Trading Options - The Basics (Part Two) By Emil Emilov At Isnare.com Ezine Articles

Definition Mumbo-Jumbo

Options, unlike stocks, are derivatives. That means that their value derives from the value of another financial instrument (called the underlying). The underlying can be a stock or futures contact or an index. For the purpose of this article we’ll concentrate on stocks.

An option is a contract between two parties, the writer (the seller) and the buyer. An option gives the buyer the right to either buy or sell a stock at a pre-determined price. And so there are two types of options corresponding to those rights: calls and puts.

Example for Put Options

Say you own a thousand shares of BHP stock currently worth 30$ each. You know that reports are coming out soon but you have no idea whether they are going to be positive or negative. If positive the price will go up, that’s easy.

In case BHP reports badly you know you will be selling. But you also know that everybody else will be selling too. This will drive the price down and you will incur a loss even if our order gets filled. Now, wouldn’t it be great if you knew beforehand what BHP was going to report? If you knew and sold that would be insider trading, which is illegal and “that never happens in Australia”. The next best thing would be to secure your right to sell at the current price of 30$ per share. As we know, there is no such thing as free lunch. So, in order to secure this right, you have to pay a premium. And you need someone to sell you that right.

This right is a put option. It is a contract between you and the other guy that gives you the right to sell stock to him at 30$ no matter what. So if the stock drops to 20$ you can exercise you right to sell it for 30$. Or, if you think that the stock has reached its bottom you can keep the stock and just sell the put options you bought previously. Now think, the stock price is 20$ and you are selling the right to be able to sell it at 30$. Of course that right would be worth much more than when you bought it for (because back then the stock was at 30$). So, the more the stock drops the more valuable the put option becomes.

A pure options trader wouldn’t have any stock to sell. His goal would be to buy puts when he expects that a stock will go down. After the stock has dropped the options trader will seek to sell the option for a profit.

So you see, it does not really matter where the market goes, up or down. Trading options enables you to profit from both directions. When you expect the price to go up you can buy the shares or attain higher leverage by buying calls. Should the reverse be the case, you can buy puts. To me, puts are easier to understand than selling stocks short. And believe it or not, there are options strategies (combining calls and puts) with which you can profit from sideways movement. But let's not get ahead of ourselves.

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