Benefits of Trading Options:

Orderly, Efficient and Liquid Markets
Standardized option contracts provide orderly, efficient, and liquid option markets.
Flexibility

Options are an extremely versatile investment tool. Because of their unique risk/reward structure, options can be used in many combinations with other option contracts and/or other financial instruments to seek profits or protection.

Leverage
A stock option allows investors to fix the price, for a specific period of time, at which an investor can purchase or sell 100 shares of stock for a premium (price) which is only a percentage of what one would pay to own the stock outright. This allows investors to leverage their investment power while increasing their potential reward from a stock's price movements.

Limited Risk for Buyer
Unlike other investments where the risks may have no boundaries, options offer a defined risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller (sometimes referred to as the uncovered writer of an option), on the other hand, may face unlimited risk.

Options Lingo

Premium - The premium is the amount that you pay up front for the option. This amount is once-off and non-refundable.

Strike Price - The strike price is the amount that you agree to pay for the stock at a later date.

Underlying Stock - The underlying stock is the stock for which you are purchasing the option.

Exercising Options - No, we are not talking about choosing to jump up and down in front of an exercise video featuring Anna. By exercising an option, you are using your right to buy, and actually purchasing the underlying stock.

Expiration Date - The expiration date is the last day for you to exercise your option. If you don't exercise it by then, your option will expire worthless. In the United States, the expiration date is the 3rd Friday of the month. So if you have a June option, that option will expire on the 3rd Friday of June.

American Options - American options are options (not limited by any geographic boundaries) that allow you to exercise the options at any time until the expiration date.

European Options - European options are options (not limited by any geographic boundaries) that allow you to exercise the options at only the expiration date. Do check with your local Options Exchange which form of options are used in your country.

Contract - Option trading is carried out in numbers of contracts. One contract equates to 100 underlying shares. If you buy one call option contract, you are buying the right to buy 100 shares of the underlying stock.

In-The-Money - An option is said to be in-the-money if it is worth something if you choose to exercise it now.

Out-Of-The-Money - An option is said to be out-of-the-money if it is worthless if you choose to exercise it now.

The Put Option

The put option is the right to sell the underlying security at a certain price on or before a certain date. You would buy a put option if you felt the price of a stock was going down before the option reached expiration.

Continuing , if you felt the stock was about to tank from $25 per share, the only way to profit would be to short the stock, which can be a risky move if you’re wrong. See Short Selling - Not for the Faint Hearted.

You could purchase a put option at $24 per share for $100 (or $1 per share), which would give you the right to sell 100 shares of XYZ at $24 per share.

If the stock drops to $19 per share, you could, in theory buy 100 shares on the open market for $19 per share, then exercise you put option giving you the right to sell the stock at $24 per share – making a $5 per share profit, minus the option cost.

As a practical matter, you would trade your put option, which would now be worth something close to $5 per share or $500.

The Call Option

The call option is the right to buy the underlying security at a certain price on or before a certain date. You would buy a call option if you anticipated the price of the underlying security was going to rise before the option reached expiration. 

For example:

Company XYZ in trading at $25 per share and you believe the stock is headed up. You could buy shares of the stock or you could buy a call option. Say a call option giving you the right, but not the obligation, to buy 100 shares of XYZ anytime in the next 90 days for $26 per share could be purchased for $100.

If you are right and the stock rises to $30 per share before option expires, you could exercise your option and buy 100 shares at $26 per share and sell them for an immediate profit of $3 per share ($30 - $26 = $4 - $1 for the option = $3 per share profit).

You could also simply trade the option for a profit without actually buying the shares of stock.

If you had figured wrong and the stock went nowhere or fell from the original $26 per share to $24 per share, you would simply let the option expire and suffer only a $100 loss (the cost of the option).

Options

An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.

Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve as an options investor.

American Options

An American Option is an option which can be exercised at any time up to and including the expiry date of the option. This added flexibility over European options results in American options having a value of at least equal to that of an identical European option, although in many cases the values are very similar as the optimal exercise date is often the expiry date.

The early exercise feature of these options complicates the valuation process as the standard Black-Scholes continuous time model cannot be used. The most common model for valuating American Options in the binomial model. The binomial model begins by evolving an seet price over a lattice with the asset price moving either up or down at each node of the the lattice. Once a lattice of asset prices has been determined the model iterates back through the lattice of prices to determine at each node if early exercise is optimal or not. The binomial model is simple to implement but is slower and less accurate than 'closed-form' models such as Black Scholes.

DerivativeOne features a free binomial model for valuing american options on Stocks, Currencies, Commodities and Futures

Swaption

A swaption is an option on an interest rate swap. There are numerous models for swaptions, DerivativeOne uses Black's 1976 model.

In addition to the black scholes inputs the model requires a Future Swap Rate (ie the future swap rate from the option maturity date to the swap maturity date) and the Risk Free Rate (ie the zero coupon government bond rate for the period from the valuation date to the swap maturity date).

The Floating Rate Reset Frequency is frequency of the payment of the floating leg of the underlying interest rate swap.