Define option trades
Should the holder not choose to exercise their option at any point, then the contract will eventually expire and cease to exist. You can read more about exercising an option here. Options are a form of derivative; which basically means they derive their value from an underlying asset. In an options contract the underlying asset is the asset which is specified in the transaction the holder has the right to carry out. For example, a contract might give the holder the right to purchase stock in Company X, in which case Company X stock is the underlying asset.
The term underlying security is also commonly used, but both terms refer to the same thing. There's a range of financial instruments that can be the underlying asset in an option.
Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too. There are even basket options, in which the underlying asset is a collection of different assets.
The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. Strike price is the term most commonly used, but it can also be known as the exercise price. The expiration date of an option is, quite simply, the date on which the contract will expire. Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year.
If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless. There are actually many different types of options, because they can be classified in a variety of different ways. In a very broad sense though, they can be categorized based on whether they give the holder the right to buy or sell the underlying asset. In this sense, there are basically two main types; call options which give the holder the right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price.
It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that point.
Please see our section on the Types of Options for further details on this. Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style.
These terms have nothing to do with anything geographical though. An American style option is one where the holder can exercise their option at any time during the term of the contract, up to and including the date of expiration. A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration. American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy.
When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place. They are physical settlement and cash settlement. Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price. Cash settlement is where the holder receives a cash payment based on any profit they could effectively make through exercising their option.
Please see Options Settlement for more details. When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. However, the amount that the buyer pays isn't the same amount that the writer receives. Options are typically bought and sold on the public exchanges, where the transactions are facilitated by market makers. They basically exist to ensure that there's always a market for options contracts.
If someone wishes to sell, and there is no buyer, then the market maker will act as the buyer and complete the necessary transaction. If someone wishes to buy, but there is no seller, then the market maker will act as the seller. Market makers make a small profit on each transaction. Options contracts are listed on the exchanges with two prices: The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them.
It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, the seller would receive the bid price and the buyer would pay the ask price.
There is certainly a lot you should learn before you actually get started and invest your money. With that being said, however, most of the fundamentals aren't actually that difficult to comprehend. Once you have grasped the basics, it becomes much easier to understand exactly what options trading is all about. Buying an options contract is in practice no different to buying stock. You are basically taking a long position on that option, expecting it to go up in value.
You can buy options contracts by simply choosing exactly what you wish to buy and how many, and then placing a buy to open order with a broker. This order was named as such because you are opening a position through buying options. If your options do go up in value, then you can either sell them or exercise your option depending on what suits you best.
We provide more information on selling and exercising options later. One of the big advantages of options contracts is that you can buy them in situations when you expect the underlying asset to go up in value and also in situations when you expect the underlying asset to go down. If you were expecting an underlying asset to go up in value, then you would buy call options, which gives you the right to buy the underlying asset at a fixed price.
If you were expecting an underlying asset to go down in value, then you would buy put options, which gives you the right to sell the underlying asset at a fixed price. This is just one example of the flexibility on these contracts; there are several more. If you have previously opened a short position on options contracts by writing them, then you can also buy those contracts back to close that position. To close a position by buying contracts you would place a buy to close order with your broker.
There are basically two ways in which you can sell options contracts. First, if you have previously bought contracts and wish to realize your profits, or cut your losses, then you would sell them by placing a sell to close order. The order is named as such because you are closing your position by selling options contracts. You would usually use that order if the options you owned had gone up in value and you wanted to take your profits at that point, or if the options you owned had fallen in value and you wanted to exit your position before incurring any other losses.
The other way you can sell options is by opening a short position and short selling them. This is also known as writing options, because the process actually involves you writing new contracts to be sold in the market. When you do this you are taking on the obligation in the contract i.
Writing options is done by using the sell to open order, and you would receive a payment at the time of placing such an order. This is generally riskier than trading through buying and then selling, but there are profits to be made if you know what you are doing. You would usually place such an order if you believed the relevant underlying security would not move in such a way that the holder would be able to exercise their option for a profit. For example, if you believed that a particular stock was going to either remain static or fall in value, then you could choose to write and sell call options based on that stock.
You would be liable to potential losses if the stock did go up in value, but if it failed to do so by the time the options expired you would keep the payment you received for writing them. Options traders tend to make their profits through the buying, selling, and writing of options rather than ever actually exercising them. However, depending on the strategies you are using and the reasons you have bought certain contracts, there may be occasions when you choose to exercise your options to buy or sell the underlying security.
The simple fact that you can potentially make money out of exercising as well as buying and selling them further serves to illustrate just how much flexibility and versatility this form of trading offers. What really makes trading options such an interesting way to invest is the ability to create options spreads. You can certainly make money trading by buying options and then selling them if you make a profit, but it's the spreads that are the seriously powerful tools in trading.
A spread is quite simply when you enter a position on two or more options contracts based on the same underlying security; for example, buying options on a specific stock and also writing contracts on the same stock. There are many different types of spreads that you can create, and they can be used for many different reasons. Most commonly, they are used to either limit the risk involved with taking a position or reducing the financial outlay required with taking a position.