If you are interested in the stock or financial markets and are managing your own investments, then you have probably heard talk of "options" and "options trading" along the way. And if you haven't heard the term before, you certainly will.
If you have never looked at options or options trading before, then you owe it to yourself to spend a few minutes acquiring some knowledge about these incredible trading and investing instruments.
Options can be traded directly, to allow people to wager on stocks or whole markets moving up or down. Options can be traded in combinations called spreads, which allow traders to make subtle bets on changes in a stock's direction, range of movement or volatility or even bet that the stock or market won't move at all. Options can also be used with stocks to help investors hedge their investment positions against risk.
Meet the Options
The general concept of an option has been around since the earliest of times. Some early writings tell us about a man that purchased the right to use olive presses.
It was mid-winter, and the owner of the olive presses was happy to sell the right to use the olive presses during the harvest season. It generated income for the olive press owner during the off season.
The man purchasing the rights ensured that he would have use of the presses during the busy season. If the olive harvest was really good, the purchaser might be able to even resell his right to use the olive presses for a profit.
The use of the options is the same. The option is a contract between a buyer of the options and the seller of the option. The buyer purchases the "right" to buy something. The seller "obligates" him or herself to deliver some item or perform some service.
The established financial markets have had options available for decades. The options contract was originally an "over the counter" product. This meant that only people with specialized needs and information tended to engage in the purchase and sale of options. This original options contract was not standardized in its terms or conditions. There was also no secondary market for options and no way to properly and consistently assess the value of the options contract.
Birth of the Modern Option
In 1973, the modern financial options market came into existence. The Chicago Board of Trade (CBOT) opened the Chicago Board Options Exchange (CBOE).
The CBOE instituted a new "exchange traded options contract". This contract was standardized in its terms and conditions. An options buyer and seller no longer had to sit down and negotiate terms of the contract every time he or she sought to buy an option. Thus, the CBOE could publish quoted options prices for the first time, and could establish a market maker system to make sure that there was a secondary or resell market for options.
At the same time, the Options Clearing Corporation was formed to make sure that the contract would be honored by all members. Lastly, the whole process came under the regulatory control of the Securities and Exchange Commission.
Thus, the trading of the modern option, "exchange traded options contract" had begun. On the first day the contracts traded, April 26, 1973, a total of 911 contracts were traded.
Since that time, options trading has grown enormously. In 2007, there were over 2.8 billion contracts cleared by the Options Clearing Corporation.
Options are now widely traded in variety of financial instruments: from stocks and bonds to exchange-traded funds, commodities and currency futures.
Next, we will take a closer look at what options are, why they are so popular and why every trader and investors should include them as part of their trading/investing toolkit.
John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.
