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)

Investing: The Long Put Option

The long put option is the 'option' to buy a leveraged i.e. via collateralized credit, position in a certain number of a businesses shares at a specific price. A fee is charged for the use of an options contract that creates a price spread within which the option user will not yield a profit. Investors use options when they want to increase their potential earnings though purchase and/or sale of stocks. This article will discuss what options and put options are, how they are priced and why investors consider them.

Options explained

Options contracts such as stock options are made with a securities dealer to buy or sell underlying financial products such as commodities, currency, shares, carbon emissions points etc Moreover, as noted above, options investing is a form of leveraged investment in which the investor is able to increase one's investment position for potential greater gain or loss. For example, an investor may purchase 1 option to buy XYZ company before November 30, of a given year. The option itself will be priced by the market and represents a multiple of shares such as 1 option=100 shares.

Options exist in two types calls and puts and can be both bought and sold. Call options have the potential to yield gain if the underlying share price rises whereas put options are the opposite i.e. a drop in underlying share price. The long put option is a type of option where the investor banks on the decline of a price value and retains the 'option' to buy a certain amount of shares at a pre-determined price.

As the name 'option' implies, the option entails the choice to either buy or sell an underlying security and not the requirement. Such being the case, investors may be able to limit potential losses to the premium cost i.e. fee of the option. This is called options "covering" as in covering as short position to protect against a rise in underlying security price.

How options are priced

The cost of options contracts are different from the options price and are three essential variables 1) the fee, 2) the option price and 3) the option loss if any. The fee charged by the securities dealer to facilitate the contract may vary from broker to broker and the option price itself is determined by several variables making it more complicated to determine a fair price.

Option price variables:

The variables that go into the pricing of an option can help an options investor determine if the option is fairly value i.e. not inflated in price and cost. Knowing the fair price of an options contract can assist the investor in minimizing the cost part of the profit venture. Specifically, the variables that go into the cost of an option include the following:

• Underlying securities price
• Market conditions
• Term of the contract
• Exercise/strike price

The above variables determine the risk of the option which in turn translates into price. The higher the risk, the lower the cost tends to be whereas the lower the risk, the higher the price of the option often is. For example, if a strike price i.e. choice to buy or sell, is within 5% of the current underlying security price, the risk of that security not reaching that price is lower than a 10% change, therefore increase the risk cost.

Pricing methods:

There are several ways to price an option in determining whether it is fairly priced or not. Three such methods include 1) mathematical equation 2) investment software and 3) Options guides and 4) investing intuition. Of these methods the last, investment intuition is the most speculative and holds the greatest risk of inaccurate pricing assessment. The first method, i.e. mathematical equation involves entering various variables into a theoretical pricing model to come with a fair price calculation. Investment software and guides may also have build in models or pre-calculated data to assist the investor in this task.

Why use a long put option?

A long put option may be a way to make larger profits in a shorter period of time without risking more than the options premium i.e. the fee for the option contract. Simply put, it can help one make more money faster. However, this is not done without risk and involves making an investment decision based on a number of market and business variables including the unknown future.

Long put option

Source: 'Gxti'; CC By-S.A. 3.0

At best, investors make a strongly calculated and intuitive decision that lowers the probability of failure i.e. loss thereby increasing the probability of maximizing profit. At worst, a poor option decision can lead to a higher probability of failure and a multiplied loss of money since options contracts are leveraged investments. For the latter of the above two reasons, options trading should be considered carefully in terms of available investment funds, loss provisions, investment accuracy, and investment know how.

The long put option is used when an investor, broker or speculator thinks the price of an underlying security will fall. By locking into pre-determined option price, the investor can then buy the put option if the price falls and thereafter sell a greater amount of shares than actually purchased at a higher price than the fallen security value. The difference between the strike price and the actual price of the underlying commodity minus the cost of the contract will then determine any profit.

Sources:

1. http://www.investopedia.com/terms/p/putoption.asp
2. http://www.optiontradingtips.com/strategies/long-put-option.html
3. http://www.smartmoney.com/options/index.cfm?Story=pricing1111
4. http://www.valueline.com/edu_options/rep1.html
5. http://www.investorwords.com/4559/short_squeeze.html