By Michael Rosenhall
The Concept of Options Trading
To better understand the concept of options trading and how it functions, one should have a pretty good idea as to how stock trading functions in general. Options trading is just one of many types of stock market trading activities that many investors prefer over the purchase and sale of bonds, mutual funds and stocks. What traders need to remember is that options have characteristics that are extremely different from those of stocks.
The key difference between options and stocks has to do with ownership in the company that has issued those shares of stocks. Purchasing shares of stocks provides you with a small piece of ownership in that company. Conversely, options are merely contracts that have nothing to do with ownership in that they provide you with the ability to purchase or sell shares of stock by a specific date in the future and at a specific price.
The What, How and Why of Options Trading
Options are classified as either “calls” or “puts.” The difference between both of these is as follows:
– With a call option, you have the right (but are under no obligation) to purchase shares of stock before the option expires at its current “strike” price. In so many words, you purchase a call option.
– When you purchase a put option, you have the right (but are under no obligation) to sell those shares of stocks before the option expires at the current “strike” price.
When companies or individuals sell options, they are basically creating a financial instrument or security that had not existed prior to the sale. We refer to this as “writing” an option. When you create a call option, you may at some point in time be under obligation to sell those shares before the option expires at the current strike price.
General Option Trading Strategies
The different types of stock trading strategies where options are concerned are similar to how shares of stocks are purchased, sold or traded. There are basically three different strategies that investors employ – bearish, bullish and neutral (non-directional) and these are based around the specific types of movements in the stock market. Here is how they differ:
Bearish strategy – this particular strategy is employed by the investor who is expecting the underlying price of that stock to start declining. In order to devise the best bearish strategy, you have to assess how low you feel that stock price is going to go and the time frame involved in its decline.
Bullish strategy – the opposite holds true with this strategy. It is based on the expected increase in the underlying price of the stock in question. Again, you must be able to assess how high the price will go and in what amount of time that will occur.
Neutral (non-directional) strategy – when the investor does not know which direction the price of the stock will go, they employ a neutral strategy that is not based on whether the stock increases or decreases in value. Instead, the strategies are based on the assumed or expected stock price’s volatility factor.