Feb 16, 2012
Trading in stock options has become increasingly popular among investors and speculators since listed stock options first began trading in the early 1970's. Stock options are a financial derivative contract with a specific term or expiration date, an exercise or strike price and amount paid for the option known as the premium.
Buying stock options carry only the risk of the initial investment, since purchasing options give the buyer the right, but not the obligation to buy or sell the stock. Selling options, on the other hand, can have unlimited risk for the seller, if the seller is not hedged with an opposite position in another option or in the underlying stock.
Buying Calls and Puts
The option to buy a stock is known as a call option.
Buying calls makes up the simplest and most straightforward way of trading stock options. Basically, buying a call would be equivalent to buying the stock at the strike price plus the amount paid in premium; nevertheless, if the option buyer is wrong on the direction of the stock, they stand to lose only the premium paid for the option.
The strategy of buying a put option consists of the opposite of a call option purchase and grants the buyer the right to sell the underlying stock at a specified price in a given time. A put purchase would be the equivalent of shorting the underlying stock.
The advantage of purchasing options instead of purchasing stock consists in the fact that if the buyer of the option is wrong, then the amount lost on the options purchase would generally only be a fraction of the amount lost if an equivalent position was taken on
Selling Calls and Puts
While buying options gives the purchaser the right but not the obligation to take or deliver the underlying stock, selling options is completely opposite.
By selling a call, the seller is obligated to deliver the underlying stock at the strike price by expiration.
Conversely, by selling a put, the seller is obligated to purchase the underlying stock at the strike by expiration. The equivalent for selling a call is shorting the stock at the strike price, while the equivalent for selling a put is buying the underlying stock at the strike price.
Using combinations and simultaneously buying and selling options for a price differential is known as spreading. This strategy is often employed by more sophisticated options traders and generally limits potential profits as well as risk.
The idea is to buy one option and simultaneously sell another for either a credit, where the spreader receives a premium; or a debit, when the spreader must pay a differential.
Time spreads, also known as horizontal spreads, involve buying an option in one month and selling another, while vertical spreads involve the simultaneous sale of options of the same expiration with different strikes.
How to Get Started Trading Options
Most stock brokers allow their customers to trade listed stock options, with an open funded account being the only pre-requisite. Nevertheless, trading in stock options carries some risk because options are contracts that expire, and not equity.
A thorough understanding of stock options is strongly advised before attempting to trade in a live account.
Many on-line stock brokers offer a stock options demo account for novice traders to get familiar with the options market, before committing their hard earned cash.