A Review Of Options Trading Basics

Options trading, like all trading is a business, but here is a review of the basics:

1. Options give the investor the legal right to sell or buy the underlying asset or instrument.

2. If you purchase options, you aren’t required to sell or buy the underlying asset, you have the right. Meaning, you can decide to buy the options, sell the options or do nothing and let it expire, dependent on what is most of advantage to your position.

3. Options are either call or put. Call options give the right to the purchaser to buy the options. Put options give the purchaser a right to sell the options.

4. Options are quoted per share, but are retailed in one hundred share lots. Meaning, if the investor purchases one option, he is purchasing one hundred shares. Note: In some stock markets, eg Australia, an option lot is 1,000, not 100. Check lot size for traded market before buying or selling options. The quoted premium will be for a single option, this price must be then multiplied by the lot size to determine final price, plus brokerage commission.

5. The investor only has to pay the option premium and not the total face value of the shares. As an example, if the option premium of a $50 stock is $3, the full amount of the contract is $300 per option. So if the investor is purchasing three options at $3 per option, since he is purchasing in one hundred share lots, the total payment would be $900 ( three options x one hundred shares per option x $3 option premium ).

6. If shares were purchased instead of options, the full share value must be paid. As an example, the share price of a company is $80. If you would like to buy one hundred shares, you would pay $8,000. While with options, if you want to invest on a hundred shares, you have to enter into a contract whereby you would buy one option at a certain option premium.

7. If you want to buy the stock prior to the end of the contract, by exercising your option, you must then pay the full amount of cash that is the same as the quantity of option contracts, multiplied by contract multiplier. Refer to six as an example.

8. If the purchaser exercises his rights to buy the option ( call ), the vendor ( called the option writer ) is required to supply the underlying asset.

9. If the purchaser exercises his rights to sell the option ( put ), the vendor is required to buy the underlying asset.

10. If the purchaser wishes to exercise his rights to either sell or buy the underlying asset, the vendor must either sell it or purchase it at the strike price, with no regard for the its current cost.

11. In case the purchaser of the option makes a decision to do nothing at the end of the contract for who knows what reason, the vendor keeps the option premium as profit.

12. In computing your profit, you’ve got to consider two things : the option premium and the strike cost. Using a call option as an example, if the option premium is $2 and the strike price is $50, your break-even point is at $52. So for you to earn a profit, the stock must be more than $52. If the stock falls below $52, say $49, and there isn’t any time left, you will not lose $3 per stock. What you will lose is the option premium you have paid for the contract.

Note : The numbers in the above examples were just picked out of the air to explain how options trading work.

Related Entries

• Why Trade Options?
• Options Trading - Call And Put Options

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