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Introduction To Options

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Options are a high-risk investment, but they are also highly profitable. Traders enter the option market for many reasons. One reason is because the amount of capital required to enter the market is lower than regular stock. The fact that most options move faster (volume) and produce higher returns is another reason traders dabble in the option market.

Many brokerage houses limit the amount of cash (margin) new traders can use to invest because of the market's high potential for loss. As option traders become experts, these limitations go away, and the trader is free to invest as much as their account allows. Once a new trader gets familiar with how the option market works, they can become an expert in no time at all.


Stock vs. Option

Regular or preferred stock is an asset. In other words, stock is equity, and it gives the holder ownership in the company where it's drawn from. It trades easy in the exchange because, like money, investors consider it a liquid asset.


An option is a derivative of stock. This means that its value completely depends on the value of the equity associated with it.


Option Buyers: Option buyers own a contract that says they have the right to buy or sell an asset by a certain date (expiration date). Option buyers are not obligated to buy or sell the asset, and if they choose not to, they let their option expire as it becomes worthless.

Option Sellers: Option sellers own a contract that obligates them to buy or sell an asset by a certain date (expiration date), if the buyer excercises the option. Most option sellers hope the buyer's contract expires, so they can collect premiums.


Online Brokers

Most investors trade options using an online broker system that connects directly to the brokerage house holding trader's investment account. Traders send orders through their broker, which go directly to an exchange. Their brokerage house, which has a seat on the exchange floor, receives the investor's order and sends the trader's request to auction after deducting or adding funds to their investment account. All this takes place in real-time, which occurs in a matter of seconds.



Every option expires. Traders call an option's expiration date, the strike date, because it stands as a marker where all options must be either be bought or sold. On or before the strike date, the trader can either choose to exercise the option and buy the underlying asset, or they can let the option expire, where its value then becomes worthless.


Strike Price, Exercise & Assignment

An option's strike price is the value an investor will pay to exercise their right to buy or sell the option. If a buyer chooses to exercise the option, the brokerage house assigns the seller's assets to the buyer's account.


Margin Requirements

Margin is the total amount in which an investor can use to make a trade. Most traders make a deposit at a brokerage house, which serves as collateral for buying and selling options. Normally, the trader can only buy or sell options up to the balance available in their account (margin). Sometimes, brokerage firms extend credit to the trader, which adds on to their margin's limit. However, if at any time a trader buys an option on credit (borrowed margin), makes a bad choice, and their option starts to lose value, the brokerage house has the right to immediately sell the option to cover the margin (margin call).


Order Entry

Home broker systems basically have two types of transactions, buy and sell. Investors can fine-tune their orders by adding details to the order, including limit, stop or market, which directs their broker on how to specifically auction it.


Types of orders

In each of the two types of order entries, there are two types of orders that a trader can place.


Call Orders

Buying a call option - Trader buys a call option thinking its price will go up (long-buying). Buying the underlying asset is not an obligation.

Selling a call option - Trader sells (writes) a call option thinking its price will go down (short-selling). Trader must sell the underlying asset, if a buyer exercises the option.


Put Orders

Buying a put option - Trader buys a call option thinking its price will go down. Selling the underlying asset is not an obligation.

Selling a put option - Trader buys a call option thinking its price will go up. Trader must buy the underlying asset, if a buyer exercises the option.



Moneyness is the real value of an option. An option starts to lose value the minute it enters the market. The closer it gets to its expiration date, the less it's worth. Investors call this occurrence time decay. Intrinsic value is simply the difference between an option's strike price and the underlying asset's market price. Option traders calculate moneyness by adding an option's intrinsic value to its time decay value.


NEXT: [thread=11548]Call Option[/thread]

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