by Amanda Harvey
The option market refers to the sum total of all the buying and selling of option contracts which is conducted and may be described either on a global or a regional basis. The option trading market is closely tied to the stock market, as one of the most widely traded types of option is the stock option.
Options are also available based on other financial instruments, such as futures, commodities, currencies and indices. The basic premise of an option contract is that by paying a premium to purchase the contract, the buyer is then entitled to buy a specified quantity of the underlying asset at a pre-determined price (known as the strike price), but is not obliged to do so. If the buyer decides to purchase the asset, this is referred to as exercising the option contract. Whether the contract may be exercised at any time prior to expiration or only at the date of expiration depends on the style of the contract; either American style or European style respectively.
How to Profit from the Option Market
One of the great advantages of trading options is that the cost of option premiums is a fraction of the price of the underlying asset, and still allows the investor to control the equivalent amount of the asset as they would by purchasing it outright. In this way, the option market offers significant leverage to investors.
Whether trading stock options or any of the other varied range of options available, there are two primary ways in which a trader can achieve a profit on their investment.
The first is by exercising their option and purchasing the underlying asset at a lower than market value. One such situation is that the trader has purchased a call option, which is basically an option entered into with the expectation that the price of the asset will rise. For example, the price of shares in company XYZ was $2.40 when the option contract was purchased. The option has a strike price of $2.80, and during the life of the contract, the share price rises to $3.20. The trader can purchase the shares at the price of $2.80, and then re-sell them right away for $3.20, generating an immediate profit.
The other method by which traders often benefit from their involvement in the option market is by selling the actual option contract for a profit once the strike price has been surpassed, and the option’s value has increased. This is frequently the M.O. of what is arguably a ‘true’ option trader – a trader who simply deals in options, and rarely, if ever, actually gets involved in trading the underlying assets.
The Option Market Offers Protection for Investors
Not all purchasing of option contracts is conducted as a form of trading. It is often undertaken by investors with positions in the underlying assets as a means of insuring or hedging their investment against potential losses.
If an investor believes that their holding may experience a loss, they can take an option position which will make money in the event that this loss does actually occur. In this situation, the increase attained by the option trade helps to offset the decrease experienced by the main investment.
There is, of course, the possibility that the anticipated loss does not occur, in which case, the cost of the option premium must be deducted from the increase that the investment has made. This works in much the same manner as buying insurance, and generally the purchaser of the ‘insurance’ is glad if they never need to ‘cash in’ on it, and feel that the outlay for its purchase has paid off in the provision of peace-of-mind.
The Arena for the Option Market
A large percentage of the trading which
comprises the option market is conducted on exchanges. There are specific
exchanges which focus on options trading such as the Chicago Board Options
Exchange (CBOE), and there are also stock exchanges like the American Stock
Exchange (AMEX) which offer options alongside the trading of stocks and other
securities. Trading options on an exchange is normally done through a broker;
whether an online brokerage service, or a more traditional full-service broker.
A certain amount of option trading is done away from exchanges with the use of ‘Over-the-Counter’ options (OTC) in private trading situations.
The option market offers the opportunity to
benefit from the movement of prices in the security markets for a small
percentage of the cost of investing in the actual securities. This leverage,
combined with various ways of profiting from trading options, as well as the effectiveness
of options as a hedging technique, makes the option trading market one of the most
attractive arenas available to investors.