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Track 'n Trade Options
Track 'n Trade Futures End-of-Day - What Are Options
Video Transcript
What is an option?
In the world of trading, we have several different types of orders that allow us to enter and exit markets using various strategies.
The most common order types are Market Orders, Stop Orders, and Limit Orders.
Once we move into the world of options buying and selling, we’re given two more types of orders we can use to take advantage of rising and falling prices.
These two order types are called Puts and Calls.
The single most asked question about options trading is, if I’m only going to be trading options, do I need to learn to trade commodities too?
Many people get confused, thinking that if they’re going to move into the world of options trading, they’re no longer trading the underlying commodity.
Of course, this is just not true, Puts and Calls are nothing more than another type of order you can use to buy or sell the underlying asset—weather that be a stock, commodity, or currency, it doesn’t matter, you still need to learn to be a trader of the underlying asset before you can ever start trading options on that asset.
If you’ll think of options like that, you’ll no longer be confused.
Before we can really start trading options, we need to get a few terms under our belt, so we’re all speaking the same language.
First of all, an option in an order that gives the trader, the right, but not the obligation to buy, or sell a commodity at a specified price prior to a predetermined date.
Now let’s break that down into some simpler concepts.
As mentioned earlier, there are only two types of options: Puts and Calls.
But, you can buy a Put, and you can sell a Put
You can buy a Call, and you can sell a Call
Options buyers are called “Holders.”
Options sellers are called “Writers.”
Simply put, if you buy a call option, you generally want to see the market rise in price, and if you buy a put option, you generally want to see the market fall in price.
And just the opposite would be true for selling puts and calls. If you sell a call option, you generally want to see the market prices fall, whereas if you sell a put option you generally want to see market prices rise.
Buying an option gives us, as traders, the right, but not the obligation to buy or sell the underlying asset at a specified price, prior to a specified date.
When buying and selling puts and calls, we also have the ability to specify a price that we are willing to buy or sell the underlying market at, so long as we buy or sell prior to a specified date.
The price that we specify is called the Strike Price, and the specified time is the expiration date of the option.
Now stick with me here…if this all sounds complicated, don’t worry, it will all become very clear once we start working through some examples. We’ll take it slow and easy, one step at a time, and build on our previous knowledge; it’s really very simple once we get past the terminology. I promise, once the lights come on, and you realize the power of options, you’re going to love them!
Okay, let’s continue…
Options have two kinds of built in values.
First is called extrinsic value, which is how much time do we have left until the option expires. We also simply refer to this as “time value.”
Second, we have intrinsic value, which refers to how far our option has moved into profitable territory, or what we refer to as “in-the-money.”
So, think about that for just a second, we have…
In-the-money, which is when your options value includes intrinsic value, as well as extrinsic value. We have…
Out-of-the-money, which is when your option value only contains extrinsic or time value, and we have…
At-the-Money, which is when your option strike price is at the same price, in relationship, to where the underlying market is trading.
Now, let’s summarize, because in the next video we’re going to go through and provide examples of each one of these concepts, so you can understand them from a trading point of view.
An option is an order that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date.
Options are called derivatives, because they derive their value from an underlying asset, either a stock, a commodity, a currency, or bond.
A call option gives the holder the right to buy an asset at a specified price within a specific period of time.
A put gives the holder the right to sell an asset at a specified price within a specific period of time.
There are four types of participants in options markets: buyers of calls, sellers of calls, buyers of puts, and sellers of puts.
Buyers are referred to as holders and sellers are referred to as writers.
The price at which the underlying asset can be purchased or sold is called the strike price.
The total cost of an option is called the premium, which is determined by factors which include the underlying asset’s current price, the strike price, interest rates, and time remaining until expiration.
An option “buyers” risk is limited to the premium and commissions paid for the option, while their profit potential is unlimited.
An option “Sellers” risk is unlimited, and their profit potential is limited to the premium they collect.
The reason traders and speculators “sell, or write” options, simply put, is to collect the premium.”
The reason traders and speculators “buy, or hold” options, simply put, is to collect the intrinsic value of the underlying asset.
The two main classifications of options are American Style and European Style.
For the most part, the only type of option you’ll be trading is the American Style, which allows you to liquidate your position at any time, whereas the European model only allows liquidation at the time of expiration of the option.