Options Basics: What Are Options?

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The best way to begin our introduction to options trading is to define exactly options trading account definition and examples options are. Although commonly referred to simply as options, the full term is options trading account definition and examples contracts, because they are financial contracts between two parties.

In very basic terms, they specify a future transaction on a specified asset at a specified price. The buyer of the contract has the right, but not the obligation, to initiate that specified transaction. The seller of the contract has the related obligation to carry out the transaction should the holder choose to initiate it. There are several characteristics of options that essentially make up the terms for any given contract.

The easiest way to define an options contract is to identify those characteristics and explain what they are. We have done exactly that below, and we have also provided some example options to give a clear idea of what they are and how they work. An options contract consists of two parties: The writer is effectively the seller of the contract, while the holder is effectively the buyer.

When the writer of the contract sells it to the buyer, they collect a payment from the buyer and that's commonly referred to as the premium. It's the holder of the contract that has the option to engage in the transaction that is specified and the writer that is obliged to engage in the transaction should the holder wish to go ahead.

If the holder chooses to initiate the transaction specified in the contract, they are said to be exercising their option. Should the holder not choose to exercise their option at any point, then the contract will eventually expire and cease to exist. You can read more about exercising an option here. Options are a options trading account definition and examples of derivative; which basically means they derive their value from an underlying asset.

In an options contract the underlying asset is the asset which is specified in the transaction the holder has the right to carry out.

For example, a contract might give the holder the right to purchase stock in Company X, in which case Company X stock is the underlying asset. The term underlying security is also commonly used, but both terms refer to the same thing. There's a range of financial instruments that can be the underlying asset in an option.

Stock is the most commonly used asset, but bonds, indices, foreign currencies, commodities, or futures can all be used too. There are even basket options, in which the underlying asset is a collection of different assets.

The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option.

Strike price is the term most commonly used, but it can also be known as the exercise price. The expiration date of an option is, quite simply, the date on which the contract will expire. Options are typically relatively short term and last just a few weeks, although they can also last for a few months or up to a year. If the expiration date passes and the holder hasn't chosen to exercise their option, then the contract expires worthless.

There are options trading account definition and examples many different types of options, because they can be classified in a variety options trading account definition and examples different ways. In a very broad sense though, they can be categorized based on whether they give the holder the right to buy or sell the underlying asset.

In this sense, there are basically two main types; call options which give the holder options trading account definition and examples right to buy the underlying asset at the strike price, and put options which give the holder the right to sell the underlying asset at the strike price. It should be noted that you don't have to actually own any of the underlying asset to buy a put option, but if you choose to exercise your option to sell the underlying asset you will, in theory, have to buy the underlying asset at that point.

Please see our section on the Types of Options for further details on this. Another way that options can be categorized is based on their exercise style. They can basically be one of two styles: American style or European style. These terms have nothing to do with anything geographical though. Options trading account definition and examples American style option is one where the holder can exercise their option at any time options trading account definition and examples the term of the contract, up to and including the date of expiration.

A European style option is one where the holder can only exercise their option, should they wish to, at the point of expiration.

American style options clearly offer much more flexibility to the holder, and because of this they are generally more expensive to buy. When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place.

They are physical options trading account definition and examples and cash settlement. Physical settlement is where the underlying asset is actually transferred between the buyer and the holder at the agreed strike price. Cash settlement is where the holder receives a cash payment based on any profit they could effectively make through exercising their option. Please see Options Settlement for more details. When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it.

However, the amount that the buyer pays isn't the same amount that the writer receives. Options are typically bought and sold on the public exchanges, where the transactions are facilitated options trading account definition and examples market makers. They basically exist to ensure that there's always a market for options contracts. If someone wishes to sell, and there is no buyer, then the market maker will act as the buyer and complete the necessary transaction.

If someone wishes to buy, but there is no seller, then the market maker will act as the seller. Market makers make a small profit on each transaction. Options contracts are listed on the exchanges with two prices: The bid price is the price you would receive for writing options contracts, and the ask price is the price you would pay for buying them.

It's important to note that options contracts aren't just sold to buyers at the time of being written; holders of existing options contracts can also sell them to other buyers. Again, the seller would receive the bid price and the buyer would pay the ask price.

You can read more about the price of options here. To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics.

The holder could exercise their option at any time because it's an American style options contract. If you didn't own the relevant stock, you would have to first options trading account definition and examples it and then sell it on to the holder. If the holder chose not to exercise their option by the expiration date, then it would expire worthless and options trading account definition and examples obligation would cease.

Alternatively, you could hold on to the stock if you preferred. If you chose not to exercise your option by the expiration date, your contract would expire worthless. The holder could only exercise their option at that point as it is a European style option. Cash settlement options are typically settled automatically if the holder is effectively in profit.

As a cash settlement option, you could expect it to be automatically exercised if you were in profit. Definition of an Options Contract The best way to begin our introduction to options trading is to define exactly what options are. Section Contents Quick Links. Parties Involved An options contract consists of two parties: Underlying Asset Options are a form of derivative; which basically means they derive their value from an underlying asset.

Strike Price The strike price is the price at which the specified transaction is to be carried out at should the holder choose to exercise their option. Expiration Date The expiration date of an option is, quite simply, the date on which the contract will expire. Option Type There are actually many different types of options, because they can be classified in a variety of different ways.

Option Style Another way that options can be categorized is based on their exercise style. Option Settlement When the holder exercises their option, the contract is effectively being settled, and there are two ways in which settlement can take place. Bid and Ask Price When the writer of an options contract sells it to a buyer, the buyer makes a payment in order to purchase it. Examples of Options Contracts To help you fully understand what an options contract is we have provided a couple of examples below, featuring some different characteristics.

