OPTION TRADING: A GUIDE FOR BEGINNERS

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Options trading may seem overwhelming at first, but it's easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.

KEY TAKEAWAYS

• An option is a contract giving the buyer the right—but not the obligation—to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a specific price on or before a certain date.
• People use options for income, to speculate, and to hedge risk.
• Options are known as derivatives because they derive their value from an underlying asset.
• A stock option contract typically represents 100 shares of the underlying stock, but options may be written on any sort of underlying asset from bonds to currencies to commodities.
  
  

Why Use Options:-

Speculation
Speculation is a wager on future price direction. A speculator might think the price of a stock will go up, perhaps based on fundamental analysis or technical analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call option—instead of buying the stock outright—is attractive to some traders because options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.

Hedging
Options were really invented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.
Imagine that you want to buy technology stocks. But you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if the underlying price moves against their trade—especially during a short squeeze.