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Options Trading: How Options Actually Work

By  Dec 10, 2009

Topics: Finance & Investing

Even if you have studied options in depth, there are a few important aspects to them you might not know. A few basics clarify how options work and how they are traded.

1. What if there are more buyers than sellers? A natural question, of course. Do you as a buyer have to go looking for someone to buy the other side? No, fortunately. The options market is facilitated by the Options Clearing Corporation (www.optionsclearing.com), which serves as guarantor of every options trade placed. This means they take up the role of seller to every buyer, and as buyer to every seller. This means that no matter how lopsided the market might be at any time, trading is always efficient and liquid.

2. If I buy an option, do I end up being forced to buy or sell stock? No, your maximum risk is always the amount you pay to buy the option. You’ve probably heard that buyers of futures contracts might end up with a yard covered in soy beans or pork bellies. That doesn’t really happen, but the story persists as a way of describing futures risk. With options, though, you can sell and close the position at any time before expiration. You are not obligated to buy or sell just because you buy the option.

3. If I sell an option, who has control? The matter is different if you sell an option. As seller of a call, you could have 100 shares exercised (called away) at the strike price. This is high-risk if you don’t own those shares, but very low-risk (conservative, even) if you own 100 shares for each call you sell. If you sell a put, you could be required to buy 100 shares at the fixed strike price (meaning those shares are “put” to you). Selling options is a different matter than buying, and the risks vary based on many factors: current stock positions, the money you get for selling, time until expiration, and volatility of the stock, for example.

4. Are options just too risky? That’s the real bottom line, of course. But the amazing attribute of options is that they can be used for many reasons: to insure your portfolio by hedging possible losses, to create extra cash income, to speculate, or to create a contingent purchase or sale of stock. Because there are so many ways to use options, risks vary too. These are unique because the risks range from highly conservative to high-risk. It all depends on which strategies you use.

The most important thing to know is that you have to get information before putting any money into options, or any other market. Begin by defining how much risk you can afford to take, what your personal portfolio goals are, and what strategies are good matches. To find out how strategies work, paper trade before putting actual money into positions. Paper trading involves using a “virtual portfolio” to enter positions without any cash at risk, and to then see how they fare in the real world. The CBOE (www.cboe.com) offers a free and excellent virtual trading link on their website. On the home page, link to “trading tools” and then to “Virtual trade.”