Once you become aware of option trading basics and the many things you can do with options, the world of option trading is suddenly very fascinating indeed! The beauty of options lies in their flexibility. You can do almost anything with them - and for a fraction of the risk involved with buying and selling actual shares, commodities or currencies.
The options market is known as a "derivative" market, because the option price is "derived" from price movements in another market, usually called the "underlying" market. So if you're looking at stock options, the underlying market is the stock market. But one of the option trading basics to remember is that an options market is a market in itself, with its own supply and demand factors in play.
Here are a few interesting option trading basics, which give them their flexibility:
Expiry Date:- number one in your 'option trading basics' list, is that options expire WORTHLESS on an agreed date IF they are "out of the money" at that time. This factor, adds to options the element of "time decay". To the buyer of an option, time decay is a bad thing, but to the seller (writer) of an option, it works in your favour.
Strike Price:- this is the agreed price that the underlying market (say, a stock price) must be above (or below, depending on whether it is a call or put option) at any given time up to expiry date, for it to be "in the money" - i.e. have what is called "intrinsic value". This is one of the most important option trading basics you should understand, as it is the key to many option trading strategies.
Volatility:- this is a component of the option price, theoretically based on the anticipated percentage movement in the underlying market price over a given period of time. So if a stock is expected to move 20% in price over the next 30 days, then the "implied volatilty" in the option price should be around 20%. This "implied volatility" is then compared with the "historical volatility" of the share price movement, to evaluate whether the option is fairly priced. Sometimes you get "volatility spikes" or "skews" which can present trading opportunities. Buyers of options usually look for low volatility, whereas sellers would like to see high implied volatility in the option price.
Buy them or Create Them:- this is one of the option trading basics that makes all the difference. Not only can you buy them in the hope of selling for a profit, but you can actually create an option contract out of nothing. This is usually called "writing" or "selling to open" an option contract. The ability to do this opens up a whole world of possibilities. Here are just a few: