How to Buy Options? - Options trading basics

New to Futures and Options Trading?

If you are very new to futures and options you might want to first read my post on Options examples and futures example. An investor who is new to futures and options trading is usually confused and a bit less confident while performing his first trade in futures and options. Naturally, these market derivatives are highly leveraged financial instruments and can be extremely risky. This post is meant as a easy guide for beginners to perform their first trade in the derivatives market.

Two warnings before we start

I know examples of people who have lost their entire capital and entire portfolio because of performing one wrong trade in futures or options. It is not my intention to scare you. In fact Futures and Options can be your best friends in the investment world if you get to know them properly. In order to avoid disasters i urge you (especially if you are a beginner) to take the following two warnings seriously.

1. Do not Trade in Futures at all. This is for time being until you become more and more familiar with derivatives.
2. Do not write or Sell Options. Only buy either call or put options.

The reason for sticking to the above two guidelines in the beginning is that in both the above trades there is a possibility of substantial or unlimited loss of capital. Instead I advice you to stick to only buying Call or Put Options in the beginning. The risk involved here is limited - at worst you may only lose the Options premium you paid. To be even safer you may first stick to only buying far out of the money options which are cheap and good for educational purpose.

Four things to choose in order to buy Options

In order to buy an Option you will have to select four of its parameters.

1. Underlying: First choose the underlying stock or index on which you want to buy an Option.
2. Type of Option: Select Call or Put Option. Sometimes the following abbreviations are used (1) CA for American Style Call Options. (2) PA for American Style Put Options. (3) CE for European Style Put Options (4) PE for European style Put Options. Note that for a given underlying you may not have all four types available. For example while trading Futures and Options on FONSE in India, all stock options are always American Style (i.e. they can be exercised anytime before the expiry date) and all Index Options are always European Style (i.e. they can be exercised only on the expiry date). The difference between American and European style Options is not very important for options trading strategies, because even if you cannot exercise European Style Options before expiry, you can always square them off, i.e. sell them. Indeed, even selling American style Options before expiry date is more profitable than exercising them, because you also get the extrinsic value or time premium of that option.
3. Expiry Date of the Option: There will be a range of expiry dates available for the Options you Choose. It is recommended that in the beginning, in order to get the feeling of Options trading you choose the nearest expiry date so that the Options are not very expensive. Options with expiry date after one or a couple of years are also available, usually on indices. They are called Option Leaps.
4. Strike Price of the Option: If this is your first Options trade, and you simply want to see how your Online trading account works, then I recommend you only buy out of the money options whose strike price is far away from the price of the underlying. They are cheap and much less risky. Later on when you have concrete Options strategies in mind, you can do whatever you want.

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