Options 101 : What are options and what should an investor know about option trading ?

In finance, an option is a contract between a buyer and a seller that gives the buyer the rightÑbut not the obligationÑto buy or to sell a particular asset (the underlying asset) at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not to exercise the right and let it expire. The underlying asset can be a piece of property, or shares of stock or some other security, such as, among others, a futures contract. For example, buying a call option provides the right to buy a specified quantity of a security at a set agreed amount, known as the 'strike price' at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote the option, must fulfill the terms of the contract.

Option trading is much more complex than stock trading. With stocks, it's easy for an investor to reason that if a particular stock rises to a target price of X, he or she will take the profits and exit the position. By the same token, if the stock falls below Y, this means it's time to cut losses. With Option trading it becomes much more complex since you come into contact what is called as position management. It requires following activities to be taken care of by investor:

1. Adjusting position based on time of expiration and relative stock price : In comparison to stock investing , investing in options also involves keeping the time of expiration of the option also in mind. It might have happened that the stock might have gone up but the since the time period for expiration is very less still the price would be very low.
2. Using OTM ( out of the money) spreads to hedge delta risk : A call option with a strike price that is much greater than the current stock price is considered to be out of the money. For instance, a call option with a strike price of $55 and a stock price of $50 is considered to be out of the money. Out of the money options tend to trade for low dollar amounts. ThatÕs because there is a small probability that the stock will make a large move. Option buyers can buy many out of the money options and if the stock makes an explosive move, they will make a very large return on their investment. This reduces the overall risk of the market suddenly shooting up or down in counter-intuitive manner.
3. Using opening trades to rebalance positions

Options trading is not esay especially if you are new investor. Some of the best tools provided for options trading is given by brokerage firms like Options Xpress. Using their tools investors can do difficult jobs like position management easily. Click here to open an Options Xpress brokerage account.

Please visit Online Brokers for Options Trading to find the listing of Options Trading brokerage firms

Learn basics about investing from How to invest stocks