Advice on How to Trade Options

By: Anne Durrell

If you are trading stocks, you are trading actual things: shares of an actual company. But when you're trading stock options, you're buying or selling the right to buy shares for a certain price on a certain date. Suppose you believe that stock in Company X is going to increase rapidly in the coming months. You can pay what is called a premium, which buys you the right (but not obligation) to buy 100 shares of Company X at a price of Y dollars on date Z. When you do this, you and the other party agree on Y, or how much you'll pay for those stocks when the date arrives. This is the underlying principle of how to trade options.

Your hope is that stock in Company X will skyrocket by the time it is date Z, because you've locked in the price you bid in the option contract. Suppose that on the expiration day of the stock option the price per share of Company Z stock has gone up from $1.00 to $1.50. But your option contract says that you only have to pay $1.25 a share. As soon as you buy those 100 shares for $125, you can turn around and sell them for $150. Your profit is $25 minus whatever you paid as a premium when you bought the option. The option to buy shares at a later date is called a call option.

As another example, suppose you buy the option to sell 100 shares of Company A for $2 each on a given date. Your hope is that shares in Company A fall in price. That way, you can unload those 100 shares at $2 each even though the market price is $1.80 each. Your profit is $20 minus the cost of the premium you used to buy the option. An option to sell in this manner is called a put option.

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When you buy a call option or a put option, if you choose to exercise your right to buy or sell on the given date, the person who sold you that call option or put option is obligated to either sell or buy the stock at the agreed upon price. The premium he or she collects is a hedge against potential losses.

Because no actual thing is traded in an options contract, its value is based on market changes. In other words, you can short sell options without even borrowing the underlying stock first. If you know what you're doing, you can make money with options whether the stock price goes up or down.

You may wonder why anyone would learn how to trade options when they are so complicated and seem to have so much risk to them. The main reason people like to trade in stock options is because the premium on an options contract is a small price to pay to allow yourself to buy low or sell high on some future date.

One thing you must remember when learning how to trade options is that the effects of market volatility are amplified with derivatives: the stock can go in or out of your favor very quickly, so you must be prepared to make fast decisions when the time comes. Those who are not comfortable with the high risk/high reward atmosphere with options trading should probably not attempt it on anything but a very small scale, if at all.

We have additional information on this subject you may be interested in reading: online trading comparison and auto forex trading

How To Trade Options

how to trade futures options

Advice on How to Trade Options

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