Options Trading 101

An option, when purchased, gives the buyer the right, but not the obligation, to buy or sell a specific amount of a specific commodity at a specific price within a specific period of time. Options contracts have limited risk, the maximum risk is that you could potentially lose the money, known as the premium, which you invested to purchase that particular option and of course brokerage and transaction costs involved, this means that your account cannot go debit as can happen with a futures contract. An investor can purchase option contracts in a range of things such as agricultural commodities, metals, energies, common stock indexes, currency interest rates, but all are traded in the same way on the futures markets.

Call Options

A call option is the right but not the obligation to buy an underlying securityat a particular price. A call options value increases as the underlying stocks or commodities value increases, or decreases as the underlying stocks or commodities value decreases, this is known as a positive relationship. Investors typically buy call options when they expect a particular stock or commodity value to go up.

Put Options

A put option is the right but not the obligation to sell an underlying security at a particular price.A put options value increases as the underlying stocks or commodities value decreases, or decreases as the underlying stocks or commodities value increases, this is known as a negative relationship. Investors typically buy put options when they expect a particular stock or commodity value to go down or to protect a long term position in it.

What makes options so attractive?

It used to be that trading options was for savvy, high net worth investors. Now, more and more private investors are using options as a way to diversify and strengthen their investment portfolio, below are just a few benefits to trading options:

Investment diversification: –

Trading commodity options can help diversify a stock heavy portfolio.Options also allow you to create unique strategies to take advantage of different characteristics of the market – like volatility and time decay.

Short term: –

As a general rule most options are traded on short term 1 – 2 month contracts (although some have a 12month or longer contract) this allows an investor a much faster return on their investment, than say with stocks, this means you can re-invest many times over in the same time that you might only trade once with shares, increasing your chance of profit.

Leverage: –

Trading options allows the investora great deal of leverage. Leverage refers to various strategies to increase potential profit, basically increasing potential returns while minimizing initial capital invested.

Hedging: –

Options are great tool to use to hedge against losses on a stock portfolio, you can take out options on stock that you already own and use it like insurance on your car. Hedging with options basically means you establish a position in one market (the options market), to offset any price fluctuations in an opposite position in another market such as shares.

Risk/reward ratio: –

Trading options offers unlimited potential for profit, the greater the price movement, provided it’s in the direction you anticipated and provided it occurs during the life of the option, the larger the profit. This comes with limited risk, because as stated previously, the most you can lose is the premium, which you invested to purchase that particular option and any brokerage fees incurred.

Profiting on the downside: –

Many stock investors choose their strategies with a very bullish attitude to the stock markets, but as experience has often shown, the markets are fickle and can decline for long periods of time. At times such as this investors can short their stock but this is very high risk as timing the short wrong can lead to unlimited losses. A much less risky strategy is to use put options to play the down markets. As noted previously, put options increase in value as the underlying stock or commodity decreases in value, so in a bear market, if your timing is right puts can be profitable, and if your timing is wrong your losses are limited.