Option Trading Explained: Learn the Basic Concepts

Option trading is one method you can involve yourself in to generate profit. There are several advantages in option trading.

However, you need to find out the basic concepts of it. It will help you decide on matters that can affect you throughout your trading experience.

This article explains the concepts of options trading. From the variables involve and to the terminologies circling around the trades, this is quite useful for your trading career. Your success or failure will be dependent on how you fully understand the concepts involved, aside from the strategies you will be using later on.

Option is defined as a legal agreement between a buyer and a seller to buy or sell a security at an agreed price during a particular period.

Maybe you will notice that it is relatively similar to an insurance policy. You (the buyer) agree to pay a certain amount of money to your insurance provider (the seller). In return, the provider will protect your property by issuing insurance. The only difference is that options can be traded, whereas the insurance policy cannot be traded.

You can deal with two types of options contracts within trading. These two options are the call and put options. You buy a call option if you forecast that the security price will go up; you buy a put option when you forecast that the security price will go down.

You will sell a call option if you forecast that the security price will go down, and vice versa, if you will sell a put option. To fully understand the put and call option, you examine the following instances.

Suppose you have options on 30,000 bushels of corn. When you have entered an option contract with your corn supplier, he cannot sell those 30,000 bushels to someone else until the contract has expired.

In return, they have the right of writing the contract and you have to pay them the agreed amount of money.

For instance, the price of those 30,000 bushels is estimated to be $3,000. If the actual price of it in a certain month in the market is $3,100, you have the right to exercise or use your option for those bushels of corn and buy that commodity from your supplier for $3,000. You can either keep it for your needs or sell it in the open market for $3,100, generating a profit of $100.

However, if in that certain amount, the price of those bushels were only $2,900, you would opt not to exercise your option. You could purchase it in the open market for $2,900 rather than exercising your option to buy it for $3,000.

Here are the things you will be dealing with when trading options:

Strike Price

It is the price that is agreed by both the buyer and seller of the option. This means that if the strike price of the bushels of corn option is $3,000, the seller is obliged to sell it to you even though the open market price of it is higher than $3,000.

You, as the owner of the option, can purchase it at a price lower than the market price. If the existing market price is $3,100, then you will earn $100.

Option Price

Option price consists of time value plus intrinsic price. Time value is the amount of money that the option is worth of until its expiration date. The longer the time option had until the expiration date, the higher the time value for this particular option.

The time value will become zero if the option has expired. Intrinsic value is the difference between option strike price and current market price.

You will also deal with other things, but so far, these are the basic concepts you need to understand. Remember these concepts and make a success out of your option-trading career.