Before jumping into any new form of investment, it is important that you are able to thoroughly understand the activity. For instance, can you explain option trading? If it is something that you will direct your nest egg or income towards, you must be able to understand exactly what it entails.
Someone who is able to explain option trading will certainly have a very clear understanding of the basic terminology, procedures, and strategies. This is not as simple or even as “basic” as it sounds. Option trading is a somewhat unique approach to leveraging information and creating a certain level of risk management, and it doesn’t even have to involve the purchase of a single stock, security or commodity.
If you can explain options trading clearly and in very few words then you are probably a good candidate to begin participating in this lucrative approach to investing immediately. If you find that an explanation is a bit too difficult to tackle, however, you may want to spend some time doing research, participating in a few classes or seminars, and developing a much clearer and adequate base of knowledge before you make your first investments.
One major mistake made by millions of investors is to simply hand over their hard-won income to a trader or brokerage without first understanding what is going to be done with their money. Even if a financial professional explains what portion of the portfolio is going to be directed at options trading, it is not good enough if the actual investor doesn’t really know what it means.
So, what is a basic explanation of options trading? Without entering into a huge amount of detail, suffice it to say that an option is a contract between a buyer and a seller. The buyer is purchasing the “right” to buy or sell at least one hundred shares of an underlying asset (which could be a stock, commodity, or other financial vehicle) at a predetermined price. The seller or “writer” is obligated to honor the terms of the contract.
How does this work in the world of financial trading? It is actually very simple – let’s say you are a buyer who believes a particular stock is going to rise in value by a certain time period. You approach a writer in order to purchase a “call option” to buy that stock at a fixed price before a certain date. If you exercise the option you can purchase that stock for the guaranteed price, or you can just sell your option for the profit. While that is the most streamlined and overly simplified explanation, it does indicate the way that options can be used to leverage risk.
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