What is option trading?
An ‘Option’ is a type of security that can be bought or sold at a specified price within a specified period of time, in exchange for a non-refundable upfront deposit. An options contract offers the buyer the right to buy, not the obligation to buy at the specified price or date. Options are a type of derivative product.
The right to sell a security is called a ‘Put Option’, while the right to buy is called the ‘Call Option’.
They can be used as: Leverage: Options help you profit from changes in share prices without putting down the full price of the share. You get control over the shares without buying them outright. Hedging : They can also be used to protect yourself from fluctuations in the price of a share and letting you buy or sell the shares at a pre-determined price for a specified period of time.
Though they have their advantages, trading in options is more complex than trading in regular shares. It calls for a good understanding of trading and investment practices as well as constant monitoring of market fluctuations to protect against losses.
Just as futures contracts minimize risks for buyers by setting a pre-determined future price for an underlying asset, options contracts do the same however, without the obligation to buy that exists in a futures contract.
The seller of an options contract is called the ‘options writer’. Unlike the buyer in an options contract, the seller has no rights and must sell the assets at the agreed price if the buyer chooses to execute the options contract on or before the agreed date, in exchange for an upfront payment from the buyer.
There is no physical exchange of documents at the time of entering into an options contract. The transactions are merely recorded in the stock exchange through which they are routed.
Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, known as options, presents a world of opportunity to sophisticated investors who understand both the practical uses and inherent risks associated with this asset class.
The power of options lies in their versatility, and their ability to interact with traditional assets such as individual stocks. They enable you to adapt or adjust your position according to many market situations that may arise. For example, options can be used as an effective hedge against a declining stock market to limit downside losses. Options can be put to use for speculative purposes or to be exceedingly conservative, as you want. Using options is therefore best described as part of a larger strategy of investing.
This functional versatility, however, does not come without its costs. Options are complex securities and can be extremely risky if used improperly. This is why, when trading options with a broker, you'll often come across a disclaimer like the following:
1. Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.
2. Options belong to the larger group of securities known as derivatives. This word has come to be associated with excessive risk taking and having the ability crash economies. That perception, however, is broadly overblown. All “derivative” means is that its price is dependent on, or derived from the price of something else. Put this way, wine is a derivative of grapes; ketchup is a derivative of tomatoes. Options are derivatives of financial securities – their value depends on the price of some other asset. That is all derivative means, and there are many different types of securities that fall under the name derivatives, including futures, forwards, swaps (of which there are many types), and mortgage backed securities. In the 2008 crisis, it was mortgage backed securities and a particular type of swap that caused trouble. Options were largely blameless