A trader’s portfolio can be filled with many different kinds of investment instruments. Some of the more common being stocks, bonds, mutual funds etc. But in this mini-course, we are going to cover a slightly more sophisticated kind of investment – options.
The first thing you need to understand is that options, like all other financial vehicles, involves risk and is probably not suitable for everybody. In fact, options trading is probably one of the riskier investments out there. This is why it is crucial that you know how to trade options before you begin. You will understand why in a minute.
The advantage of trading options really lies in the fact that it gives the trader a lot of freedom to choose how they want to trade. A trader can be extremely speculative or conservative depending on their trading personality. The main aim of this series of mini-course is to equip you with the fundamental knowledge of what options trading is, so that you are able to navigate the market independently and confidently.
So, what are options?
Options are essentially contracts that give the owner the right to buy or sell an asset at a fixed price, also known as “strike price”, for a defined period of time. This is different from stock trading where the investor buys and sells the actual asset itself, however, an option is still a security. The buyer of the contract has the right to purchase the underlying asset, but is not obligated to do so. On the other hand, the seller of the contract is obligated to sell, if the buyer wishes to buy. Because of its speculative nature, an option is also known as a form of derivative.
If this sounds confusing, here is an example to demonstrate what we have covered:
You saw a vintage 1960s Ford car and negotiate a deal with the seller to reach a sale price of $100,000. However, you don’t have money to buy it until 1 month later. So you buy an option to purchase in one month time for $100,000. The contract itself costs $1000.
In one month time, the price of the car rockets because it was discovered to be a limited edition vintage car. It is now worth $500,000. However, because you have bought the option to purchase it at $100,000, you may choose to exercise that right and make the purchase. Your net profit is $500,000 – $100,000 – $1,000 = $399,000.
Of course, you may choose not to exercise this option and forfeit the right to purchase the car. To do this, simply let the expiration of the contract go by and your contract will be useless. However, you will lose the $1,000 you paid for the contract. This means that you will lose 100% of the initial investment which you have put in.
This example outlines simply how an option works. As you progress, you will discover more complexities. Therefore, it is important that you understand the absolute basics first! Take some time to figure out a few different scenarios you can work out with options before you move on to the next chapter. As always, if you have any questions, feel free to email us. By the end of this tutorial, you should have a solid foundation on how to trade options.