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THE BASICS OF OPTIONS AND TRADING REPORT A Beginners Guide to the Wonderful World of Stock Options Trading
www.OptionMillionaires.com
TABLE OF CONTENTS
INTRODUCTION......................................................................................................................................... 1
WHAT ARE OPTIONS?............................................................................................................................... 4
TYPES OF OPTIONS................................................................................................................................... 7
OPTIONS TERMINOLOGY.......................................................................................................................10
OPTIONS: WHY WOULD YOU WANT TO USE THEM..........................................................................12
OPTIONS: HOW THEY ACTUALLY WORK.............................................................................................15
OPTIONS TRADING: THE REAL REALITY..............................................................................................17
THE PRICING OF OPTIONS.....................................................................................................................18
CATEGORIES OF OPTIONS......................................................................................................................20
OPTIONS TABLES: ADVICE ON LEARNING TO READ THEM.............................................................22
WRAP UP...................................................................................................................................................23
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INTRODUCTION
There are many different kinds of investments available even to the most average of the
Average Joe investors out there, all of whom are looking to add the best investment
vehicles to portfolios buffeted by the market turmoil that seems to be a constant
companion of most investors since the Crash of 2008. Such investments include mutual
funds, bonds, stock and the like. All of these securities are fairly well-known to investors
large and small but there's another kind of investment vehicle that's perhaps less well-
known but which is also of such a high caliber character that many sophisticated
investors always make sure they dedicate a certain percentage of their portfolios to
them. Called an “option,” this class of investment vehicle can present a huge
opportunity for those investors willing to learn about them and then trade in them.
One of the most notable factors speaking for options as an investment vehicle is how
versatile they are when it comes to trading them. Holding options, you're able to adapt
your trading position or trading holdings or to adjust them in accordance with just
about any trading or market situation that develops, for one. If you're a daring and
adventurous trader, then options are perfect for you. But if you're very conservative
and don't like risk, then options are also perfect for you. How this can be so from one
investment vehicle is also why the power of options trading is so potentially lucrative
for those willing to learn how options work and how and why they're traded to such
great effect by investors savvy enough to master the ins and outs of investing and
trading in them.
A point to remember in all this happy talk about options, though, is that there are
potential costs to trading in them as well. Unlike most forms of stock, options are
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sometimes (okay, most of the time) among the more complex securities to trade and
they can be very risky to deal in.
In fact, when dealing with options trading brokerages and the like, there's inevitably a
pretty strong disclaimer presented that takes care to remember potential options
traders that dealing in options comes with risk and that they're certainly not for
everybody. At heart, options trading is speculative in nature, too, and comes with
SUBSTANTIAL risk of loss. When it comes to options trading, you should only do so with
what's called “risk capital,” or capital that you'd have no problem losing should your
options trading strategies not come to fruition.
Because options trading can be a complex business and because of their risky nature,
many investment experts advise those not familiar with how they work to avoid placing
them in an investment portfolio, at least until some time has been spent learning their
complexities. But with great risk comes great reward and options can be among the
most reward of investment vehicles available to the average investor. Given their
speculative nature, though, it's a foolish investor indeed that doesn't take the time to
learn as much about them as is reasonable before investing in them, and that's where
this report comes in. Use it to learn the basics of options before you jump into trading
them, for one. Just jumping into the options market and expecting to learn about them
as you trade in them is downright dangerous and it's the quickest route to losing all of
your investment capital.
Lastly, understand that most options traders have several years' worth of experience in
the ins and outs of options trading, which – by using this report – you'll be able to
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reduce in terms of the experience you yourself will need to develop before actively
trading them. Also, it's strongly recommended that you combine study of options
trading via something like this report with some sort of membership at one of the
better options trading website on the Internet nowadays.
There are a few exceptional sites where top options traders are willing to discuss the
right ways to go about trading in them, and they'll take person interested in this
fascinating trading sector from crawling to walking and then to running, so to speak, in
the options markets. Springing for a membership at one of these sites could be one of
the better investments in your options trading education that you're likely to see
relatively quickly, too.
One last thing: If you're new to options trading and you're also not sure you have a firm
grasp of the basics of the stock market and how stocks are traded then spend some
time boning up on your stocks basics before trying to tackle the more complex activities
that take place when dealing in options trading.
