How Trading Options Works #
Stock markets are secondary markets, where existing owners of shares can transact with potential buyers.
It is important to understand that the corporations listed on stock markets do not buy and sell their own shares on a regular basis (companies may engage in stock buybacks or issue new shares, but these are not day-to-day operations and often occur outside of the framework of an exchange).
So when you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from some other existing shareholder.
Likewise, when you sell your shares, you do not sell them back to the company – rather you sell them to some other investor.
You can trade a number of different types of securities from:
Remember: We trade OPTIONS!
What are options #
Options are financial instruments that are derivatives based on underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they choose not to.
- Call options allow the holder to buy the asset at a stated price within a specific timeframe. (You want the stock to go up).
- Put options allow the holder to sell the asset at a stated price within a specific timeframe. (You want the stock to go down).
- Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price.
How Do Options Work #
- Options are a versatile investment product. These investments are two-sided trades that involve a buyer and a seller.
- Each call option has a bullish buyer and a bearish seller, while put options have a bearish buyer and a bullish seller.
- Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a premium fee for each contract. For example, if an option has a premium of 35 cents per contract, buying one option would cost $35 ($0.35 x100 = $35).
The premium is partially based on the strike price—the price for buying or selling the security until the expiration date. Another factor in the premium price is the expiration date. Just like with that carton of milk in the refrigerator, the expiration date indicates the day the option contract must be used. The underlying asset will determine the use-by date. For stocks, it is usually the third Friday of the contract’s month.
How Orders are Executed #
Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers.
- A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer.
- The more narrow the price spread and the larger size of the bids and offers (the amount of shares on each side), the greater the liquidity of the stock. Moreover, if there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth.
- Markets of high quality generally tend to have small bid-ask spreads, high liquidity, and good depth. Likewise, individual stocks of high quality, large companies tend to have the same characteristics.
- Generally speaking, the bigger the spread the harder it will be to secure the bid or ask you want. This is a case where MKT orders can be utilized.
Benefits of Trading Options #
Options offer fantastic leverage for 3 reasons:
- You don’t have to invest a lot of money to get started.
- You can achieve enormous returns if you are correct on direction and time.
- Risk is manageable; you only can lose what you put into the trade as a buyer.
Summing it up #
Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.
- Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation.
- Although there are many opportunities to profit with options, investors should carefully weight the risks.