Let's look at the basic facts about options trading before we go any
further. Like any human endeavor, options trading is best
described in very careful language so that there's no confusion about
our meaning. First, let's take a look at exactly what an "option"
is. An option refers to just that, the option to purchase certain
stocks or certain commodity items by a certain date. This means
you do not gain controlling interest in the
stock or commodity until
that date. For this reason, options can, and often do, expire
worthless. There are two types of
options
contracts:
1) Contracts to buy blocks of stocks by a certain date
2) Commodity futures which are options to buy blocks of hard goods by a certain date
If you have options on 10,000 bushels of corn, whoever sold it to you
cannot sell it to someone else until the expiration date of your
contract has expired. In exchange for giving you this right, they
wrote the contract and took money from you. If you don't exercise
your options prior to the expiration date, they will expect full
control of their corn again, and will sell it someone else. What
makes options such fascinating instruments are these facts:
1) With options you can sell that which you don't own or ever plan on buying
2) You can buy something you don't ever plan on physically holding and sell it for a profit
Another great thing about options is their inherent flexibility:
although you have the right to buy or sell a certain stock or
commodity, the choice is yours. You're not forced to exercise
your options. You can always sell your options contract to
someone else. Many traders of commodities and options always sell
the contracts only and have never taken physical possession of any
underlying asset they've ever traded. The leverage in options
gives you a chance to earn extremely high returns. These types of
options we're describing are referred to as covered options. With
covered options you actually plan on or do own the underlying asset
that you purchase options contracts for. Uncovered options are
the exact opposite.
Like the word uncovered means exposed, uncovered or naked options are
considered more dangerous, because you are merely speculating without
having an ownership interest. Your are exposed to the risk
without the benefit of owning the asset. Options trading involves
a great deal of leverage in the form of margin loans to your trading
account. All options trades are highly leveraged, so you need to
add margin interest to your calculated costs when considering a career
in trading options.
Pricing and potential returns on options trading depend on very real
world circumstances. If you purchase corn futures, for instance,
there are literally hundreds of variables that affect the price of the
corn, and hence your investment. If a corn shortage is expected
in a certain part of the world, your investment might hit big because
the price of corn could rise dramatically. On the contrary,
perhaps government subsidies have introduced a glut of corn into the
world market. In that case, your investment might tumble.
Futures contracts for commodities and options contracts on stocks are
strictly based on guessing what events will happen in the future.
Of course you'll always attempt to make as accurate as a guess as
possible, but let's face facts: in this world unforeseen things can and
do happen. For this reason, protect your downside, and only invest with
money you can afford to lose. Options trading can be very
profitable, but unsurpisingly it's also very risky.
