by Robert Williams
Options trading from a computer allows greater scope for profitable trading when compared with some other historical trading operations. Sailing ships from England to India must have involved considerable risk and overhead expense. The silk route from Italy to China was well trodden but must also have involved great risk. Nevertheless, trading persists through the ages with success and failure integral aspects of the risks involved.
Stock options are contracts that are made between buyers and sellers. It is the contracts that are traded as objects. Each contract allows the owner to buy or sell an underlying asset such as a large mining company, commercial or financial organization that is constituted as a company. Commodity options on goods such as gold or oil may also be traded.
Contracts to buy and sell options on underlying assets are called derivative contracts because they are derived from trade in primary shares. Market makers create these contracts as entities that may be traded as though they are assets. They take a premium of each sale as reward from creating the market but transfer the risk from themselves to individual traders.
Traders accept the risk because they hope to profit from leveraging. Instead of using a large amount of capital to purchase a share in a company they have to outlay a small amount for a potentially larger profit. This is their way to leverage a large profit than would be the case if they bought only a few shares in the underlying asset.
Unfortunately leveraging can also work against a trader in the event of a loss making deal. A loss on one hundred shares in an underlying share will be relatively less than the loss on a thousand shares purchased in terms of the derivative contract. Therefore the risk of loss is commensurate with the potential for possible reward.
In addition to leveraging this form of trading also allows flexibility. If a trader believes that a share is likely to decline he may buy a 'put' option which gives him the right to sell it. If his prediction is correct and the price continues to decline after he has bought the put he may sell it at a yet lower price, his profit being calculated from the additional amount that the price has fallen.
There are people who would like to see put options regulated out of existence. They don't like the fact that speculators might benefit from taking a negative view. However, those in favour of market freedom believe that put options perform a valuable role in stabilizing markets and preventing disasters such as the Great Depression. Every put option is sold at a particular point and the buyer is someone who comes in with a positive view, so stabilizing the market.
Call contracts are the opposite of puts. They allow a trader to purchase shares in the underlying asset and profit from an increase in the price. Just as put contracts can actually suppress limitless collapses, so calls can help to prevent bubbles. The price of oil could rise unrealistically in the face of war, but holders of call contracts will be likely to take profits at some point so preventing episodes such as the South Seas bubble in which greed got quite out of hand.
Many different types of trading are possible. Some traders buy vegetables, divide them up into small packets and sell them at a profit. This is done at streets levels and in large supermarkets. Large amounts of stock must be held, and overheads include salaries, rates, rents and the like. Options trading involves few overheads and the real opportunity to make more profit than loss.
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