Options Trading Basics: A Quick Options Primer

Options may very well be the most versatile trading instruments ever created. Where else can you be provided with high-leverage and yet at the same time limit the overall risk to you for a particular trade, especially if it happen to be done in tandem with a stock or futures position.

It is necessary to understand the difference between stock and options or futures and options. When you buy shares of a stock you actually own part (albeit a small part) of the actual company. Buying an option does not give you ownership in the company. Likewise, if you are investing in futures you need to understand that a futures contract is a legally binding agreement that gives you the right to buy or take delivery of a particular commodity or financial instrument at a set price. An option on a futures contract gives you the right to buy a futures contract; it does not give you the futures contract itself.

An option, where a futures option or stock option, gives you the right, but not the obligation, to either buy or sell the stock or the futures contract.

Buying an option does not give you any obligation at all. Once the money is taken from your account you don't have to do anything else. However, if you have sold the option as an opening position (you didn't hold the options that you are selling) you have an obligation to buy the stock or futures contract at the strike price if you are asked to do so by the person who owns the option contract.

In other words, if you are a buyer, you have rights. If you are a seller, you have obligations. If you have bought an option you have the right to buy the stock or futures contract at a specified price (strike price) on a before a particular date (expiration date). If you sold the options contract you are now obligated to buy or sell the stock or futures contract if the buyer of your option wants you to do so. They will usually only do so when the stock or futures contract is in the money.

Now there are two distinct type of option contracts: put and calls. Put options are bearish instruments. You expect the price of the stock or futures contract to move lower if you purchase a put option. If you buy a put option you have the right to sell (or put contract to) the stock or futures contract at a specified price (strike price) on or before a certain date (expiration date). Call options are just the opposite. If your purchase a call option you have the right, not the obligation, to purchase shares of the stock or the futures contract at a set price before a certain date.

Now understand for every one who buys an option there is someone on the other side who is selling an option, although you do not deal directly with a seller. If the buyer of an option decides that he/she would like to exercise the option then the individual who sold the option will get a notice from their options brokerage firm that they will need to provide the stock shares or futures contract (call option) or buy the stock shares or accept delivery of the futures contract (put option). In the options industry this would be called an assignment.

So if you are going to trade options recognize that you take on a risk of assignment if you are a seller rather than a buyer.