What Is Options Trading?

what is options tradingWhen you are options trading you take on contracts that grant the owner of the contract the right to buy or sell stock at a specific price before a specific date. The size of an options contract is 100 shares of stock. The buyer of the option contract pays a premium for this right adding to his cost. What the buyer is doing is betting that the stock is either undervalued or overvalued by more than the premium and want to lock in a fixed price to buy or sell. Options contracts are written by owners of stock and sell these contracts because they do not believe the stock will change price which will make the contract valuable between the time of sale and the time of expiration.

In options trading the contract where you buy the right to buy stock is called a ‘call,’ because the current owner of the stock can have his shares ‘called away’ from him when the owner of the option exercises his right to buy, otherwise known as ‘striking’ the contract.

Conversely, a contract where you buy the right to sell stock you do not own is called a ‘put’. This is because the seller of the contract can be ‘put’ into the stock if the stock drops in price below the strike price of the put option.
The terminology for options trading is slightly different than for stocks. As opposed to just buying and selling, when you buy a contract, even a put, it is known as ‘buying to open.’ Conversely when you sell the contract you are ‘selling to close.’ That will allow you to sell the option contract for the market price. If you want to exercise the contract and take possession of the stock in the case of a call option, then you ‘strike to close.’ The option will be executed, the shares called away from their owner and transferred to your account. You will then pay 100 times the strike price for the stock option for 100 shares of stock.

Stock options are very volatile in price and the more volatile the underlying stock itself the greater, in general, the premiums will be per share of an options contract. It is what is known as the ‘volatility premium.’

Trading options carries a stupendous amount of risk and requires even stricter trading discipline than stock trading. A small move in the underlying stock can create massive moves in the value of an option so your timing must be excellent and your protective stop-loss orders set tight.

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Pete Southern

About Pete Southern

Pete is an active investor with knowledge of all sectors but his first love are IPO's. A failed day trader who now understands research. A love of economics and writing seen Pete begin to publish content for various finance blogs. Our main editor and collator of contributions, he is your point of contact via editorial at stockpricetoday.com

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