Options Trading Basics – The Good and The Bad of It

If you plan to enter the options market, you need to get acquainted with the options trading basics, which is exactly what the present article intends to deal with.These securities come in various forms, but the most encountered and “popular” are listed stock options and listed index ones because they provide you with flexibility to capitalize on opportunities while limiting losses. In order to best appreciate the benefits of such transactions, you must get a good handle on what an option is and on its associated risks and rewards.

A discussion on options trading basics always starts with the central element – the option itself. This derivative financial instrument is a contractual agreement concluded between two parties that provide the buyer with rights and the seller with obligations. The most often used options are stock and index options, which use standard agreements and trade on exchanges. These two types fall in the same category of the so-called listed derivatives.

When you use  stock options, these ensue the following:

  • in capacity of owner, you get the right to buy a specific amount of stock at a predetermined price (in the case of call options) or the right to sell a specific amount of stock at a predetermined price (when speaking about put options);
  • as a seller, you have the obligation to sell a specific amount of stock at a predetermined price (call option) or the obligation to purchase a certain amount of stock at a predetermined price (put option).

Since we used terms like call and put options, the following lines will provide you the definitions and benefits of these two types of derivatives:

  • call options – they entitle the owner/the seller with the right/obligation to buy/sell a stipulated number of shares for the underlying stock at a specified price by a predetermined date. Using such a derivative, you are enabled to invest smaller amounts and still benefit from an upward move in stock value;
  • put options – in their case, the owner/seller has the right/obligation to buy/sell a specified number of shares for the underlying stock at a specified price by a predetermined date. If you have put options on a stock that you hold for the long-term, they will gain value during those downturns that are so difficult to watch.

Since stock options derive their value from an underlying asset, you need to understand how these assets work to minimize risk and maximize rewards. This is why one of the most important principles of options trading basics requires you to always analyze the risk involved with the worst-case scenario after you begin trading with any security.

Further on our journey to explore the options trading basics, let us see what these securities allow you to do:

  • to benefit from upside moves for less money;
  • to enjoy gains from downward moves without the risk of short-selling;
  • to safeguard a stock position or portfolio during market downturns.

Up to this point, we have discussed the features and benefits of these financial instruments. Allow us to present the downsides as well:

  • limited validity – each contract is issued with an expiration date; depending on this timeline, you have to operate your moves; if the moves you anticipate are late, you will lose your entire investment. To minimize this negative effect, be very careful with option selection and position management;
  • improper aggressive trading strategies  – employing such strategies helps you cap rewards but simultaneously expose you to unlimited losses; it is about the same risks you face when you short a stock.

Understanding the fundamentals is a must if you want to know how to best balance the risks and rewards of options contracts and start trading with confidence.

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