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WHAT ARE OPTIONS?
While investment vehicles like stocks, bonds, mutual funds and others are tangible
assets (or tangible losses when they decline in value) it's best to think of options as a
kind of contract. With an option you have the right but you don't have the obligation to
buy or sell what's called an “underlying asset” (see above for types of assets) at a
specific price or or before a certain specified date, which is mainly why these
investment instruments are called “options.” You have the “option” to buy or sell them,
in other words. Likes stocks and bonds, options are also classed as “securities,” which is
also a legal description for their character or as what they're looked at in the world of
investments. Never lose sight of the fact, when it comes to an option, that it's a legally
binding contract and that like most contracts it will come with very tightly defined
terms, conditions and properties. This is another reason why options can be complex
investment instruments. The below is a good workable example of how an option
would work:
Consider that you're in the market for a house and that you've found a great one. It's in
a nice neighborhood, with good schools, plenty of green space and a super low crime
rate. Plus the house has just been modernized. In other words, it's a potentially great
purchase with good long-term prospects for appreciation in price. However, you don't
have the money to purchase it outright right at this moment and it's going to take you a
few months to line up financing at any rate. The owner of the house, though, is willing
to work with you and will agree to a contract that gives you the option to buy the house
in two months, for example, at an agreed-upon purchase price at the end that two
months. For the privilege of having the option, but not the obligation, to buy that house
at that agreed-upon purchase price all you have to do is pay the owner $2,000, which
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he keeps regardless of whether or not you end up buying his house. Now, there are two
ways this option could play out.
One: In the intervening period between the time you and the owner enter into the
option a real estate boom kicks in and the house has tripled in worth and is now able to
command a sale price at a level far above what you and the owner agreed to when you
entered into the option agreement. Too bad for the owner, though, because he has to
sell you the house at the agreed-upon price should you exercise your option to
purchase it. That's good news for you, because you can exercise your option, purchase
the house, turn around and sell the house at its new market value and pocket a
handsome profit.
Two: In the intervening period between the time you and the owner enter into the
option, a market crash ensues, termites are found in the home and its value declines
sharply. You're now left with an option to purchase a home worth far less than its
original agreed-upon price and you know there's no way you'd want to buy it at this
point. Fortunately, because you're under no obligation to purchase the house – under
the terms of the option agreement – you're able to avoid a potentially perilous financial
situation. Of course, avoiding this situation by not exercising your option will come with
definite costs, those “costs” in this case being that you lose at least $2,000 dollars on
the deal, which is the price you paid to purchase the option to buy the house at the
mutually agreed-upon price. You're out two-grand, but you're not out $200,000, in
other words. This is where the risk equation when it comes to options is most evident.
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The above example perfectly illustrates a couple of characteristics when it comes to
options. First: When you purchase an option you have the right but you don't have an
obligation to do something. If you don't want to do that something – typically, this
involves purchase a block of stocks or some other underlying asset – simply let the
option period expire and walk away and be out only your option purchase price. In
some cases, this could be the smartest investment decision to make and losing 100% of
that investment money could save you lots more
money in the end. The second characteristic to remember is that options are nothing
but contracts that are supported by their underlying assets, such as stocks, bonds and
the like. For that reason, options are called “derivatives,” and they DERIVE their value
from the underlying asset, usually. In and of themselves, options have no redeemable
value whatsoever. In the vast majority of cases, the asset underlying an option is a stock
or some sort of index.
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TYPES OF OPTIONS
Options come in two types: Calls or Puts. A call option (if you're a poker player, you've
heard the term “I call,” right?) give the holder of the option the right purchase an asset
at a certain price and within a specified time period. If you know what stocks about,
think of call options as “going long” or taking a “long position” on a stock. When you
buy a call option, you're taking the position that the asset (typically a stock, in which
case the option would be known as a “stock option”) will appreciate in price or value
before the option expires. If it does, you exercise your option to buy, purchase it at the
lower price and then turn around and sell it at the new higher price, pocketing the
difference between the two prices as pure profit.
In the case of a put option, you're holding the right to sell an asset (typically a stock) at
a certain price and within a specified time period. Again, in the stock world, having a
put option would be like a stock investor who takes a short-term position on a stock.
