Understanding Trading Options

Before you begin trading options, you first need to know what options are all about. It is a type contract between two traders. An option buyer or taker does not have the obligation to buy or sell a part of the share at a specific price and at a specific date of the option but he or she has the right to do so. You have to pay an initial fee to the seller or writer of the contract to obtain this right.

Basically, there are two options that you can exercise:

• Call options
• Put options

In call options, it gives the buyer the right to buy the shares at a specific price stated on the contract, on or before an expiration date but not the obligation. For example, a company shares have a last specific sale price for a share. You can buy these shares for a lower price. You, as the buyer have the right, but not the obligation, to buy a specific number of shares at the lower price per share at any time before the expiration date stated in the contract.

You in turn will have to pay an initial fee to the seller of the option. Then, the seller of the call option is supposed to deliver the number of shares you purchased at the lower price per share if you exercise the option. You should always remember that you, as a taker do not have the obligation to exercise the option.

In put options, the taker does not have the obligation to sell the shares at a specific price on or before an expiry date but has the right to do so as stated on the contract. You will be required to deliver the shares if you exercise the option. For example, a put option would have a specific price per share that has an expiration date. You, as a taker, will not have the obligation but has the right, to sell a specific number of shares for the specific price per share before the expiration date. You will have to pay the writer a premium or purchase price for the put option in order to obtain this right. Remember, you have no obligation to exercise the shares. It is your choice if you want to or not.

To put both in simpler terms:

• Call option
The taker will have the right to purchase shares at the strike price in exchange for paying the initial fee to the writer. The writer in turn receives the initial fee but he or she is now obligated to deliver the shares if you, as a taker, exercise the option.

• Put option
The taker will have the right to sell shares at the strike price in exchange for paying the initial fee to the writer. The writer then receives the initial fee but is now obligated to buy the shares if you, as a taker, exercise the option.

You should also know that there are two types of exercising options: The European style and the American style. The American style offers much more freedom for the trader. This is because you can exercise an option at any time on or before the expiration date, whereas the European style only allows you to exercise an option on the expiration date. The most popular style is the American style option.

Managing risk is the main advantage of an option. Try to think of it as insurance in case the price of the stock you are trying to sell falls.

Deciding time is also an important advantage of options. It will give you, as a call option holder, up until the expiration date to make a decision to exercise or not to exercise the option and purchase the shares. This is also true for a put option holder. He or she has the decision to sell or not to sell the shares he or she is holding.