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Options Trading Tutorial

Options Trading Tutorial

Options present a world of opportunity for sophisticated investors. Usually options are viewed as risky and speculative instruments which investors tend to avoid, but if used wisely options help to substantially enhance profits. Options are also used as a hedging instruments in order to protect investments from downside risk.

An option is a contract that gives the option buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price on or before a certain date.
The definition might seem confusing but it is very simple, in fact we come across many option type contracts in everyday life.

For example: You discover a house you would like to purchase but you don’t have the money for at least one year. You talk to the owner and negotiate an agreement which gives you an option to buy the house at the expiry of one year for $100,000. For this agreement the owner demands $5,000 and you pay in order to get the flexibility of the option to buy the house.

Now consider two situations that may arise:

i) It is discovered that the house is sitting on a gold mine. The price of the house sky rockets to $1 million. Since the owner sold you the option he is obligated to sell you the house for $100,000 irrespective of its market value. You stand to make a substantial gain.

ii) There is a rumor that the house is haunted and now the price of the house plummets to $40,000. You now consider the house worthless. Because you bought the option you are not under any obligation to go through with the sale. In this case you will lose $5,000 which you paid to the owner for selling you the option, but you will save $55,000 since now the price of the house is much lower and you are not obliged to go through the sale.


From the above example the following point emerge:

1. The option buyer has the right , but not the obligation to buy or sell the underlying asset at the predetermined price. In order to get this right without the burden of any obligation, the buyer has to pay to the seller an option premium.

2. The option seller has the obligation to buy or sell the underlying asset at the predetermined price, if the buyer opts to buy or sell the same. The option seller receives the option premium as a compensation for the obligation he takes.


A call option gives the buyer the right to buy the stock at a certain price within a specified time and a put option gives the buyer the right to sell a stock at a certain price within a specified period of time.

Strike price is the price at which the underlying stock is purchased or sold, it is like the predetermined price at which the stock will be purchased or sold at a future date, if the buyer exercises his option.

There are four types of participants in the options market, depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called option holders and people who sell options are called option writers. As noted above the option buyers or holders are not obligated to buy or sell, they have an option to exercise their rights as they choose. Option sellers or writers are obligated to buy or sell. Option writers receive premium from option holders.

A call option is said to be in-the-money if the share price is above the strike price. Call option is said to be out-of-the-money if the share price is less than the strike price.
A put option is said to be in-the-money is the share price is lower than the strike price. Put options are said to be out-of-the-money if the share price is higher than the strike price.

On the exchange against each strike price the option premium is traded. Option premium is paid by the option buyer to the option seller. The price of option premium is determined by various factors like stock price, strike price, stock volatility, time remaining until expiration, expected or implied volatility and interest rates.
Options can be a great investment vehicle if used wisely and with proper money management can reap substantial rewards.

Contributed by NinadMT

November 2012


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