Option trading is a type of investment that is very popular, and it is done both in the stock exchange and by private agreement. When you trade options, you make an agreement with someone that you will buy a particular number of shares of a stock that they are selling on a specific date for a certain price. You pay them an option premium, which is an amount of money that gives you the right to buy those shares at that time, at the particular price.
Option trading is much like commodity futures trading, except that when you trade futures you are obliged to make the purchase based on the contract you agreed upon and make a down payment. With option trading, you can make the purchase or even let the option expire, depending on which one will earn you more profit.
How Options Work
Most options trading are done through a public exchange, where you don't know who the seller is. When you trade options, you pay an option premium for the right to purchase a set number of shares from a seller for a particular amount of money per share. When that date comes, if the shares of that stock are selling for higher than you agreed upon, you would make the purchase. You can then immediately resell those shares at the current market price, making an instant profit.
If the shares of that stock are selling lower than you agreed to pay for them, you could decide not to make the purchase and you therefore let the option expire. If you wanted to buy the shares, you would be paying much more than the current market price. You can instead buy the shares cheaper in the open market. When you let the option expire, your only loss is the amount of the option premium you paid to hold those shares for you and that becomes the seller's profit in that trade.
The benefits of option trading are that you can make a substantial profit, and your loss is limited to the amount of the option premium you pay that gives you the right to make the purchase you desire, on a certain date. Unlike futures, where you must go through with the contract even if it incurs a loss to you, you can choose not to make the purchase here. Option trading can give you immediate returns for your investment.
The initial cost is known as the strike price (aka exercise price), which is the option premium you pay for the right to buy the security or commodity at a later date. That could be just a few dollars to hold the instruments for you, which you must then pay for in full if you decide to go ahead with the purchase.
You should invest in stock options only when you have sufficient knowledge on stock options and how the markets work. This knowledge will help you decide on the time factor for making the investment.