What is option and how to trade it?

Options are like insurance policies because they share many same characteristics. The difference between options and insurance policies that can be seen is their purpose; option and insurance have difference purpose.  Both of them are used for different purpose. We bought insurance to protect something valuable that we deem is worth to protect. Usually, this is the thing that we do not afford to loss However; we bought options to earn speculative profit if we are able to anticipate the market direction correctly. Options also can be used to hedge portfolio that we existing have against opposite market direction. Besides that, options are marketable securities which can be traded, whereas; insurance policies are not able to be traded.

Option contract is a financial instrument that is market ready to be purchased and sold. If you are holding some option contract and wish to sell it to exchange money, you can do so as long as the market is open.

After an option has been purchased or sold, it is unnecessary to be held until expiration date of the contract. Option can be sold or purchased to exit from the market anytime as long as if you are not intended to hold it. For private trader, this is extremely good news because he or she can enter and exit the market anytime as he or she wishes. The correct title for options is Exchange Traded Options. This means that they are traded in standardized contracts based on the regulated stock or futures exchange. Based on this regulation, option buyers and sellers can get together to trade their options based on the bid and ask prices. Usually, it is over 100 of the underlying shares taken out in the stock market for an option contract whereas the right to buy or sell a single futures contract is constituted in the futures market. Novation is a process where the exchange effectively transforms to the other party of the transaction. This gives a further meaning that to exit the trade; you are not depending on the same party that you originally traded with. For you to exit, at any time, as long as there is any party that is willing to take the counter side of your trade.

Options are different from other financial instruments because it has five specific components. These five components are as follows: (i) option has two types that are call and put options, (ii) there is an underlying security for each option either shares, futures or an index, (iii) every option possesses an exercise price, which is also known as strike price, (iv) each option has a fixed expiry date and (iv) each option has a premium attached together, which needs to be paid when purchasing them.

With the call option, buyer has the right to buy underlying security at the exercise price at any time until the option expiration date. However, the buyer is not obligated to buy the underlying security. This means that the buyer does not necessary to buy the underlying security.  Therefore, when the security price has dropped, the call option will be left worthless until expiration date. Premium has to be paid by the call option buyer to obtain this right, the right to buy the underlying security at any time at the exercise price until expiration date. While for the put option, buyer has the right to sell the underlying security at the exercise price at any time until the option expiration date. Same as the call option, the put option buyer is not obligated to sell the underlying security. This situation usually happens when the security price has gone up. The put option will be left worthless until the expiration date.

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