Option Trading is continuing to see a rise in popularity with traders and its easy to see why.

You can take small amounts of capital and leverage it up for fast gains. You can also learn how to hedge your portfolio against drops in the market. Or maybe you could take the other side and become the insurance salesman, collecting premium every month.

But with all of the opportunities, there is a fundamental lack of understanding as to how the options market works.

This guide about Option Trading Basics will get you the information you need to become a great options trader.

What is an Option, Anyways?

Options are a contract. Thats it.

Its a contract between two parties to exchange something.

What are they exhanging? Risk .

Capital markets are risky by nature. Stocks go up, stocks go down sometimes they crash. Due to this risk, some investors want to remove some of that risk, and are willing to pay a risk premium for it.

The Risk Exchange in Options Trading

Its like car insurance. Driving is risky, and to protect yourself, you pay a risk premium to the insurance company so if anything really bad happens, you dont lose a ton of money.

Options are also a derivative. That means their price is derived from something. That something is simply the relationship with the underlying stock, and the risk premium people are willing to pay.

How the Price of an Option is Derived

Options are contracts that have an expiration date. If the buyer of the option does not use (exercise) that option before the date, then it will be rendered null and void.

Where Options Trade the Options Market

Since options are a contract, there will always be two sides to each trade. There will be an option buyer, and an option seller.

The buyer is looking to pay a premium to transfer risk. The seller is willing to accept that risk for a certain premium.

Because there are so many stocks and so many kinds of options, it makes sense to standardize the contracts.

For most options, the standard size of the contract is 100 shares .

Because the market is so big, it wouldnt make sense to have thousands of different people trying to call each other to match their needs. To solve this, we have a centralized options clearing organization to help match buyers and sellers. This organization is known as the Options Clearing Corporation (OCC).

All Standard Options are Cleared Through the OCC

There are differnet markets like the CBOE, Nasdaq, and the NYSE, but they are all participant exchanges within the OCC.

Why You Should Trade Options