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Basic Options Trading Tutorial
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In this basic options trading tutorial we'll introduce the main concepts involved with option trades. Although the traders may treat this kind of security with a bit of mysticism, there really isn't a whole lot of mystery behind why leveraged trades like these are popular.

Basic Options Trading Tutorial Part 1: Terminology

Before anyone delves too deep into what is essentially derivative trades it is important to have a fundamental understanding of the terms used in the market. While most of the terms are intuitive it is critically important to not get them mixed up, because doing so can cause significant losses. We've sorted these in some reasonable order of importance.

  • Underlying Asset - the stock or other security on which a contract has been created
  • Calls - these represent a right to buy a security.
  • Puts - These represent the right to sell a security
  • Strike Price - This is the price at which a stock or asset will be bought or sold (depending on whether it is a call or put)
  • Expiration date - This is the date when the contract becomes invalid - ie when the trader loses their right to buy (call) or sell (put). Contracts must be executed on or before this date
  • Premium - The price paid for the call or put
  • Going Long - means owning the option (and paying the premium)
  • Going Short (or writing an option) means selling the call or put (and receiving the premium)
  • Execution - when a contract has been enforced, resulting in the delivery of share (of the underlying asset)

Basic Options Trading Tutorial Part 2: Basic Strategies

Given a basic idea of the terms traders use to describe stock derivatives trades it is possible to describe some simple strategies used in the market. In the vast majority of cases contracts expire without ever having been acted on (executed), most either expire worthless or are sold (closed) long before expiration. Typical strategies a trader might use include:

  • Going long a call (or put) option as a stand-alone investment
  • Writing (Going short) a put option in order to potentially secure the underlying asset at a discount to today's actual price
  • Writing a call option as a means of cashing in on a market top without actually selling the underlying security

While more advanced strategies exist that remains beyond the purview of this basic options trading tutorial. A companion options trading payout worksheet demonstrates the profit and loss characteristics of the basic contract types. While simple payout charts won't explain all of the possible systems for using contracts it does help to have a visual understanding of what makes trades profitable.

Basic Options Trading Tutorial Part 3: How the Market Functions

Trades are handled via an option broker, who passes on orders for contracts via an exchange clearinghouse. The benefit of handling these highly leveraged contracts this way is that doing so eliminates counter-party risk - ie it reduces the risk of failed trades.

Brokers are responsible for their clients maintaining proper collateral (cash or other assets) in their accounts, as it then falls on the brokers to fund the clearinghouse on any trades executed by their clients. Margin requirements vary between brokers however it is highly unusual for trade restrictions to be put in place unless significant numbers of contracts remain outstanding near expiration.


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