Buying a put option would mean that you're expecting that the price of the asset (a
stock, say) will fall before the expiration of the option. You can then short-sell the asset
and pocket a handsome profit as well.
There are four, and only four, types of options market players (participants, really), and
having only four types makes it easy to understand just who's playing the options game.
One: Buyers of call options.
Two: Sellers of call options.
Three: Buyers of put options.
Four: Sellers of put options.
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If you're buying options you're also going to be known as a “holder” in the options
language used by all options traders. If you're selling options you're going to be known
as a “writer.” In all cases, holders (buyers) have long-term positions and writers (sellers)
have short-term positions, so never forget that when it comes to the buying and selling
of options. You buy or sell call options and you buy or sell put options. Holders are
“long” while writers are “short.” Here's the most important thing to remember about
holders and writers, though:
Call holders and put holders (buyers) don't have to buy or sell. They've got the right to
exercise the right to buy or sell if they so choose.
Call writers and put writers (sellers) must buy or sell. They can be required to make
good on a promise they make to buy or sell the assets underlying the options, in other
words.
After reading through the above you'll see it's easy to figure out why options trading
can be a bit complex, especially if you're dealing with options as seller, which is riskier
than being a buyer of options (though it can also be more financially rewarding). At
base, what you need to understand is that there are always two sides to an options
contract; buying and selling. Buying options is always easier to understand, so we'll
spend some time working our way through that aspect of options trading first.
Before proceeding any further with options, it's important to understand some of the
terminology a bit more thoroughly. Doing so will give you a level of comfort with the act
of options trading that will help prevent you being sucked into this or that unsteady or
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outright fraudulent options trading scam, for one. For another, understanding the
terminology that defines options will give you a higher level of competency in a shorter
length of time, thereby allowing you to more easily participate in options trading,
perhaps to your ultimate financial benefit.
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OPTIONS TERMINOLOGY
Strike Price: The price at which an underlying asset (for purposes of this report, we'll
use stocks) can be bought or sold. The strike price is the price must go above (for calls)
or go below (for puts) before you can exercise a position for a profit. Remember;
positions can be long or short. All of this activity has to occur, though, before the
option's expiration date or all bets are off and you're out, at minimum, your option
payment.
Listed Option: All options that are traded on a national options exchange (a well-known
one is the CBOE, or “Chicago Board Options Exchange”) are called “listed options.” Their
strike prices and their expiration dates are fixed and each option in them represents
100 shares of a company's stock, which is also known as a contract.
In-the-Money: For call options, when the share price is above the strike price, the call
option is said to be “in-the-money.” For put options, when the share price is below the
strike price the put put option is said to be “in-the-money.”
Intrinsic Value: Regardless of the type of option, call or put, the amount by which the
option is in-the-money is said to be that option's intrinsic value.
Premium: The price (its total cost) of an option is called its premium. That price is
arrived at through a number of means, including the stock price, its strike price, its
“time value” (the time remaining until the expiration of the option) and the volatility of
the option (some options are highly unstable or “volatile” while others a far less volatile
and, hence, far more stable and predictable). Figuring premiums on an option is very
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complicated, so if you're curious about how to figure such things we suggest advanced
study or time spent on just options premium determinations, which is a field of study
all its own.
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OPTIONS: WHY WOULD YOU WANT TO USE THEM?
For the most part, investors deal in options for two reasons: To speculate or to hedge.
At its core, speculation – at least when it comes to securities – is a bet on the
movement, one way or the other, of a security. The beauty of options, and one of the
major reasons why sophisticated investors trade in them, is that you're able to make a
profit – if you're good – on options not only when they go up in price (when their
market goes up) but you can also make a profit when they go down in price (their
market goes down) or even when their prices move sideways, neither up nor down. You
can realize profit on options in all three market conditions because options are so
inherently versatile just by nature. And if you're into the idea of making really big
money in securities, then options speculation is definitely where you want to be. Just
keep in mind, though, that options speculation is also where really big money can just
as easily be lost if you're not sophisticated or experienced enough to trade in options.
