Options Trading

Options trading is the buying or selling of options derivatives either on public stock exchanges or over the counter (OTC). Most options trading is done via public exchange houses and are known as exchange traded options. In this type of options trading, exchanges work as the facilitators and formulate specifications to standardize the trading.

The over the counter market is more complicated. Traders from large financial institutions trade non-standard options derivatives and device their own rules and procedures.

How is Options Trading Conducted?

One of the first questions on prospective trader's minds is how to trade options. Options trading involves a buyer and a seller (a writer) of an underlying asset. Options buyers can be considered risk seekers (speculators), who try to profit from a potential rise/fall in the underlying asset. Meanwhile, sellers can be considered risk avoiders or hedgers, who try to hedge their losses by transferring the risks to speculators.

The buyer of an option pays a premium to the seller for obtaining the right to buy (call) the asset on a specified date and time. When the option is bought, the actual transfer of the underlying asset does not take place until desired by the buyer. S/he might choose to either buy the asset on the specified date or sell the right to buy it (put) before the specified period expires. The option value is determined by the value of the underlying asset.

For example, a trader wishes to buy stock options, which will provide him/her the right to buy or sell a specific number of shares. This number of shares that the trader can opt to buy/sell is calculated by multiplying the number of options contracts with the contract multiplier (or the contract size, which varies from exchange to exchange). For instance, in the US, the options contract size is 100, which means that for every option, the buyer of the option gets the right on 100 shares. The price of the option is also multiplied by the contract size.

Benefits of Options Trading

Here are a few benefits of options trading:

It is beneficial for small investors since it offers them an opportunity to trade in large numbers with small outlays.
Since option buyers have the right, and not the obligation, they have the opportunity to realize large profits with limited risks.

Risks of Options Trading

The risks associated with options trading are:

When trading in OTC options, the seller might decline to buy or sell the underlying asset.
Since the buyer is paying for small outlays while buying options, s/he may underestimate the losses that can be incurred due to unfavorable market conditions.

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