The Options Trading Basics You Need to Know

Why do option trading?

In today’s world where many new ways are being created on a regular basis to earn money, options trading remains the oldest starting from the days of Ancient Greece who started the basic concept of options contracts mid of the fourth century BC. So, the best possible reason for you to enter options trading is that it can make you money for a small amount of investment as compared to buying equity stocks and being financially independent while you sit in the comfort of your home.

Saying with personal experience, research, and watching other traders as I go ahead:

“Believe me it’s worth doing but with some basic rules which should not be broken ever”

What is options trading?

Here I can let you know the long textbook version of the options trading definition or a concise simplified version of what I have done. Well as all of you can gather the bookish definition online anywhere, I would tell my version in two halves below.

So, to start let’s understand option first – “Option is a type of financial derivative”

Now you must ask “What is a financial derivative”. So financial derivative means the value of the financial asset will be derived from its real financial asset or technically known as the “underlying asset”.

Let’s understand it better with an example-

Suppose today TESLA Inc stock is running at $121.82, but its option is running at $1.9 which we can buy or sell.

So, to clarify- 

  • The underlying asset here is TESLA Inc priced at $121.82
  • The financial derivative of TESLA Inc stock is priced at $1.9

Hope now we stand at a someplace good place on the word “option” than before.

Now let’s start on the trading part – “Short term investment”

 I know most of you must have an idea about it, but there is no harm in giving an eye to it again along with our friends who are new to this. So, as I have written above in simple 3 words that trading is an investment of money that we do for a short amount of time. How short you ask? Well, it can be short as 1sec and can go up to days.                                                                

Now is the time when you guys along with me add points “a” and “b”. Do you see where I am going?

So, to sum up “options trading is trading in which we buy or sell financial derivative of an underlying asset”.

Strike Price and Expiration Date

Now we will add some more terms to our above definition of options trading. Strike price and Expiration date are some variables due to which option prices vary.

  1. The Strike Price for an option is a fixed price of an underlying asset that can be bought or sold.
  2. The Expiration date is the date after which an option bought or sold is deemed invalid

So, adding the strike price and Expiration date to get at a final definition of options trading.

“Options trading is a trading in which we buy or sell financial derivative of an underlying asset at a particular strike price and on or before the expiration date”.

Types of Option

Guys, we are going deep now. Have a glass of water and come back to dive more into options trading.

Now in options trading, we try to predict in which direction the stock will go next and accordingly take a call option or put option. Two more terms to learn now.

Now, there are 2 types of options that we can trade:

  1. Call Option: We buy a call option when we think the stock price will go up and make profits on it.
  2. Put Option: We buy a put option when we think the stock price will go down and make profits on it.

Long and Short Position

Now that we have learned that there are 2 types of options, next is the types of position we can take with the call and put option.

  1. Long position: In this position, we only buy an option on an underlying asset, it can be on the call side as well as put.
  2. Short position: In this position, we only sell an option on an underlying asset, it can be on the call side as well as put.

So, if someone was to ask how many different trade position you can make at a time?

The answer would be 4, which can be understood by the below diagram.


What are the advantages of options trading?

Option trading has many advantages, including:

  1. Low capital requirement: As told earlier in the example of TESLA Inc, 1 Share can be purchased for $121.82 however on the other hand an option can be purchased for $1.9
  2. High return on investment: There is a very high volatility in the option of an underlying asset resulting in much higher profits than in equity stocks.
  3. Flexibility: There is no need to sit for full hours of NASDAQ regular market session from 9:30 AM to 4:00 PM ET, you can even just sit for 5 minutes book $1000 profit, and enjoy the rest of the day with friends & family.
  4. High Liquidity: As a record on highest option contract monthly was booked on CBOE (Chicago Board Options Exchange) on Aug 22 summing up to 59.2 million contracts leading to easiness in buying or selling large no of a number of options.

What are the disadvantages of options trading?

As nothing good comes without its cons, options trading is no different as it can provide you high profits but at the same time take your money as well if the trade taken by you goes in the opposite direction of which you have taken trade-in.

But it’s nothing to get disheartened, with the right approach and following some rules strictly you will succeed even if you have some bad days of losses.

Looking forward to your queries and the topics you need help with. Stay tuned for the next post!

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