Options are commonly known as "derivatives" because the Options market is a market which is "derived" from another market. The most commonly known options are derivatives of the share market, but you can also have options on commodity futures such as gold, silver, sugar, wheat or pork bellies, or on other financial instruments such as currencies. The market is based purely on supply and demand, which means the prices rise and fall according to market sentiment. Whether we are talking about shares, commodities or currencies, these upward or downward trends can be tracked on charts. It is a true saying that "a picture paints a thousand words" and in the same way, charts can give us a visual representation of the movements in price, in a way that no amount of tabulated data can. Charts are our best friend if we want to learn option trading because they help us to decide when to buy or sell, or what strategy to employ.

What is an Option?

Before we can learn option trading, we first need to understand what an Option is. An option is a contract between two parties to exchange an asset for an agreed price, by an agreed time. If you buy an option, you are outlaying a much smaller sum than you would for the full purchase price of the asset the option covers. You may have heard of someone having an option to buy land. In this case, you would pay a few thousand dollars to give you the right to purchase something worth many thousands of dollars for an agreed amount, within a given time frame. So you have paid for a right, but not an obligation. You can exercise that right if you wish, or you can let it lapse, or expire. The same principle applies to options on shares. When you buy a CALL option, it gives you the right to "call" on the owner of the shares, to sell them to you at the agreed "strike price" by an agreed date.

Let’s look at an example. If you purchased a $30 October ABC Bank (ficticious name) call option, you now have the right (but not the obligation) to purchase ABC Bank shares for $30 up until the contract expiry date in October. Now, imagine that before the option expiry date, the daily market value of ABC Bank shares rose to $32. This would effectively mean that you now have the right to purchase something for $30 and then immediately turn around and sell it on the open market for $32. If you had purchased contracts for 1,000 shares, you have an immediate profit of $2,000 at the time the option expires. It shouldn’t be difficult to see then, that the higher the share’s market value goes before the expiry date, the more valuable your call option will become. As long as the market price is above the option strike price, the call option contract is said to be "in the money". To learn option trading, it is critical you understand this simple concept.

On the other hand, you might think the price of a share is going to fall. You may want to ensure that you can still sell your shares for at least what you paid for them, or slightly below. So you take out a form of insurance called a "put" option. A put option gives you the right, but not the obligation, to sell (or put) your shares to someone else, for an agreed amount, by a given date. Let’s take our ABC Bank example above and imagine that you owned 1,000 shares that you purchased for $30 but before our October expiry date, the share price plummeted to only $26. Normally, you would have lost a cool $4,000 (1,000 shares x $4 loss in share value), but if you had also purchased $30 October put options, you have the right to sell (put) the shares for $30 to the market. For a small cost, you have avoided a $4,000 capital loss - so you would feel like you’ve taken out "share insurance" which is what a put option really is. So again, it becomes evident that as the price of a share drops, so a put option becomes more valuable. As long as the market price is below the option strike price, the put option contract is said to be "in the money".

Why Options?

Options have often been perceived as high risk and indeed, can be so, because their price can rise or fall rapidly as the "underlying" share price moves. If we want to learn option trading it is imperative we avoid the traps. If we understand how we can harness and tame this power, our perception of options as a trading vehicle can change dramatically.

Options, if used wisely, can actually be far less risky than simply trading shares alone. Why? Because options contain the elements of time (to expiry) and price (movements), as well as the ability to either buy them or create them out of nothing, to sell them. When these three elements are understood and effectively combined, they provide a wonderful flexibility that allows us to protect our trading positions, while at the same time, providing opportunity for the same profit that would ordinarily have come from ten times the investment capital needed to produce a return from investing in the underlying shares. This is called "leverage" - less dollars to produce the same profit. If you can invest a much smaller amount to produce a better profit, this leaves your other capital free for other option investments, bringing even more profit.

You can implement some great option trading strategies with surprisingly little capital and excellent returns. Learn option trading the safe way! It's not rocket science. Just buying a simple call or put option with the hope of selling it for a profit can be your express route to financial ruin. With a little more education, you would be surprised how much better you can do, with much less stress and with the same trading capital.