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## Option Trading Education – Back to the Basics

Getting a solid options trading education is critical to your long-term success as a trader. That’s because, unlike many other securities, they are multi-dimensional in both function and form. Options are a form of derivatives. What they mean is that they are byproducts of their underlying stocks, indices, bonds, forex, and commodities.

An option is the right to buy or sell a financial instrument at a specific price on or before a specific date. The above definition is for the US version.

Only the European version can be used on the contract expiration date. They are located in various underlyings such as stocks, indices, bonds, commodities, and forex. An options trading school should aim to teach the basics first. In their most primitive form, there are two types of options; “Calls” and “Puts”.

A “call” gives the buyer the right to buy a financial instrument at a specific price (also known as the “strike price”) on or before a specific date. On the other hand, a “put” gives the seller the right to sell a specific financial instrument for a specific price on or before a specific date.

A trader has the option to buy or sell a call, or buy or sell a put. The method they choose will determine whether they are “long” or “short” the market, and how much risk they have. Being “long” the market means that the derivative needs the price to go above the strike price to be profitable. Being “short” the market means that you need the derivative price to go below the strike price to be profitable.

The options trading school you choose to learn should address the way these derivatives are traded in the market. When a buyer chooses to buy a call or put, they must pay a small price called a “premium.”

An option seller, if not properly hedged, can have unlimited downside. Selling “naked” options is considered very risky, and should be left to professional traders. However, options can be a very attractive investment class to hedge any risk you may have. Also, if done correctly, you can create positions if the market goes up, down, stays the same, or trades within a certain range.

If a trader is very bullish on a security, but doesn’t want the exposure, or doesn’t have the capital to buy the stock, they can use options to leverage their investment. A trader can control the exact same number of shares but for much less money.

If an investor is “long” the market and wants to protect or hedge his portfolio, he can buy a “put” on a broad stock index such as the S&P 500. Thus, in the event of extremely negative market movements, they can sell their index positions and let the puts ride.

An options trading school should try to educate on different pricing models. Pricing is the method of determining the fair market value of an option. Market value serves as a guide to fair market value. However, most professional options traders use a pricing model such as the Black-Scholes model to determine whether an option is overvalued or undervalued.

According to this model, the value of an option depends on various variables such as strike price, time to maturity, implied volatility of the financial instrument, interest rate etc.

Another important aspect of profiting in the world of options is to properly understand the “Greeks” and how to use them. They are important tools for measuring risk management. The three most important Greeks are “Delta”, “Theta”, and “Vega”. The other two Greeks are “gamma” and “rho”.

Delta is used to measure the rate of change of the option value with respect to the change in the price of the underlying asset. Vega is a measure of sensitivity to volatility. Theta measures the value of the derivative with respect to the passage of time, also known as “time decay”. Rho measures how interest rates affect the value of a derivative. Gamma, which is the second-order derivative, measures the rate of change in delta.

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