Options Trading Explained
Options are a contract of agreement that can be bought or sold by anybody.
The above is a simplistic explanation of an option. It is the contract that is bought and sold. So let’s take that a bit further. If I make an agreement to buy something from somebody, I haven’t actually bought it. All I have done is make an agreement to buy it. So if I wish to, in the world of options, I can pass that agreement on to somebody else, without ever having owned the item I agreed to buy.
Potentially, I can make money out of something like this, because the item I agreed to buy may have risen in price during the time I had that agreement. So, an option is the agreement, not the actual sale of the item.
Two parties are in involved; a seller of the agreement and the buyer of an agreement. In the world of options, there are hundreds of thousands of agreements and hundred of thousands of buyers and sellers. It is a marketplace with many, many agreements and people trading those agreements.
The underlying item, that the agreements are made upon, is really secondary concern to the options trader. Not to say that the options trader shouldn’t be concerned with the underlying item, but just that the agreement is more of a concern to the trader than the actually item the agreement is made upon.
There are rules and conditions placed on options traders. These rules are part of the process of trading the options. Education in these rules is important to fully understand how options are traded. The rules are made by a governing body, who oversee the trades and uphold the rules. This makes the trading arena a fair place for everybody to participate in. nobody gets the upper-hand in the trade by bending the rules.
Option brokers handle the trades and take commission, or charge a fee for each transaction. Brokers are responsible for the orders to buy or sell the options in the market place. You, as a trader of options cannot trade directly with a buyer or seller. The broker will place you order into the arena and, based on your instructions achieve the best result for you.
Another third party involved in the transaction of options are the market makers. This group set the prices for buying and selling the contract of agreements –the options. The price they set is a calculated price based on market conditions, the price of the underlying item, and a host of other factors. The term “fair price” is meant to be reflected in this setting of the price by the market makers.
The market makers set a price to buy the option and a price to sell the option. The difference in these two is called the spread. It is not a fixed price on either, but it is meant to represent fair price. The difference between the two or the spread moves constantly as demand and supply shift in the market place. Sometimes there is a wide spread, and sometimes there is a narrow spread. The market makers make their money from the difference between the two prices of buy and sell. With a narrow spread they are encouraging the transactions and with a wide spread they are trying to make more profits in the transactions. The volume of sales orders being place directly affects the spread.
When large volumes are being placed into the market the market makers will often widen the spread to enhance their profits, and when low volume is in the market, they will often shorten the spread, to move sales along.
Later we will discuss the rules of options trading and try to clarify why those rules exist. Meanwhile for further information you can learn options trading and more at http://www.i-tradeoptions.com.
