2. Basics of Options: Types and Underlying Assets

(1). Definition of Options

An option is one of financial derivatives, which is "the right to buy or sell a certain thing on a certain day at a certain price."
Trading options means buying and selling such rights.

Buying and selling rights? That sounds complicated.

Just keep it in mind for now.
We will learn how options work, step by step.

(2). Types of Options

There are two basic types of options, which are call and put.
  • Call Option
    (The right to buy a certain thing at a certain price.)
  • Put Option
    (The right to sell a certain thing at a certain price.)
Note: Call and Put
A call option and a put option are often labeled just "call" and "put".
Options trading consists of buying (and selling) calls and puts.

options trading

Unlike stock trading, you don't just buy or sell options, but you need to choose from 2 types to buy or sell, right?
Now I've got a hunch that options are difficult...

No, they are not.
Once you learn the rules, you will realize that options trading is far more flexible than stock trading.

In the markets where options are traded (the options market), you always have 4 options which are buying and selling a call, and buying and selling a put.
For the first step, remember that there are 4 types of trades in options.

(3). Types of Underlying Asset

Another thing to learn first about options is "a thing" for which options (rights to buy or sell) are traded.
The thing is called underlying asset.

All right. What types of underlying asset are there?

In the U.S., there are stocks, indices, bonds, futures, currencies, etc.
You can trade options on all kinds of stuff.

* Note
There are two main categories of underlying asset in the U.S. options market.

One of those is securities options, which includes equity options (or stock options), index options, ETF options, and the like that are traded on the securities exchanges.
The other category is futures options. Options are available on a variety of futures markets such as index futures, bond futures, crude oil futures, gold futures, wheat futures, Japanese Yen futures, etc.

From now on, we will take equity options (options on stocks) as examples for learning how to trade options because they are the simplest options.
Regardless of the underlying asset, however, the mechanism of options is the same.

I see.
By the way, tell me a little about options markets in the world.

Options are traded around the world, but the U.S. has the largest and oldest options market.
Average daily volume of options at Chicago Board Options Exchange (CBOE), founded in 1973, is now more than 15 million contracts. (as of 2011)

Equity options are available on the stocks of most companies in America, such as Microsoft, Google, Disney, and so on. (over 2,500 companies)

Sounds great. How can I trade them?

Now people can trade the options in America from all around the world.
The internet has enabled us to online-trade options wherever we are. Some brokers provide a trading environment for mobile devices like iPhone, BlackBerry, etc.

Viva la IT revolution!!

(4). Why is an option categorized as a "derivative"?

When you trade options, you don't trade actual assets but you simply trade "rights" to buy or sell something. So options "derive" from certain things. (underlying assets)
This is why they call an option a derivative financial instrument.

Speaking of derivatives, I remember those hideous things that caused "Lehman Shock" in 2008.
Options must be some sort of lousy stuff if they are in the same category!

Those derivative products mixed with sub-prime loans were indeed lousy, but they are just extreme examples of derivatives that completely neglect risks.

You should know that many financial derivatives are traded by individual traders in today's market. Standard & Poor's Depositary Receipts (SPY), PowerShares QQQ Trust (QQQ), CBOE Volatility Index (VIX), and iShares Trust Russell 2000 Index Fund (IWM) are the most actively traded Exchange Traded Funds (ETF), and they are all financial derivatives.

I didn't know derivatives were popular today.

All you need is just an idea, and you can make as many derivatives as you want.
The result is that there are literally all kinds of derivatives in the world.
Some of them are very risky while others are easy to trade with relatively small risks.

So options aren't special, are they?

Right. Now that you understand what options are, let's learn how to trade them.
In the next two lessons, we will learn Call and Put, the first step of trading options.