What is Options Trading?
What is options trading? First we need to understand what an 'option' is. Options are contracts between two parties which give the buyer or 'taker' the right to buy or sell a parcel of shares at a price that has already been determined. This sale takes place on or before a certain specified date. To make use of this right the taker must pay the seller or 'writer' of the contract.
There are two types of options trading or 'contracts' that may be entered into. Call options allow the buyer the right to buy shares at a price previously decided on. This can take place on or before a specified date. As an example:
If ABC Holdings has a last sale share price of $5.00. A call option would allow a buyer to buy 1000 of these shares at a price of $5.00 per share until a predetermined expiry date is reached. The buyer pays a premium for this right to the seller. The seller will be required to deliver 1000 shares at the named price in the event that the buyer does take the option. Even if the buyer does not make use of the option the seller keeps the premium. This is the first kind of options trading used by investors.
A second type of options trading is called 'put' options trading. Put options allow the buyer to sell the shares at a previously determined price on or prior to a certain, specified date. In this case the buyer only has to deliver the shares if they make use of their option to sell.
Here is an example:
Put options trading in the aforementioned scenario would mean that the buyer has the right to sell 1000 ABC Holdings shares for $5.00 per share until the expiry date is reached. The buyer is required to pay a premium to the seller or writer. This right is only available until the contract's expiry date. If the option is taken up by the buyer then the seller must buy the shares for $5,00 per share. The premiums are kept whether the option is used by the buyer or not.
In either of the above options trading scenarios the shares must be traded at the price that has been specified. This fixed price is called the 'exercise' or 'strike' price.
Put options trading allow a trader to minimize the risk of a slump in the value of shares held. It is like an insurance policy against lowered prices. Call options ensure that the price for a particular stock is fixed. This means that time can be taken to decide whether or not to make use of an option to buy. Sellers can also choose not to sell the shares in the option.
Because it is relatively easy to trade in and out of an option it makes options trading a lower risk trade. You might decide to buy call options if markets rise or put options if the market falls. You can sell your options to make money or avoid losses. Options trading allows profits to be made from share price fluctuations while avoiding having to pay full price.
