Acquiring a solid Option Trading Education is critical to your long-term success as a trader. That's because, unlike many of the other securities, they are multi-dimensional in both function and form. Options are a form of derivatives. What they means is they are the byproduct of their underlying stock, index, bond, forex, and commodity.
An option is a right to buy or sell a financial instrument at a particular price, on or before a particular date. The above definition is for the American version.
The European version can only be exercised on the expiry date of the contract. They exist on various underlyings such as stocks, indices, bonds, commodities, and forex. An option trading school should first aim at teaching the basics. In their most primitive form, there are two types of options; "Calls" and "Puts".
A "Call" gives the buyer the right to buy a financial instrument at a particular price (also known as the "Strike Price"), on or before a particular date. A "Put", on the other hand, gives the seller the right to sell a particular financial instrument for a particular price on or before a particular date.
A trader has the option to buy or sell a Call, or buy or sell a Put. The method that they choose will determine if they are "long" the market or "short" the market, and how much risk they have. Being "long" the market means that you need the derivative price to go up beyond the Strike Price to be profitable. Being "short" the market means that you need the derivative price to go down below the Strike Price to be profitable.
The Option Trading School that you elect to learn from should address the way these derivatives are traded in the market. Whenever a buyer opts to buy a Call or a Put, they have to pay a small price, called the "Premium".
An option seller, if not protected correctly, can have unlimited downside. Selling "Naked" options is considered very risky, and should be left to the professional traders. However, options can be a very attractive investment class to hedge any exposure you may have. Also, done correctly, you can create positions whereby you profit if the market goes up, goes down, stays the same, or trades within a certain range.
If a trader is extremely bullish on a security, but doesn't want the exposure, or doesn't have the capital to afford the stock, they can use options to leverage their investment. The trader can control the exact same number of shares but for considerably less money.
If an investor is "long" the market and wishes to protect, or hedge, their portfolio, they can buy a "Put" on a broad stock index like the S&P 500. This way, in the event of an extremely negative market movement, they can sell their index position and let the Put ride.
An option trading school should also try to educate on the different pricing models. Pricing is the way to determine the fair market value of an option. A market price serves as guidance to the fair market value. However, most professional option traders use a pricing model like the Black-Scholes model to determine if an option is overpriced or underpriced.
As per this model, the price of an option is dependent on various variables like Strike price, Time to maturity, implied volatility of the financial instrument, interest rate etc.
Another critical aspect of profiting in the world of options is to thoroughly understand "The Greeks", and how to use them. They are vital tools for measuring risk management. The three most important Greeks are "Delta", "Theta", and "Vega". The other two Greeks are "Gamma" and "Rho".
Delta is used to measure the rate of change of an options value with respect to changes in the underlying asset's price. Vega is a measure of sensitivity to volatility. Theta measures the value of the derivative with respect to the passage of time, also known as "time decay". Rho measures how interest rates affect the derivative's price. Gamma, which is a second-order derivative, measures the rate of change in Delta.
Still confused? Want help learning how to navigate the rocky stock market waters? If you would like to learn about different strategies that can be used during volatile times in the market, be sure to check out our Free Online Trading Education. TradingPub is a Stock Trading School where professional traders share from their experience, tools and techniques. Join us at our next free online event.
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