Option trading is simply trading of assets, commodities or financial instruments.



 

In trading, there are two types of options “put option” and “call option.” A put option is a contract between two parties – the buyer and seller (writer) of the option. This contract allows the buyer the right but not the obligation to sell to the writer the commodity or financial instrument if the buyer exercises his option. The price of the commodity or financial instrument is called strike price. In exchange, the buyer pays the writer a premium or a fee, in advance.

 

A call option likewise is a contract between the buyer and seller. In this case, the buyer has the right but not the obligation to buy an asset from the seller certain commodity or financial instrument at a certain time for a certain amount. As in the put option, when options are exercised a premium is paid.

 

When a put is made, the trader of the option hopes that the price of the commodity or asset will fall, while the buyer of a call option hopes that the price of commodity or asset will rise.

 

Let’s see how this works.

 

Peter wants to buy as house. After searching a number of houses, he found a house that suits his specification. The price of the house is pegged at $200,000. However, Peter doesn’t have enough cash at the moment. Peter decided to call the owner of the house and talked him into selling his house within 6 months. The owner agrees but put a premium on the option for $3,000. Peter agrees and pays the owner the $3,000. The house now costs $203,000.

 

Within the period of six months, a dramatic event happened. The house that Peter purchased was discovered to be sitting on an oil well. Because of this, the value of the house now shoots up to $2 million dollars. The owner is obligated to sell the house to Peter at $203,000. After the sale is consummated, Peter sells the house at its current value, making him $1,897,000 richer!

 

If an opposite thing happens, like if the house was discovered to be haunted and its value plummets to zero. The owner wisely didn’t exercise her option to buy the house, thus Peter loses the premium he paid, in advance for the house.

 

Market trends are important indicators for options traders. When market prices are up, then it is time to buy calls and sell puts. Remember never put all your apples in one basket.

 

 

 

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