Options trading is like going to a shoe store. Imagine you see a pair of shoes you like, but you’re not sure if you want to buy them just yet. So, you talk to the store owner and pay a small fee to hold the shoes for you for a week. This fee doesn’t go towards the price of the shoes; it’s just to reserve them.
Now, you have two choices:
- Call Option (Buying): You come back within a week and decide to buy the shoes. The price you pay is the agreed-upon price from before, regardless of whether the store has since increased the price of the shoes.
- Put Option (Selling): Or, you could come back and decide not to buy the shoes. The store keeps your reservation fee, and that’s it.
In this scenario:
- The shoes are like the stocks or other assets.
- The reservation fee is like the option premium.
- The agreed-upon price of the shoes is like the strike price.
- The week-long reservation period is like the expiration date.
So, in financial terms, buying an option gives you the right (but not obligation) to buy (call option) or sell (put option) an asset at a set price (strike price) within a certain time period (before expiration date). And for this right, you pay a premium.
Remember, options trading can be complex and risky, so it’s important to understand it fully before getting involved!
How Does Options Trading Work?
When a trader/investor purchases or sells options, they attain a right to apply that option at any point in time, although before the expiration date. Merely buying/selling an option does not require an individual to exercise it at the time of expiration. Because of this, options are regarded as derivative security.
Participants in Options
- Buyer of an Option: The one who, by paying the premium, buys the right to exercise his option on the seller/writer.
- Writer/seller of an Option: The one who receives the premium of the option and thus is obliged to sell/buy the asset if the buyer of the option exercises it.
Types of Options
- Call Option: A call option is an option that provides the holder the right but not the obligation to buy an asset at a set price before a certain date.
- Put Option: A put option is an option that offers the holder, the right but not the obligation, to sell an asset at a set price before a certain date.
Notable Terms in Options Trading
- Premium: The price that the option buyer pays to the option seller is referred to as the option premium.
- Expiry Date: The date specified in an option contract is known as the expiry date or the exercise date.
- Strike Price: The price at which the contract is entered is the strike price or the exercise price.
- American Option: The option that can be exercised at any date until the expiry date.
- European Option: The option that can be exercised only on the expiry date.
- Index Options: These are the options that have an index as the underlying.
- Stock Options: These are options on individual stocks (with stock as the underlying).