An Introduction to Options Trading

You may be wondering what are share options ? Assuming many of you have tried buying share/equities before, think of options as insurance premium that you pay/receive for the shares that you own. Wait a minute, collect additional money from my shares ? Yes that is right and we'll get to that part later on.

An option is a contract, which gives the buyer/holder of the option the right to buy/sell a specific quantity of the underlying assets at the Strike Price at anytime before the contract duration expires. It is to be noted that the holder of the option has the right but not the obligation to exercise the right. Options are available for various assets such as wheat/cotton/gold or financial instruments such as stocks/bonds. In this article however, we will be focusing on Stock options.

Stock options started as a mean for stockholders to insure their holdings against any huge upswings or downswings in the market. It is a small premium to pay in order to avoid potential huge losses in a highly volatile market.

I will use the example below to explain a PUT option. (Holder of the PUT option has the right to sell)

An example :

Simon has 100 shares of Microsoft which he bought at $20 each.
He is hoping that the price of the share will go up for him to make gains from his stocks.
At the same time he is afraid that the price might go down and he will incur huge losses, so
he bought a PUT option (the right to sell) for Microsoft at $0.40/share.
This contract is valid for 1 month. If during that month Microsoft fall to $15, Simon would have lost $500 on his holding if he sells his shares. However, he has purchased the insurance (PUT option) on his Microsoft shares at $20, he has the right to sell at $20 althought the market price is at $15.

In this scenario, Simon is lucky that he bought the option because he does not have to incur huge losses of $500 as he has the PUT option contract he bought for $40. (0.40 * 100)

In the example above, Simon is utilising the option for his own benefit and not trading options as a means of making money. To make money from options trading, I will alter the same scenario a bit to show you how to do that.

Altered example :

Now Simon does not own any Microsoft shares. However he predicts that the share is trending down and its price will go down soon. He then bought a PUT option for Microsoft at 0.40/share for 100 shares and paid $40. Microsoft is trading at $20 when he bought the option contract. 2 weeks later, Microsoft has plunged to $15. Now when the share price of the option goes down, the option values actually appreciates in value.

Simon bought his PUT option at 0.40 each and paid $40 for 100 shares. Now that Microsoft share has plunged to $15, his PUT option contract has risen in value. It is worth $90 (0.90 * 100). As Simon does not hold any Microsoft shares he will just sell his PUT option contract to whoever needs it, and in the process makes a healthy profit of $50 ! This is only for 1 contract, can you imagine how much Simon will make if he has bought 10 contracts ? That will be (50 * 10 = $500) in just 2 weeks time.

There are countless Option Trading Strategies out there, you'll have to educate yourself and find those that suits your risk tolerance.