Understanding the components of option trading clearly outlines how much advantage a trader has. Without a doubt, people who have sufficient knowledge of a certain trade have better chances of profiting from it. In the same way, a trader who is knowledgeable in options trading has better control of his profits. In this article, three basic concepts will be presented. Let it be noted that the information covered here are intended for neophytes in options trading.
What is option trading?
Option trading is a category of trading stocks, bonds or any type of assets that acts more like a contract, which allows for liberty to buy or sell the asset but does not necessarily oblige the holder to exercise his powers within a certain period of time. In layman term, it simply means “buying” the right to buy or to sell an asset within a specified duration. It should be noted that buying the option is very different from buying the stock itself.
What are the types of options?
There are two types of options: the calls and the puts. Both of them work in exactly opposite principles.
The calls are options that provide the right for a holder to buy a certain asset at a specific price, during a specific period. This investment will be profitable only if the stock would increase during the period of the option. Calls are also oftentimes considered long positions.
The puts, on the other hand, are options that provide a holder to sell the asset at a certain price, within a specific period. This will yield profit for the holder if the stock price will depreciate during the period. Conversely, puts are often seen as short positions.
What are the styles of option trading?
There are two: the American Style Options and the European Style options. The difference between the two lies on the date when the option can be exercised. In European Style, options can only be exercised after the expiration date. American style option, on the other hand, provides more leeway as it allows the option to be exercised from the day of purchase until the day it expires.
Most stock traders hold the common misconception that the style of options depends largely on the geographical location where the trade was made. Wrong. Actually, the names American and European styles are just terminologies to separate one style from the other. It does not necessarily mean that when one trades in Europe, the trading style adopted is automatically a European Style or vice versa.
Who are the Buyers and Sellers in Option Trading?
These two types of options then lead to four different types of traders namely, the buyers and sellers of the calls, and the buyers and the sellers of the puts.
But, buyers and sellers of options are further distinguished by their general names: buyers are called holders and sellers are called writers.
Buying and selling of options comprise a very complicated scheme of trade. For the holders of calls a puts, an options contract does not oblige them to participate in the trade through either buying or selling. They have, at their disposal, their rights to either maintain an asset or to dispose it.
However, for writers of calls and puts, the contract necessitates that they either buy or sell an asset.
Option trading is by nature, a speculative type of trade. In trading-speak, it suggests that this kind of trading best suits those who seek risks and enjoy taking them.