Options trading is becoming popular in the investment community. An option gives the investor the opportunity to purchase an asset at a predetermined price. The price of the option is derived by calculating the difference between the underlying asset and the reference price. The underlying asset is usually a stock, bond, currency or futures contract. Options can be created for any type of asset that holds a reasonable value.

The two most common terms used in options trading is a “call” and a “put.” The “call” is that right to buy an asset, and the “put” is the right to sell an asset. The exercise price is often referred to as the “strike price.” When the option is activated and traded at the underlying price, it is called exercising it. The option is not valid after the expiration date listed on the option.

Another term used is called, “writing” the option. During this process the originator of the option collects the premium. The writer must deliver the cash equivalent or the asset when the option is exercised. Options may be sold over-the-counter (OTC) through an investment bank or in a standardized form on the options exchange for the general public. Two private parties are typically involved in an OTC options trade. These types of options may be customized to the investor’s business need. There are three common OTC options: Interest rate options, Currency Cross Rate Options and Options on Swaps.

Investors prefer options because of their versatility. Depending upon the type of investor exercising options, options investing can be speculative or conservative. Investors often predict the movement of the market or protect their investment from decline. Options trading can be risky depending on the investor’s attitude. Experts suggest only using risk capital to invest.

There are four basic types of options trades: Butterfly Spread, Iron Condor, Straddle and Strangle. Each one will be explored in brief to provide investors of an overview into this particular investment vehicle.

Butterfly Spread

The Butterfly Spread allows the trader to profit if the stock price is near the middle exercise price. There are four components to this particular options trade.

Iron Condor

The Iron Condor is similar to the Butterfly Spread but this type of options trade usually results in a larger profit than most. The straddle involves selling a put and a call at the same exercise price.

The Strangle

The Strangle consists of a call and a put. The profit originates from the different strike prices. However, this is type of trade is less risky and the profit is traditionally smaller, because of the strike prices.

Covered Call

A covered call is also a popular strategy for options investors. This strategy involves purchasing a stock and subsequently, selling a call. If the stock price exceeds the exercise price of the option, the call will be exercised. A fixed profit will be given to the investor. However, if the price of the stock declines, the call will not be exercised. The loss will be transferred to the investor minus the premium price.

Real Estate Market

Call options are popular in the real estate market, historically. Call options were used to assemble parcels of land from separate owners. In this type of deal, the investor may purchase the right to buy large parcels of land. However, they are not obligated to buy these plots. Lines of credit will give investors the right, but not the obligation to borrow a certain amount of dollars in a specified period of time.

Exchange Traded Options

There are several different types of exchange-traded options available to consumers. These options include: Stock Options, Commodity Options, Bond Options, Stock Market Index Options, Option on Futures Contracts and others.

Types of Options

Investors may exercise the option according to the rules included with the option type. The various types of options available indicate when the options may be exercised. Investors should be aware of these types before selecting an option for investment.

European Option: This type of option may only be exercised on the expiration date.

American Option: This option may be exercised on a trading day. This will be used on a trading day on or before the expiration date.

Bermudan Option: Specified dates of option exercising are included. The options may only be exercised on these specified dates.

Barrier Option: This type of option has an underlying security whose price must pass a certain level before the option may be exercised.

Exotic Option: This option combines numerous financial structures.

Vanilla Option: These options are not exotic.

Evaluating Options

There are several statistical models that will help an individual study the historical nature of the market. The two most common models used, include: The Black Scholes and the Stocastic Votality Models. Each of these models is designed to help investors predict the best entry and exit points into the market. Advanced investors utilize software to implement these strategies to promote these types of investments.