How does options trading work

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How does options trading workHow Does Options Trading Work

In many ways there are two different options markets: there are the options markets on which average investors participate, and then there are options markets where institutional investors participate. Technically, options are traded on the same market, but the techniques and strategies that institutional investors deploy are very much more complex than those used by individual investors.

One prerequisite to a profitable career in options trading is an understanding of stock trading. Unless you understand how stocks rise and fall in value, then you can’t possibly begin to understand how stock options—a derivative of individual stocks—rise and fall. However, stock options, being the complex investment instrument that they are, bring in another variable that doesn’t much matter with stock picking: time.

Stocks vs. Stock Options

When traders buy and sell stock options they seek not to buy or sell stock. Instead, they are buying and selling the right to buy and sell stock at a certain price. The best example here is one many will experience, regardless of their financial background: purchasing a home. It is common to see that investors and first time homeowners alike place what are essentially options on the right to buy a home when they offer a small down payment for first consideration on new homes being built in a specific neighborhood.

You might, for example, give a homebuilder $5,000 with the understanding that you have the right to buy a home that they are building at any time in the next three years. Should you back out of the purchase of the home, the builder keeps both the home and the $5,000, but you save the money you might have otherwise spent on the home. If you follow through with the deal, you then have the right to purchase a home at the price stated in the contract.

Notice how much of the language is similar here: contract, options, and time. These elements, which are part of the very basic process of buying a home, illustrate better the relationship between stocks and options than any other market.

Time and Volatility

In the example above, the home builder required a premium of $5,000 to purchase the option to buy a home at a certain price within a timeframe that extends two years into the future. But while that homebuilder might accept $5,000 for a two-year timeframe that is largely predictable, it would be reasonable that the same homebuilder would require a larger premium for the option to buy the home if 1) home prices are changing rapidly or 2) the length of the contracted time is extended further into the future.

Many options traders sustain themselves by exploiting these two basic market phenomena. Since the price of options rise when predicting the future movement in stock prices becomes less certain, investors of all types can make money by playing very simple volatility strategies. If the markets are calm and cool, investors would be wise to snap up every option available, and hope that a larger daily range in the price of each stock buoys the general level of option premiums. This concept is the basis of the VIX volatility index, which determines the relative level of expected volatility by evaluating the changes in options premiums on the options contracts for the 500 stocks in the SP 500 index.

Hit the Ground Running

Options are considered risky investments because they are essentially leveraged investments. While this may be alarming at first, consider that this also means that small investors can effectively own a large portfolio of stocks with only a modest investment. Stocks in the $50 price-range, for example, often have options premiums ranging from $.05 to $1, meaning that one contract of 100 shares costs anywhere from $5 to $100, compared to $5,000 for a purchase of straight stock.

Should you have any experience in stock trading, options trading is the next logical step. Consider opening a demo account to “paper trade” the options markets to test your strategies. Alternatively, investors with more risk capital should consider opening an options account and having at it. Whereas “paper trading” allows investors to test their skills without risking their own money, trading with real money requires that new options traders experience something most will never experience in their paper accounts: the emotional influence of rising and falling account balances.