A Fanciful Way Of Illustrating The Basic Principles Of Option Trading

Among the many investment opportunities that exist, option trading stands as both one of the most exciting and risky as well as one that offers some of the best chances for a substantial return. In order to understand option trading, consider first the word "option." An option is a choice. When you deal in options, you are making a contract that gives you the right, but not the obligation, to purchase a block of stock at a given price at a future date. Let's consider an example that could help explain how the option market works. In place of a block of stock, we will use a painting that we discover in a dusty corner of a flea market.

The painting has a price of $50, but we do not have that much money available, and will not have it until the end of the week. So, we purchase an option from the owner to buy the painting for $50 by Friday afternoon. We pay him $5 dollars for that option. Before the week ends, it is discovered that the painting is actually the work of a well known local artist, and has a value of $500.

Since we have the option to buy the painting for $50, we quickly exercise our option. When we turn around and sell the painting for $500, we have realized a profit of $445. This is $500 minus $50 for the cost of the painting minus the $5 we paid for the option contract.

There is another way this story can end. Let's suppose that before the week ends, we learn that the painting is known to have a famous curse, and every owner for the last one hundred years has died a horrible death within a week of purchasing it. We do not have any obligation to buy it, and simply by not doing so, we exercise the negative aspect of our option.

We do lose our $5 investment, but that is the limit of our loses. This fanciful example illustrates the basic principles of option trading. It is quite a bit more complicated in many ways, but these basic principles remain the same. Options are known as derivatives because the value derives from something else. In our example, the value of the painting is what has the underlying value, and the value of the option depends on it. It is important to understand that options can also be the right to sell at a certain price as well as buy.

An option to buy is known as a call. An option to sell is known as a put. Other useful terminology used in Option trading is the strike price. The strike price is the price that has to be reached before a call option can show a profit.

In our painting example, the strike price would be $50. There is much more that must be learned about option trading. It is in many ways an extremely risky investment. It is usually thought to be the kind of investment that is best suited for risk capital. Risk capital is exactly what it sound like, the money that you can afford to lose. With that thought firmly in your mind, you can investigate options in more depth, and you might find that the old adage of investing holds true.

In order to really make a good profit, you need to be willing to take some risk. The more you understand about this fascinating investment, the less that risk will be.

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