Getting Started with Options Trading
What are Options
Options are contracts, which enable a user to buy and sell a specific asset like stocks or currencies etc. for a specific price and for a specific period of time.
In every contract, there is a buyer and a seller. In this options trade, one party has an obligation to participate in the trade whereas the other party has the option to participate in the trade or not.
Option trades are very popular and part of the appeal stems from the fact that you can realize faster and larger profits as compared to trading stocks. However, the risk associated with options is also higher. It is rare to lose your investment when trading stocks, especially those of reputed companies but losing your investment in options is common.
Apart from the opportunity to make more money in lesser time, options also allows you to trade without having to commit a lot less capital.
Buyer or Owner
Buyer in an options trade is also known as owner.
- Buyer has the right to buy a specified quantity of a specific stock at a specific price within a specified time. Too many specifics in there, isn’t it 😛
- Buyer does not have the obligation to exercise the option
- Buyer may sell the option to another party at any time for any price.
Seller or Writer
Seller in an options trade is also known as a writer.
- Seller writes (theoretically since everything is electronic) and sells the contract guaranteeing the buyer the right to purchase a specific quantity of a specific stock within a specified timeline at a specific price. Again, too many specifics in there, isn’t it 😛 😛
- Seller is obligated to sell the specified quantity of the specified stock within the specified timeline should the buyer exercise the option.
Types of options trading:
Stock options trading may be the most common type of options trading, which people may be aware of but options trading is not just limited to trading stock options. In fact there several types of underlying assets, which let you do options trading on.
Stock Options Trading:
Stock options trading involves trading wherein the underlying asset is shares of a a publicly listed company such as Apple (AAPL), Amazon (AMZN), Exon Mobil (XOM) etc.
Index Options Trading
Index options trading involves trading wherein the underlying asset is an index fund, which is also traded just like stocks. For example, S&P 500 (SPY), PowerShares QQQ Trust (QQQ).
Forex Options Trading
Forex options trading involves trading wherein the underlying asset is currency such as Australian Dollar (AUD), Euro (EUR) etc.
Futures Options Trading
Futures options trading involves trading wherein the underlying asset is futures contracts.
Commodity Options Trading
Commodity options trading involves trading wherein the underlying asset is either a physical commodity or commodity futures contract.
Basket Options Trading
Basket options trading involves trading wherein the underlying asset is group of securities that could be made up of shares, commodities, currencies etc.
Just like stock exchanges, options exchanges facilitate the trading of options. There are several exchanges in the US, which allow for options trading including Chicago Board Options Exchange (CBOE), International Stock Exchange (ISE) etc. The complete list can be found at the SEC website.
There are several options brokers. I currently use TDAmeritrade and Robinhood.
The Market Maker
A market maker is a broker dealer firm, which ensure that the markets liquidity by enabling traders to buy and sell options even if there are no public orders to match the required trade. They do this by maintaining large and diverse portfolios of a wide range of different options contracts. Without market movers, there may not be enough volume for proper execution of trades.
Their computer systems continuously feed their quotes – the prices at which they are willing to buy and to sell – to the options exchanges where they operate. The market makers’ profit comes from the difference between the prices at which they buy and those at which they sell.
Jane Street Capital and Optiver are two of the markets makers that operate at NYSE. You won’t ever need to contact them but when your options trade gets executed, which you desperately wanted to — you know the one to one behind the scene to thank!
Options Clearing Corporation
The Options Clearing Corporation (OCC) is the firm that guarantees that sellers meet their obligations and transactions get settled. You won’t ever need to contact them but it is good to know that they’re behind settlement of your options trade.