Speculating on options this way is precisely why they're known as being risky
investment vehicles, in fact. Reasons for why they're risky can be boiled down to the
following points:
When you buy an option you have to be right when it comes to the direction of the
stock's movement (up, down, or sideways). You also have to be correct on
the stock's magnitude of movement as well as also being correct on the timing of that
same movement. You'd have to: 1) Correctly predict whether a stock is going to go up
or down; 2) Be correct about just how much the price of the stock will change; and 3)
Be correct about the length of time (the time frame) in which all this will happen. Plus,
during all this activity you're also racking up commissions that will have to be paid to
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the broker executing all these options moves for you. Because of all these factors the
odds of you successfully speculating on an option generally tend to be against you
prevailing or making a profit. This would be discouraging except for the fact of what's
called “leverage.” Using leverage, which is an inherent feature of an option contract.
With you able to control, for example, 100 shares of a stock with just a single contract,
even a very small price movement can generate a substantial profit, in other words.
When it comes to hedging (you've heard the phrase “hedge your bets” before, right?),
what you're basically doing is purchasing an insurance policy. It's really no different
than taking out insurance on your car or on your home, and you can use options to
insure your investments against a market downturn. Many sophisticated investors are
disdainful of hedging because they think it's a way-too-safe (meaning, that with less risk
will come less reward) act that greatly limits the profit potential that can be realized
when one deals in a generally risky investment vehicle, which an option normally is. In
essence, if your stock pick makes you so unsure that you require a hedge against the
risk it present, then maybe you shouldn't make an investment in it in the first place, or
so goes the thinking of all the so-called “smart money” players and investors in the
options world.
However, the thing to keep in mind about hedging of options is that if it wasn't so
useful, in certain circumstances, then there wouldn't be a need for it. A good hedging
strategy to manage risk when it comes to options trading can make a
great deal of sense, even for the small individual investor (hedging is often seen among
large institutional investors, generally speaking). For an individual investor, hedging can
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help limit losses on a particular stock and you would do this by making use of options,
thereby restricting downside issues while taking full advantage of the upside movement
in a way that's most cost-effective. Hedging options can also get complicated, so take
some time to study up on what are called “married puts” as a way of limiting downside
risk when it comes to stock options.
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OPTIONS: HOW THEY ACTUALLY WORK
The best way to explain how options work is to provide an example of options in action.
For example, let's take a look at XYZ Company, a manufacturing firm of some note. On
the first of this month, stock in XYZ Company stood at $35 per share. The premium (its
cost) on a 100-share option on XYZ Company is $2.50 for an August 40 Call. The
preceding figures indicate that expiration of the option is for the 2nd Friday in August
and the strike price of the stock would be $40 per share. The total price of the option
contract would be $2.50 X 100 = $250 (broker commissions are also normally a part of
the price of an option contract, too). Remember that we also pointed out that an
option contract is for 100 shares of stock, which is why you multiply the contract by 100
to arrive at the price of the contract itself, being $250 in this particular case.
Take a look at the strike price in this example, which is $40. That means that the stock
price in XYZ Company must rise above $40 before a call (buy) option is worth anything.
And because this contract is $2.50 per share the “break-even price” would be $42.50
per contract. At this point, because the stock price is only at $35 per share, the option is
essentially worthless. And because you paid $250 to purchase this contract you're $250
negative or “in the hole.”
Let's say that a month later, stock in XYZ Company is now worth $45 per share. The
options contract has also moved up in price and is now worth $3.50 x 100, or $350.
Your profit in this case would be $100 ($350 - $250 = $100). If you wanted to, you could
“close your position” on this options contract by selling your contract and take your
profit. Or, you could hold onto the contract in expectation that the stock's price will
continue to rise, which is known as “letting it ride.” Unfortunately, by the expiration of
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the options contract, stock in XYZ Company has declined to $33 per share, two dollars
less than the $35 strike price and leaving you with a worthless contract yet again. You're
now down to your original investment of $250. As an example of leverage in this
example take a look at the price swing in the stock options contract, which went from a
low of $250 up to $350, which would have realized you a $100 profit just by controlling
100 shares of stock – via an options contract – in the company.