Example 1 Underlying Asset: Stock in Company X Strike Price: Call Option Option Style: Physical Settlement Bid Price: Example 2 Underlying Asset: Stock in Company Y Strike Price: Put Option Option Style: Cash Settlement Bid Price: Read Review Visit Broker.

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Margin is a very widely used word in financial terms, but it's unfortunately a word that is often very confusing for people. This is largely because it has a number of different meanings, depending on what context it is being used in. In particular, the meaning of the term as used in options trading is very different to the meaning of the term as used in stock trading.

The phrase profit margin is also a common term, and that means something else again. On this page we explain what the term margin means in these different contexts, and provide details of how it's used in options trading.

Profit margin is a term that is commonly used in a financial sense in a variety of different situations. The simplest definition of the term is that it's the difference between income and costs and there are actually two types of profit margin: Gross profit margin is income or revenue minus the direct costs of making that income or revenue. For example, for a company that makes and sells a product, their gross profit margin will be the amount of revenue they receive for selling the product minus the costs of making that product.

Their net margin is income or revenue minus the direct costs and the indirect costs. Investors and traders can also use the term profit margin to describe the amount of money made on any particular investment. For example, if an investor buys stocks and later sells those stocks at a profit, their gross margin would be the difference between what they sold at and what they bought at.

Their net margin would be that difference minus the costs involved of making the trades. Profit margin can be expressed as either a percentage or an actual amount. You may hear people refer to buying stocks on margin, and this is basically borrowing money from your broker to buy more stocks. If you have a margin account with your stock broker, then you will be able to buy more stocks worth more money than you actually have in your account.

If you do buy stocks in this manner and they go down in value, then you may be subject to a margin call, which means you must add more funds into your account to reduce your borrowings. Margin is essentially a loan from your broker and you will be liable for interest on that loan. The idea of buying stocks using this technique is that the profits you can make from buying the additional stocks should be greater than the cost of borrowing the money.

You can also use margin in stock trading to short sell stocks. Margin in futures trading is different from in stock trading; it's an amount of money that you must put into your brokerage account in order to fulfill any obligations that you may incur through trading futures contracts.

This is required because, if a futures trade goes wrong for you, your broker needs money on hand to be able to cover your losses. Your position on futures contracts is updated at the end of the day, and you may be required to add additional funds to your account if your position is moving against you.

The first sum of money you put in your account to cover your position is known as the initial margin, and any subsequent funds you have to add is known as the maintenance margin. In options trading, margin is very similar to what it means in futures trading because it's also an amount of money that you must put into your account with your broker.

This money is required when you write contracts, to cover any potential liability you may incur. This is because whenever you write contracts you are essentially exposed to unlimited risk. For example, when you write call options on an underlying stock you may be required to sell that stock to the holder of those contracts.

If it was trading at a significantly higher price than the strike price of the contracts you had written, then you would stand to lose large sums of money. In order to ensure that you are able to cover that loss, you must have a certain amount of money in your trading account. This allows brokers to limit their risk when they allow account holders to write options because when contracts are exercised and the writer of those contracts is unable to fulfill their obligations, it's the broker with whom they wrote them that is liable.

Although there are guidelines set for brokers as to the level of margin they should take, it's actually down to the brokers themselves to decide. Because of this, the funds required to write contracts may vary from one broker to another, and they may also vary depend on your trading level.

However, unlike the requirements when trading futures, the requirement is always set as a fixed percentage and it isn't a variable that can change depending on how the market performs. It's actually possible to write options contracts without the need for a margin, and there are a number of ways in which you can do this.

Essentially you need to have some alternative form of protection against any potential losses you might incur. For example, if you wrote call options on an underlying stock and you actually owned that underlying stock, then there would be no need for any margin. This is because if the underlying stock went up in value and the contracts were exercised you would be able to simply sell the holder of the contracts the stock that you already owned.

Although you would obviously be selling the stock at a price below the market value, there is no direct cash loss involved when the contracts are exercised. You could also write put options without the need for a margin if you held a short position on the relevant underlying security.

It's also possible to avoid the need for a margin when writing options by using debit spreads. When you create a debit spread, you would usually be buying in the money options and then writing cheaper out of the money options to recover some of the costs of doing so. Assuming you buy the same amount of contracts as you write, your losses are limited and there is therefore no need for margin. There are a number of trading strategies that involve the use of debit spreads, which means there are plenty of ways to trade without the need for margin.

However, if you are planning on writing options that aren't protected by another position then you need to be prepared to deposit the required amount of margin with your options broker. In reality, even if you are trading futures options this isn't something you really need to concern yourself with. However, you may hear the term used and it can be useful to know what it is. The SPAN system was developed by the Chicago Mercantile Exchange in , and is basically an algorithm that's used to determine the margin requirements that brokers should be asking for based on the likely maximum losses that a portfolio might incur.

SPAN calculates this by processing the gains and losses that might be made under various market conditions. As we have mentioned, it's far from essential that you understand SPAN and how it's calculated, but if you do trade futures options then the amount of margin your broker will require will be based on the SPAN system. Full Explanation of Margin Margin is a very widely used word in financial terms, but it's unfortunately a word that is often very confusing for people.

Section Contents Quick Links. Profit Margin Profit margin is a term that is commonly used in a financial sense in a variety of different situations. Margin in Stock Trading You may hear people refer to buying stocks on margin, and this is basically borrowing money from your broker to buy more stocks. Margin in Futures Trading Margin in futures trading is different from in stock trading; it's an amount of money that you must put into your brokerage account in order to fulfill any obligations that you may incur through trading futures contracts.

Margin in Options Trading In options trading, margin is very similar to what it means in futures trading because it's also an amount of money that you must put into your account with your broker. Read Review Visit Broker.