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The Basics of Trading Stock Options

Updated on September 9, 2017

Options Trading

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Stock Options: A Beginner's Guide

In the fields of finance and investment the contract to trade options between a buyer and the seller gives the buyer the right (but not the obligation) to buy or sell a particular option.

Options are used as hedges and bets for investors and companies.

Most options trading strategies employed by a trader involves the desire to protect against loss of capital (coverage). Most of the options strategies used by investors (and investment banks, insurance companies and other large institutional investors) are used to control the buying and selling of a higher percentage of goods using less capital (leverage).

Assuming you are a CIO of a company, consider this example. Say an airline wants to make sure that fuel costs in the coming fiscal quarters will remain stable. The airline buys option contracts that are profitable if the price of fuel increases. In this scenario, the cost of fuel will be offset / covered by the profits of the derivatives contracts that pay when the price of fuel increased. If fuel prices fall below the contract value then the company should be prepared to lose money. But this result is covered by the lower cost of entry of fuel that the company would have to buy.

Investment options contracts are used for a different reason. An individual or a company may want to control a larger share of business capital than the cash flow at hand can allow. In such cases, options can be used to add leverage to the investment position.

One contract, for example, can be written as an option on 1000 shares of Apple. The cost of the contract will be much less than the total cost of 1000 shares of Apple stock. However, the buyer of the contract will pay a cash premium to the seller (payment due to the "writer" of the contract). He may decide to directly buy shares at a later date once the contract is settled. With an option, if the shares of Apple are higher than the "price", then the stock option is said to be "money."

The value of a stock option should be evaluated using one of several distinct models. Quantitative stock analysts, who more often than not have an educational background in mathematics and qualitative statistics are essential in the development of these models. The financial models make an attempt to mimic the future changes in the value of changes in the financial (macro) stock environment. This option pricing model "is necessary to accurately assess the risk to an investor of stock options in a particular model.

There are many different types of stock model options. For example, if an investor wants to build a financial position in a large stretch of private land then he or she can use real estate options for that purpose.

Financial options are a great tool and resource for any investor!

The Very Best Stock Options Training Materials

Index Options and Futures

In the financing of an option is a contract between a buyer and a seller gives the buyer the right - but not the obligation - to buy or sell an asset (underlying asset) at a later date at an agreed price. In exchange for the grant of the option, the seller charges a fee (premium) for the buyer. An option gives the buyer the right to buy the underlying asset, a put option gives the buyer of the option the right to sell the underlying asset. If the buyer decides to exercise this right, the seller is obliged to buy or sell an asset at an agreed price. The buyer can choose to not exercise the right and left to expire. The underlying asset can be a piece of property or shares or other security, such as, a futures contract.

For example, an option to purchase the right to buy a certain quantity of a security in an amount determined by agreement, known as the 'price' at any time on or before expiration, while buying a put option provides the right to sell. Following the election of the option holder to exercise the option, the party who sold, or wrote the option, you must comply with the terms of the contract.

The theoretical value of an option can be evaluated according to various models. These models, which are developed by quantitative analysts, trying to predict how the value of the option will change in response to changing conditions. Therefore, the risks associated with the granting of ownership, or options trading can be quantified and managed with greater precision, perhaps with some other investments.

Options Trading for a major class of options which have standardized contract features and trade on public exchanges, facilitating trading among independent parties. Over-the-counter options are traded between private parties, often well-capitalized institutions that have negotiated separate trade agreements with others. Another important class of options, particularly in the U.S., are employee stock options, which are issued by a company to its employees as a form of incentive compensation.

Other options that exist in many financial contracts, for example real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans. However, many of the valuation and risk management principles apply all financial options.

© 2009 Madison Miller


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