Today’s investors have multiple financial instruments to choose from such as mutual funds, bonds, commodities, stocks and exchange traded funds. But the range of securities does not end there, one other type of instrument is known as ‘options’ which provides a great investment prospects for the traders.

Below are some of the fundamentals of Options trading:

1.)    Option is a type of contract between the buyer and the seller, where in buyer of the option contract has a right to buy or sell the underlying asset at a certain price but is not obliged. Since the buyer is not obliged to exercise his rights he may choose to wait for the contract to expire without acting upon it.

2.)    There are two types of Options namely Call and Put. With Call Option trader gets a right to buy an underlying asset where as in case of Put Option trader gets a right to sell an underlying asset.

3.)    Every Option contract has a lot size associated with it. And since traders are buying a right to buy or sell and not the actual underlying asset the Options are being traded at premium price for a contract and not the stock price of the lot. So for example: if the underlying asset is being traded at $49 in the market and premium on its $ 49 strike price Call option is $2 for a lot size of 1000, then a trader who chooses to buy the Call Options today is supposed to pay only $2000 per contract instead of paying $49,000 for buying 1000 stocks at $49 each.

4.)    Further, at the end of the Call Option contract period if a trader wishes to actually buy the stock only at that time he/she is supposed to pay the total amount of $49,000 as per the example referred in point number 4. So near the expiry of the contract even if the market price of the stock has climbed up to $52 still the trader has a right to buy that particular stock at $49.

5.)    So if the buyer of Call option chooses to execute his rights then the opposite party in the contract is obliged to sell his holdings of the underlying asset at the agreed upon price.

6.)    In the same way if the buyer of Put option chooses to execute his rights then the opposite party in the contract is obliged to buy the underlying asset.

7.)    On the other side if the buyer of the option chooses not to exercise his rights, in that case the seller of the contract can retain the premium as profits.

8.)    While calculating the profits and losses one needs to keep in mind premium paid for buying an option contract and the strike price. So if the premium on the option is $5 and the strike price is $110, trader’s break-even point is at $115. If the trader wants to make profits the stock prices should stay above $115. On the other side if the stock price falls to $108 the trader is not losing $7 but he/she can forget about the premium paid and bear the loss of $5 per stock.

Keeping the above mentioned fundamentals in mind one can at least better understand how the market forces work for options trading.

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