How to trade options

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09/24/2018 | 03:07 pm
Option trading is never a simple matter. Nevertheless, we will try to give you a brief and simple overview, should you wish to have a go at this rather complex trading activity.

Compared to stock trading, option trading is a completely different ball game. Options are contracts granting, in return for the payment of a premium, the right to buy or sell a specified quantity of an underlying at a predetermined price (strike price) during a period (American option) or on a specified date (European option).

By guaranteeing the investor the purchase or sale price of the underlying, options allow him to bet on an increase or decrease in the underlying. Options can be traded on organized markets. The investor has access to standardized commitments in terms of amount, price variation and maturity. But they can also be traded on over-the-counter markets.

In any event, the clearing house replaces all the participants as guarantor of the proper functioning of the transactions, in particular so that the option writer can fulfil his obligation.

CALL is an option that gives its buyer the right to buy the underlying at the exercise price. Conversely, the seller of the Call is obliged to sell the underlying in the event of exercise. The Call increases in value when the market for the underlying rises, hence the idea of bullish anticipation.

PUT is an option that gives its buyer the right to sell the underlying at the exercise price. Conversely, the seller of the Put is obliged to buy the underlying in the event of exercise. The put increases in value when the market for the underlying falls, hence the idea of bearish anticipation.

The exercise of the option is the fact that the investor exercises the right he holds, by buying (as part of a Call) or selling (as part of a Put) the underlying product. It should be noted that, from the point of view of the seller of the option, exercise is called assignment. This purchase or sale of the underlying is made at the strike price, which is fixed at the outset and cannot be changed.

This exercise price should not be confused with the premium, which is the option price on the market, depending consequently on supply and demand. This premium is the counterparty to the option seller's obligation to sell the underlying (as part of a call) or to buy it (as part of a put). It is definitively vested even if the option is not exercised. The premium applies per underlying security. It must therefore be multiplied by the size of the contract (percentage or multiplier).

The option always has an expiry date. It can be at maturity, when the buyer's right expires and the seller's obligation lapses. When it can be exercised at any time until its expiry, the option is called American. Conversely, it is said to be European when it can only be exercised on the due date.

Whether American or European, the option remains freely tradable before maturity, which means that investors can sell or buy it at any time on the market.

To sum up, if you’d like to open a position, you can buy or sell a Call or Put. As a result, there are four basic operations that summarize how the options work. Be careful, this notion is fundamental and must be understood to continue your journey in this special market.

Here is a very simple description that will help you understand the meaning of these four operations. If we replace the meaning (purchase or sale) of a contract by + or - and the type of contract (CALL or PUT) by also + or -, with the sign set, you can know the meaning of the basic strategy.

1) Purchase of a call + + + , an increase

2) Sale of a call - +,  a decrease

3) Purchase of a put + - ,  a decrease

4) Sale of a put - - - ,  an increase

These four basic principles can be combined (almost infinitely) to implement strategies of a wide diversity, which makes this product very attractive.

Romain Fournier
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