How Are Options Traded

Options are a contract agreement between the option contract supplier and than buyer of the options. Options are purchased in time periods of about a month and can be commonly purchased as far in advance as four months. The purpose of buying options is to make a profit by exercising the contract at a favorable price. Favorable prices are determined by assessing the contract price, underlying securities price, and expected exercise price of the contract Since options contracts are derived from underlying securities such as stocks, they are termed 'derivative securities'.

How to buy options:

To buy options one must have good credit and enough money to support adverse results in the course of trading. The contracts are offered through brokerage firms and/or investment banks and each option represents 100 units or shares if the options are for stocks. The contracts are usually sold with expirations of 30 days beginning every month. 

There are two types of options contracts called 'calls' and 'puts'; calls are options that allow the contract holder to buy underlying stocks at the fixed 'strike' price whereas puts allow the trader to sell at a 'strike' price. While stock options are well known and actively trader, there are also several other types of options in several different securities markets that include the following:

• Stock Options
• Futures Options
• Foreign Currency Options
• Interest Rate Options
• Index Options

In the Money Vs Out of the Money Options Vs At the Money

Choosing options that are in the money or out of the money depend on what one believes a security will do in the time period of an option and the risk adversity of the options buyer. In the money options are considered less risky than out of the money contracts.

When options contracts are bought 'in the money', the securities purchased through the options contract are priced lower than the time of purchase if the option is a call. This worth is reflected in a higher cost of the options contract. An out of the money contract is the opposite, the underlying securities are priced higher than the actual market price of that security and this makes the call options contract cheaper. The inverse is true for put options and securities purchased through options at the money contracts are equal to or near equal to the price of the underlying security.

When to exercise options

Stock options traded on U.S. stock exchanges can be exercised at any time during the term of the contract whereas European options can only be exercised at the expiration date. The best time to exercise i.e. buy underlying stocks if it is a call option or sell underlying stocks if it is a put is when the perceived value to the trader is highest. Since prices fluctuate frequently, there is no sure way to know exactly when the best time to exercise is. For this reason it is good to have a pre-determined expectation and trading strategy in mind as it can make the options experience more palatable.

Trading strategy

Developing a trading strategy for options may take some time. Since these contracts are leveraged through credit it can be considered betting using borrowed money. For this reason a new trader of options might be advised to follow a few precautionary steps as follows:

• Only borrow within your financial means.
• Familiarize thoroughly with the trading process and financial instrument.
• Use a reliable broker that is trustworthy and has a good reputation.
• Consult family or friends if the money to be used is shared.
• Develop a trading strategy or method.

Options trading is a sophisticated form of exchanging property through derivative calculations and means. While the potential to make money using options is higher than with non-derivative securities the risk can also be higher. Options contracts are bought from brokerage firms with expirations within 30 day increments and are bought with prices calculated in terms of the underlying security. The resulting contract prices therefore become either in the money, out of the money or at the money. Exercising options is not an exact science and is often done using trading strategies.

Sources:

1. Zvi Bodie, Alex Kane and Alan J. Marcus. 'Investments' New York. 2002 McGraw-Hill Irwin. p.662-670.
2. http://www.888options.com/basics/options_pricing.jsp
3. http://www.investopedia.com/ask/answers/05/buyingoptions.asp
4. http://en.wikipedia.org/wiki/Exercise_(options)