What is Options Trading??!!

Options trading become very popular lately because option is one of the most flexible and versatile instruments that can greatly enhance the performance or reduce the risk of an investment portfolio. By deploying the right strategies, options trading enable us to make money whether the market is bullish or bearish or even when the market going sideway.

So, what is an Option?

Option is a contract that has the right but not obligation to buy or sell a stock at a specific price on or before a specific date.

How does an option work?

An option is very similar to when we want to buy a land to build our home sweet home. For example, when we found an ideal piece of land and need time to obtain permit, land approval, securing financing and seek confirmation from Feng Shui master, etc.

At the same time, we would like to secure the land while putting everything in place. We can go to the land owner and “strike” a deal to buy the land for $5 million. We create a contract that gives us the right to buy the land but it does NOT constitute an obligation that we must purchase the land.

The contract has an expiration of 3 months to put everything in place. Hence, we are controlling the land for 3 months and we must decide whether to buy the land or not before the expiration date.

As a return, the land owner is expecting to collect a premium of $200,000 for being obligated to sell the land to us at $5 million. This premium is based on how much the land might increase in value during the 3 months period.
The land owner will be more than happy to receive and keep the $200,000 premium paid for the contract no matter what happens. At the same time, the agreed upon sales or strike price is likely to be much higher than he or she could obtain if he or she sold the land without obtaining all the necessary approvals.

The contract in this example is very similar to a Call option in stock market. The strike price is $5 million while the option premium is $200,000 for a 3 months expiration contract.

During the 3 months period, if we discover a gold mine underneath the land. The value of the land shoots up to $50 million. However, the land owner is still obliged to sell the land for $5 million. We bought the land for $5.2 million and can now sell it immediately for $50 million to make a $44.8 million profit.
However, if for some reasons such as the application to build a house is unsuccessful or the Feng Shui master confirms that the land is not suitable to build a house. We decide not to exercise the option to buy the land. In this case, we will lose $200,000 premium paid for the option.

Using the similar example and apply it to the share market or options trading, investors who anticipate a bullish market can buy Calls option on the stock to ride on the upward moving wave. When the stock prices go up, the premium of Calls will go up. That’s how an option trader can make money from option but at a fraction of the cost of owning the actual stock.

On the other hand, investors who anticipate a bearish market can buy Puts on stock to profit from falling prices. As the stock prices go down, the premium of Puts will rise to profit the investors. Puts are also used to protect portfolios like insurance to hedge against a fall in stock prices.


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