Options Made Easy for The Novice Investor

Options made easy for the novice investor takes a look at the options market in the hope of breaking down some of the terminology used so that novice investors can have a better understanding of what goes on.

History

Options trading started its present-day life on the Chicago Board Options Exchange (CBOE) in April 1973, with the sole purpose of trading options on a number of limited New York Stock Exchange (NYSE) equities.

Option Arrangement

A fundamental of options trading is to understand that an option gives the purchaser of the option the right to purchase or sell the specific commodity, at the set price, within the specified period. The option - which is not the same as the obligation. Moreover, the right is that of the buyer, not the seller. In other words, the seller cannot enforce the sale, but the buyer can. Third, the buyer of an option can only lose the maximum amount he paid for the option itself – if he decides not to pick up the option. These all combine to make the option arrangement a fairly unique tool in investment strategies.

Call/Put Options

Put and call options are the cornerstones of options trading, i.e. they're what it is all about. A put option gives the buyer of the option the right to sell the specified commodity within the time specified. Conversely, a call option gives the buyer of the option the right to buy the specified commodity within the time so specified.

Parties To The Arrangement

The parties to an option contract are the "holder" and the "writer". The holder of the option is the buyer of the option – thus he "holds" it. The writer of the option is the seller of the option – thus he "writes" the option.

Financials

The financials in an option arrangement are called the "premium", the "strike price" and, respectively, "in-the-money", "out-of-money", and "at-the-money".

Simply put, the premium is the non-refundable amount paid by the buyer for purchasing the option. The strike price is the agreed to sale price for the commodity. To be "in-the-money" the buyer needs to have agreed a strike price that is lower than the prevailing market rate on the agreed to sale date. To be "out-of-the-money" means the buyer agreed a strike price higher than the prevailing market rate on the agreed day of sale. And, "at-the-money" means the strike price and prevailing market rate on the agreed to sale date are one in the same.

…And Finally

As can be seen then, options trading need not be complex and act as a form of insurance against price movements of commodities. In short, they act as a form of hedging your bets!

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