Guide To Options Trading 101 & Derivatives: What are Options in Trading?

What Are Derivatives, and Why Are They Important?

Think about a trip you are planning six months from now. You spot a hotel you like, but you’re concerned the rate might rise. So, you ask the hotel to “lock in” today’s price in exchange for a small fee. If prices rise, you win, you pay the lower price. If they close, you can walk away and get another one. You had purchased the option, but not the obligation, to reserve the room. That is the main idea of what derivatives accomplish, as they help you navigate future uncertainty.

In finance, derivatives are contracts whose value derives from an underlying asset: stocks, commodities or currencies, for example. They assist traders to minimize risk and speculate on price changes.

So, What Exactly Are Options in Trading?

Options are a type of derivative that provide you with the right, but not the obligation, to purchase or sell an asset at a set price before a certain date.

Option types

There are basically two kinds of investing options:

• Call Option – gives you the right to purchase an asset.

• Put Option – the right to sell an asset.

Here is a simple way to be consider it:

Call = Buy & Put = Sell

The two primary reasons that people use options:

• Hedging: protecting against potential loses.

• Speculation: to forecast where prices might go.

An Options Contract: Key Features

Options may sound complicated, but they’re really just a few essential ingredients.

• Underlying Asset: A stock or other instrument that the option is written on.

• Strike Price: The price at which the asset can be purchased (or sold).

• Expiration Date: The last day one can exercise the option. The option is worthless after this date.

• Premium: The price you pay to purchase the option.

Real Life: How Do Options Work

Suppose Christy believes that the stock of a company, let’s say “Senyar Inc.” is going to go up in the next month. It is now trading at $100.

Christy purchases a call option, buying the right to purchase the stock for $105 at any point over the next 30 days. She pays $3 for this option.

What could happen?

• If stock goes up to $115:

She can exercise her option to purchase at $105 and sell at $115. That’s a $10 gain, minus your $3 premium = $7 gain per share.

• If the stock remains under $105:

The option expires worthless. Christy is not exercised, and only loses the $3 premium, her maximum loss.

That’s the beauty of options: limited downside, unlimited upside (with calls).

Why Do Traders Use Options?

Options provide greater flexibility for traders than just buying and selling. Here’s why:

Advantages:

• Less capital required than outright purchasing shares

• Defined risk: loss is limited to the premium paid

• Many strategies: simple buys to complex spreads

• Hedging instrument: safeguard your portfolio against surprise movements

Considerations:

• Time-sensitive: options have expiration dates!

• Premiums can be expensive: especially when you’re wrong a lot

• It takes strategy: not only a guess on direction but also a guess about timing

Wrapping It Up

Options are financial “power tools” extremely functional in the right hands, but risky in the wrong ones. They provide a means to hedge risk, speculate with less invested capital, and make intelligent options.

If you’re a beginner, here’s some things to consider:

• Learn first: Familiarise yourself with terms such as strike price, expiration and premium.

• Learn with paper trading: Start trading virtually, before you risk a penny.

• Keep it simple: Only trade basic calls and puts before seeking out more advanced strategies

Knowledge and a strategic, considered approach can help make options trading a core part of your investment toolkit.