Option trading demystified
You want to enter the stock market but would like to limit the investment that you would have to make. Then you need to try option trading. It could give you a much bigger bang for your buck. Option trading commits you to paying a premium in return for a right to buy or sell a specified amount of shares within a specified time period.
In option trading with stock for example, an option gives you the right to purchase or sell a fixed number of shares, determined by the option contract specification, within a specified time period and at a specified price. Hence, as an option buyer, you either execute that trade within the specified time period or forfeit the premium you paid, or else you sell the option itself for either a profit or loss depending on what has happened in the intervening period. Option trading expirations for a given option series are generally spaced one month apart, and the termination date is generally the third Saturday of the month or any other day decided by the Stock Exchanges. Once that date has expired, all rights of the trader cease and he cannot use the option to buy or sell that particular underlying stock.
You would have to be deeply involved in stock market trade to understand the difference between stock trading and option trading. If you as a newcomer still want to be involved in option trading you must make an effort to understand terminology used and the ideas behind the concept. The terms by used by traders in option trading are quite specific and have their own meanings. When you go in for option trading you would have to decide a price for the stock you want to trade in , the number of shares, and the time period in which you would make such a trade.
You do not have to exercise your rights during the specified period, but your failure to do so will cause the premium you have paid for such future rights to be forfeited. The premium is charged to you so that you can lock in the agreed price for the time period that you have contracted to honor. So during these period, if you find that the price of the stock has appreciated, you are free at any time to make the balance payment and acquire the shares at the price agreed. On the other hand if the price has gone down and you do not feel that it is worthwhile honoring the option, you can take no action and allow your contract to lapse. You would however forfeit the premium you have paid. This may look like a loss, but would be much smaller than if you had bought the shares at the prevailing price before the start of the options contract.
Should the stock price fall or merely remain below the exercise price, the call option buyer cannot exercise the option at all, but can either sell the option and thereby exit the position at a loss or breakeven. Alternatively, he can hold onto it with the expectation that the market value of the option will rise, dependent upon factors such as the underlying stock price, volatility, time to expiry and more.
Generally though, because of the leverage that options provide, you can control a far larger amount of the underlying stock for a relatively small capital outlay compared with buying or selling the underlying instrument. That is what makes options so attractive because there exists the potential to make far higher return on capital than through merely trading the underlying instrument. When you know what you are doing, there are also far more trading opportunities with relatively lower risk compared to merely buying or selling the underlying.
What do the words mean?
Option trading for stocks is generally in blocks of 100 shares
The option giving the right to buy the underlying instrument at the strike price is called the "call" option.
Put option: The option giving the right to sell the underlying instrument at the strike price
The price that you agree to when the option trading contract is made is called the strike price.
In option trading, for call options you are "in the money" if your strike price is below the market price of the stock. For put options, if the strike price is higher than the current market price, you are again said to be "in the money".
Out of the money: When the strike price is above the existing price of the stock and you exercise a call option, and when the strike price is below the existing price of the stock and you exercise a put option.