The above is a nice illustration of how a relatively small amount of money can control a
much larger amount of stock assets, potentially, without even really having to buy the
stock first. What you've invested in is a right to buy or sell some stock but not the stock
itself, in other words. If you've taken out an options contract on shares of XYZ stock at
$2.50 per share (remember, a contract is for 100 shares of stock) and the stock
increases in value before the expiration of the contract, thereby driving up the premium
on the contract to $3.50, you'll have made $100 on the option contract, and all without
having had to initially purchase the 100 shares in the first place! This is a major reason
why options trading can be so attractive, and options really are attractive under many
circumstances, especially if you're skilled enough to buy and sell them as the situation
dictates. Just remember the element of risk in them, as was pointed out in the story of
XYZ company, because there really is a measurable amount of risk in the trading of
them. It behooves you, then, to learn as much about trading them as you can before
actually getting into the options trading game in a big way, which is one reason why
you're reading this report.
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OPTIONS TRADING: THE “REAL REALITY”
Up to this point, the discussion on options trading has involved how they're bought and
sold (known as “exercising” your right to buy or sell the underlying asset), which in
most circumstances is a fairly cut-and-dried affair. However, most aren't normally
exercised at all. That's because options holders normally trade out – called “close out” –
their positions when it comes to these instruments or investment vehicles. What this
means is that holders mostly end up selling their positions in the market and writers
buy their positions back in order to close out. Research has shown that only about 10%
of all options contract are exercised, which is a low number indeed. Another 30% of all
options contracts are allowed to expire – with holders of those options losing the
money they used to purchase the options – while the remaining 60% of options
contracts are traded out, which is where the real money is options trading is made, of
course. If you're smart and you learn how to manipulate your options activities
correctly, the positions you take via your options trading activities can generate
lucrative income for you. But you'll really have to work at developing the faculties
necessary, as well as the access to all the data and information you'll need to trade in
options, before you can do well enough at them to realize consistent profits. Options
trading isn't for the faint of heart and if you can't tolerate a healthy amount of risk then
they may not be for you.
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THE PRICING OF OPTIONS
In the last section, we showed how the change in the premium, or price, of the option
moved from $2.50 all the way up to $3.50 (in reality, premiums can move in much
greater amounts over a short period of time, which is why seriously nice money can be
made from them). Why a premium on a stock option moves the way it does can be
ascribed to two factors: its intrinsic value and something called “time value.” Most
people who have even a small amount of interest in investing or saving have heard the
term “time value of money” and time value as it's applied to options trading is really no
different. In investing there's value in time and time in value, so to speak.
Keep in mind that when it comes to an option, the premium for that instrument is its
intrinsic value plus its time value. As we defined in the terms section “intrinsic value” is
the amount in-the-money which, if we're discussing a “call” option, means that the
price of the stock will equal its strike price. The concept of “time value” when it comes
to an option has to do with the POSSIBILITY of the option increasing in value over time.
Here's an example:
Premium (of a stock): $2.50
Intrinsic value: $2.00
Time value: $0.50
Out in the real investment world, options almost always trade above their intrinsic
value – which we observed previously is a complicated equation or calculation. How
options can work in real life can be somewhat more complicated, therefore, than what
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we've illustrated above, but it serves to show just how options traders size up an option
using a variety of measures of value and risk before they take a position on that option.
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CATEGORIES OF OPTIONS
Two types of options exist: American options, and European options, though location
(America or Europe) actually has nothing to do with why they're referred to so. Actually,
it has more to do with how they're traded than anything else. With American options,
they're able to be exercised at any point between the date of purchase and their
expiration. The XYZ Company example we highlighted earlier is an example of trading in
American options. If you decide to make use of what are called “exchange-traded
options” you'll probably be dealing in American options, for what it's worth. European
options, by contrast, can only be exercised at their expiration, which is the end of their
useful lives.
Another characteristic of options lies in how long they live, which we've only touched
upon in a broad sense. Most options traders, being people comfortable with greater
risk, tend to prefer shorter-term investment horizons, which the typical option contract
brings to the table. However, there actually are longer-term options available to the
options investor or trader. These types of longer-term options are called LEAPS, or
“long-term equity anticipation securities.” Most long-term options feature 1, 2 or even
3-year or longer holding times, which tends to appeal to those investors out there that
prefer long-term investing horizons. LEAPS aren't available on some options types but
they're almost always available on all the most widely held stock issues. LEAPS also
offer the opportunity to control or manage risk to a greater degree than is possible with
the typical short-term options contract and are almost identical to those shorter-term
investment vehicles, so they may make sense for you if you're not completely
comfortable with large options of risk.
