Trading options is similar to what occurs in our everyday lives. You need not worry about having to memorize all of these investment terms. When investing or trading in options you just need to understand how to buy options and how to sell them, along with some basic fundimentals of investing and buying stock. When option trading, it’s like driving. You don’t need to know how an engine works to drive a car, but if you take a few lessons on actually driving and you practice you can still learn with just a few basic tips. You can actually understand the process if you consider the following examples on how trading options can be compared to real life situations.
For example, you want to buy a dress by Valentino for yourself or your girlfriend depending on your gender. Lets say it costs $3,000. However, you will not be able to afford it till the 7th of the month, when you get your pay check. What you could do is to make an arrangement with the shop owner to let you buy the Valentino dress on your payday for $3,000. It means that she will reserve it for you till you are able to buy it. However for her to do this, you should have to still pay her a down payment which may be something like $500.
What just happened is an example of an options trade. The arrangement between you and the shop owner is called a stock options. It means you have the right to buy the Valentino dress at an agreed price for a period of time, which is till you get your salary.
Now during that week, Angelina Jolie wore the exact same Valentino dress at her latest movie premiere. It instantly became a fashion trend and women all over town wanted to buy that exact same dress. Because of this, the price of this dress increases to $6,000. When payday comes and you went to buy the dress, you have the right to purchase it for only $3,000 because you have the options to buy it at this price. However, if 3 days after your salary and you still did not buy the dress, or if the dress was now on sale for $1500, then the arrangement expires and you could no longer buy it at the agreed price. In that case, you lose out on the initial down payment as it would be pointless to carry out the agreement at such price.
Here we see two qualities of trading stock options, it has an expiry, and it has a fixed price, called strike price.
What if the scenario was changed; that same week you attended a friend’s party and she was wearing the exact same dress that you like. Now that party included everyone you know in your town and they even complimented your friend on how attractive she looks in that dress. There is no way you would wear that dress anymore because you do not want for people to think that you just copied your friend’s dress. Thus in this case you do not have to buy that dress anymore simply because you changed your mind. This is one trait of trading stock options, you are not obligated to buy. However, you would lose the $500 that you have invested initially to be able to reserve that dress. This, in turn, is like the payment that you give the shop owner for reserving you that dress. Of course, in the process of holding it for you, that week there might be someone who would actually buy that dress for $6,000 and she has lost that opportunity.
Now that you have at least some basic knowledge on options trading, you know that it is a security which gives you the right, but not obligated, to buy something, which could be a stock. In this case the stock is equivalent to the dress. There are many online option trading which gives you the chance to trade online without having to go through a trader in person. They also provide good research and tips of trading stock options right at the comfort of your home.
Now that you understand options, you need to understand how trading them might work. The above example could work for anything. The way stock option contracts work is rather than a dress in the above example, it would be a block of 100 shares.
So lets instead start saying you wanted to preorder 100 items or 100 shares that are normally priced at $100 per share at a reserve price of $10 per share. While the contract costs a total of 100 times the per share price, it is a fraction of the cost to actually buy he 100 shares. The total contract value would then be $1000. The stock normally might priced at $100 per share, and the contract might have an agreement that you have the right to buy the stock at $100 per share 1 month from now. So you are buying it at 10% of the cost of the actual stock. If suddenly the thing you were reserving (in this case shares of stock) were in high demand, the value of that contract would go up. Maybe they had an earning announcement that launched the stock higher. If this is the case, the stock might suddenly be worth $110 per share. Now because very little time has passed, your stock option is suddenly worth $20 per share. At this point your $1000 is now worth $2000. This is a huge increase relative to the percentage of money you put down, while the stock only went up 10% and would have resulted in a much smaller relative gain. However, if you do nothing with the stock option, and the stock price remains the same at expiration, you can buy the stock for $100 instead of $110, however, you already paid $10 per share. So you might as well just sell the option contract now to someone else who may wish to buy the stock at $100.
This is in general how trading options works, if you want to trade options, you have to buy a contract which changes in price as a result of the change of the underlying stock, while also giving you the right to buy stock at a designated price. You don’t even have to really buy options to buy a stock you can’t afford right now, you can just treat them as volitile stocks themselves since the cost is much less, but the gains can be much more. If you do so, of course, you need to keep your position sized much smaller than normal because of the large fluctuations in price mean there’s a much bigger chance that your option expires worthless and you lose your entire investment.