Investing in the stock market is risky. One never knows what the price of a stock will do. Take Enron in 2001 as an example. Options were invented as a way of managing this risk by either accepting the risk or transferring it. Consider your car insurance: You are transferring your risk of having an accident in exchange for money, while the insurance company is accepting the risk of you having an accident in exchange for money.

It is the same broad principle with options trading. While some investors want to transfer their risk and are willing to pay, other speculators are willing to accept the risk. In essence, Options allow you to selectively pick and choose the risks you are willing to accept or avoid. It’s up to you how you use options. They can be used to transfer the risks inherent in the stock market or to accept risks and speculate on future high profits.

An option is a contract between 2 people to buy and sell stocks at a fixed price over a given time period. There are 2 types: calls and puts. A call option gives the buyer the right to BUY (but not the obligation) at a certain price and time whereas a put option gives the buyer the right (but not obligation) to sell at a fixed price within a certain time period. An option seller has obligations as opposed to rights. This means they must fulfil their contract if the buyer decides to exercise their option. Option sellers are paid in return for assuming the contractual obligation. So if a call buyer wants to buy an option, the seller must sell it to them and vice versa. Each participant – buyer and seller is fulfilling the opposite halves of the agreement. A further factor is long and short calls and puts.

To summarise the long call has rights whereas the short call has obligations. In the case of a long call (the call buyer) has the right to buy; a long put means a right to sell. Conversely, a short call obliges the seller to sell and a short put obliges the seller to buy. In this way both sides of the contract are fulfilled and the market can operate. So, long options have rights, short options have obligations.

Once you are in a contract ie. By either buying or selling a call or put, you can get out of the option by entering a closing transaction or a reversing trade. Simply put, you reverse all the actions it took you to enter the contract. This does not mean you will not loose money if the exercise or strike price is higher, but it does ensure you always have an exit strategy.

As you can probably appreciate from this short article, options trading is very different from buying and selling stocks. The single biggest error for people starting out in options is lack of understanding of basic concepts. Understanding fundamental principles when trading options is essential if you are to be successful and it is this lack of understanding that gives option trading an undeserved reputation for being unnecessarily risky. As we have seen, options trading was designed to manage risk and offer different options for different investing profiles.

I strongly recommend getting educated before embarking on any options trades. Unlike stock trading, it is difficult (and costly) to “learn by doing”. Far better to do the research before hand and preferably watch over the shoulder of an expert as an apprentice as this expert trades options live. You owe it to yourself to do it right from the beginning and reap the rewards of successful trades.