Stock Trading Tips

The rudimentary knowledge of options is very essential to get into stock option trading. Go through this article and get yourself educated on the basic terminologies related to stock option trading system that can further enhance your understanding of the intricacies involved in options’ trading.

What is Stock Option Trading?

An option is just the contract representing 100 units/stocks of the underlying asset that offers the buyer the right to purchase (call option)/sell (put option) the stocks of the underlying asset.

Stock option trading is very similar to the scenario of wanting to buy a house and signing a sale agreement for the same. Suppose, you are interested in buying a house that costs $10, 00000. Though you currently don’t have the financial affordability to but that right away, you can sign a contract with the seller that gives you the right to purchase the house within a stipulated period of time, say, 2 months from the date of signing the contract. In return, you pay $3000 for this initial contract to be signed.

Irrespective of whether the construction costs are going to go up or come down, the seller has the obligation to sell the house to you at this fixed price of $10, 00000 and you possess the right to make the purchase. In this scenario, you are under no obligation to purchase the house at any cost. If you don’t make the purchase, you just loose the payment that you made towards the contract and in this case it amounts to $3000.

Here 2 different scenarios can arise. The cost of the house may go up or come down in those three months. If it goes up, say, doubles in value, you would have the tendency to make the purchase and enjoy the profit of $10, 00000 that you made in a 2-month duration. If it comes down to $8000, you might not want to buy the house and suffer a loss. In this case, you don’t exercise the purchase and just end up in loosing the initial payment of $3000 paid towards the contract and the contract here becomes void at expiry of the timeframe.

Stock Option Trading Terminologies

Options are just the derivative products that represent the underlying asset. A call option is the contract that offers the right of purchase to the buyer, commonly called as the holder in stock option trading. This type of option obligates the seller or the writer of the option to sell the underlying asset based on the request from the holder. A put option is the contract that offers the right of sale to the buyer. It obligates the seller to purchase the underlying asset based on the requisition from the holder.

Option price is often referred to as the premium and the value of the underlying asset as per the option contract is cited as the strike price. Price of the stock, strike price, timeframe till expiry and the option estimates are the factors that determine the premium of options in stock options’ trading.

Given this, you would now have an idea of the very basics involved. There are much more to be understood to completely imbibe the in and out of stock options. But, a thorough understanding of these concepts discussed above is very vital to barge into stock options’ trading. Have these in mind and get into options trading slowly and steadily with ease.

While the increased complexity of stock options has kept many investors away from stock options trading, there are others who think that stock options trading is very analogous to stock trading since both are dependent on the bullish and the bearish movement of the underlying assets. However, there are myriad differences between the two. Before diving into stock options trading, it is imperative that you understand the underlying differences which are often complex and incomprehensible.

The primary difference between stock options and stock trading lies in the fact that stock trading revolves around the stocks which in turn entail the possession of a proportional part of the company’s stake while stock options are contracts that empower the buyer/holder the right to sell (put option)/purchase(call option) the underlying asset while making the purchase(in case of a put option) and sale (in case of call option) obligatory for the seller, at the strike price before the expiration date once a contract is written. The concept of expiry prevalent in stock options trading does not appear in the arena of stocks trading.

The second difference arises out of the risk that is involved in these trading avenues.

While the stock trading implicates loss/profit proportional to the ownership of the individual, the profit and loss associated with holders and sellers in stock options trading is complex and completely different. While the buyer in case of stock options trading is bound for a loss that is limited to the value of the contract, he enjoys the advantage of unlimited profits. Nonetheless, the sellers undergo the risk of being forced to sell (call) or purchase (put) the underlying security at the strike price before the expiry date.

While trading stocks can be analogous to playing casino where all the owners who bet against a house profit inexplicably when there is an favorable market trend, the stock options trading is analogous to the participation in the horse race where the buyers’ profit is the sellers’ loss and vice versa.

Stocks move in a direction proportional to the supply and demand. In case of stock options trading, the movement of the options is internally dependent on several factors. When the price of the underlying asset or the current interest rate moves up, call options go up while put options come down in their value. Call options move along the asset value and the current interest rates while the direction of the put options is on the reverse. Call options are valuable as long as the strike price is below the current market price of the option whereas the put options are worth only when the strike price is above the current option price.

Dividends paid out on the stocks have a remarkable effect on the options. The put options increase in value with the pay out of dividends while the call options’ value drastically comes down in such scenarios. Even if the stock value is not volatile, options tend to undergo a rise/fall due to uncertainly of future price associated with the underlying asset and options estimates is another attribute that gives rise to the change in option prices in case of stable markets.