price. Your decision is basically this. In a call contract, you are expecting that the price will rise higher than the strike price by the expiration date. If you are right, you get to buy the stock at a price less than it is really valued at, and this difference is your profit.

In a put contract, you are expecting that the stock will drop in price more than the strike price by the expiration date. If you are right again, you get to sell it for a price higher than it is really worth, and again the difference represents your profit. The stock can go either way and the thing to remember here is that you make a call contract, or a put contract based on which way you expect it to go.

Options are not Death or Taxes

Death and Taxes are reputed to be the only "sure things", and options certainly have no argument with that. There is risk here and uncertainty. The stock you think is going to go up, may go way down. You then have made a contract to buy the stock at a price a lot higher than the actual price.

Imagine you make a contract with Wal-Mart to buy a new pair of jeans for $20 dollars, and give them five dollars to reserve the right to do so in two months. When the two months is up, Wal-Mart is running a sale on your jeans for only $10 dollars a pair. You paid $5 for the right to buy them at double the price. This example illustrates the risk, but also the advantage of options. You are not obligated to buy the jeans, and can refuse to exercise the option. In this case, you lose the $5 dollars, of course, but still can buy the jeans at $10, which even when you add in the lost $5 still is less than $20.

There is still risk, but having an option can reduce it somewhat. Just make sure you understand that they are not a "get rich quick sure fire scam", but a legitimate investment opportunity that shares the common features of all investment opportunities. This can be expressed as "The greater the risk, the greater the potential for profit."

These are just some of the fundamentals of option trading. It is a very diverse and interesting field, but the facts are out there, and you are not required to be a stock broker or financial professional to take advantage of this market. It is open to all.