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The last thing to understand when it comes to options types is that there are many,
many different variations, though most of the simple buy-sell/call-put/hold-write
options are often referred to as “plain vanilla options” there are an array of non-
standard options that traders call “exotic options.” For those just starting out in options
trading, plain vanilla options – which are very easy to understand, for the most part –
are most likely the options trading investment vehicles to take on, at least until you've
gained some experience and training in the ins and outs of trading in other variations of
options, including the exotic versions. It's these exotic options that present some truly
intricate variations on the payoff profiles of plain vanilla options or are even completely
different options with their optionality being the facet most thoroughly embedded
within them. What this means is that you'll probably need a fairly sophisticated
understanding of them before giving them a try. Exotic options come with so many
variables you'll need to pay close attention to them in order to effectively trade in
them, in other words.
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OPTIONS TABLES: ADVICE ON LEARNING TO READ THEM
One piece of advice to remember when it comes to trading in options is that you should
never do so until you have a basic familiarity with the various types of options table
published online these days. Though each website or source supplying an options table
may vary the content of the table slightly, almost all of the online versions carry much
of the same information that can be found in their competitor website options table
offerings. In addition, a number of quality options trading software programs populate
their options tables with an array of data that today's increasingly sophisticated and “in
the know” Average Joe options trader has learned to quickly grasp, which is why we
recommend spending some time learning the basics of how to read a typical options
table.
It's beyond the scope of this report to break down and then explain in some detail each
of the data boxes within an options table but it's a fact that you can, if you spend just a
small amount of time learning about facets of an option table such as “Delta Bid/Ask
(%)” or the “Open Interest” column or any of several other columns found on the table
that, if you understand what they're saying, will make you a much more confident – and
successful – options trader. There are a few top-quality options trading and options
trading education websites out there on the Internet that will gladly take the time to
explain the intricacies of the options table and it's definitely worth your time, if you
intend to make income from options trading, to explore them.
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WRAP UP
It's been said before, but it requires saying yet again: Options trading isn't for
everybody, mainly because they tend to be sophisticated trading tools and on a level of
investment above standard trading activities in stocks themselves. That's why it's
important that you gain an education and an understanding of how they're traded
before you invest any of your capital in them. Options come with measurable risk that's
sometimes quite high, as well, so never trade in them with capital that you're not
prepared to lose, if it comes to that. Keep the options trading review below in mind as
you contemplate becoming an active investor in them:
An option is a contract. It gives you the right, but doesn't require an obligation, to buy
or sell an underlying asset such as a stock at a specific price with you having to do so on
or before a specified date.
An option is considered a derivative, and trading in derivatives in typically considered as
trading in an exotic investment instrument. Options are called “derivatives” because
they DERIVE their value from the underlying asset, not from the mere fact of the
existences of the option itself.
When you “call” on an option, you have the right to buy, when you “put” on an option
you have the right to sell. There are also only four types of participants in the options
markets: Buyers of calls, sellers of calls, buyers of puts and sellers of puts. Buyers of
options are typically referred to as “holders,” while sellers of options are referred to as
“writers.” Lastly, the “strike price” of an option is price at which an underlying stock can
be purchased or sold.
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We can't emphasize enough that you spend the time and effort gaining a solid
grounding in options trading before you decide to engage in them. While extremely
potentially lucrative, if you trade them smartly, they can also be extremely risky if you
trade in them without having a complete understanding about what you're doing.
That's why we always recommend that you invest a little in a good pre-options-trading
course or a membership at one of the top options trading websites on the Internet,
where you can learn about options trading at your own pace, discuss in real-time and
with real options traders how options trading works and pore through all of the articles,
examples, videos and other education materials these options trading education
websites make available. Your initial monetary investment in one of those programs or
at one of those websites is likely to be repaid several times over with just your first
options trade if you conduct it smartly, which you'll be much more likely to do if you
first spend some time gaining crucial knowledge about options and about how to trade
them. Good luck in all your trading activities, both now and in the future!