Options Trading Education – Back to Basics

Acquiring a solid education in options trading is critical to your long-term success as a trader. This is because, unlike many of the other values, they are multidimensional in both function and form. Options are a form of derivatives. What they mean is that they are the by-product of their underlying stocks, indices, bonds, currencies, and commodities.

An option is a right to buy or sell a financial instrument at a certain price, on or before a certain date. The definition above is for the American version.

The European version can only be exercised on the expiration date of the contract. They exist in various underlyings such as stocks, indices, bonds, commodities, and currencies. An options trading school should first aim to teach the basics. In its most primitive form, there are two types of options; “Calls” and “Puts”.

A “Call” gives the buyer the right to purchase a financial instrument at a particular price (also known as the “Strike Price”), on or before a particular date. A “Put”, on the other hand, gives the seller the right to sell a particular financial instrument for a particular price on or before a particular date.

A trader has the option to buy or sell a Call option, or buy or sell a Put option. The method they choose will determine if they are “long” or “short” in the market, and how much risk they have. Being “long” on the market means that you need the price of the derivative to rise beyond the strike price to be profitable. Being “short” the market means that you need the price of the derivative to fall below the strike price to be profitable.

The options trading school you choose to learn from should address the way these derivatives are traded on the market. Every time a buyer chooses to buy a Call or Put option, he must pay a small price, called “Premium”.

An option seller, if not properly hedged, can have unlimited downside. Selling “naked” options is considered very risky and should be left to professional traders. However, options can be a very attractive investment class to hedge any exposure you may have. Also, if done correctly, you can create positions where you profit if the market goes up, down, stays the same, or trades within a certain range.

If a trader is extremely bullish on a stock, but doesn’t want the exposure or doesn’t have the capital to pay for the stock, they can use options to leverage their investment. The trader can control exactly the same number of shares but for much less money.

If an investor is “long” on the market and wants to protect or hedge their portfolio, they can buy a “sell” on a broad stock index like the S&P 500. This way, in the event of an extremely negative market move, they can sell your position in the index and let the put flow.

An options trading school should also try to educate you on the different pricing models. Pricing is the way to determine the fair market value of an option. A market price serves as a guide to fair market value. However, most professional options traders use a pricing model such as the Black-Scholes model to determine if an option is overvalued or undervalued.

According to this model, the price of an option depends on several variables such as the exercise price, the time until expiration, the implied volatility of the financial instrument, the interest rate, etc.

Another critical aspect of profiting in the world of options is to thoroughly understand “The Greeks” and how to use them. They are vital tools for measuring risk management. The three most important Greeks are “Delta”, “Theta” and “Vega”. The other two Greek are “Gamma” and “Rho”.

Delta is used to measure the rate of change in the value of an option with respect to changes in the price of the underlying asset. Vega is a measure of sensitivity to volatility. Theta measures the value of the derivative with respect to the passage of time, also known as “time decay”. Rho measures how interest rates affect the price of the derivative. Gamma, which is a second order derivative, measures the rate of change in Delta.