Options trading has become increasingly common over the past few years, especially as a larger number of exchange traded funds (ETFs) have allowed investors to utilize this strategy.

Options and the trading they allow are common these days, and as more providers offer this strategy, it is wise to understand it first. Pinyo for Moolamoney reports that an option is a contract that gives you (the buyer) the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date.

The two types of options are:

• Puts: A put gives you the right to sell an asset at a certain price within a specific period of time. This is similar to short selling a stock where you hope the price will fall before the option expires. This can hedge your long position against  a short term price decline.
• Calls: This gives you the right to buy an asset at a certain price within a specific time frame. When you buy calls, you’re hoping that the price of the underlying asset will go up before the option expires. This can hedge a short position against a short term price increase.

Since an option is a contract that deals with an underlying asset, options are called derivatives — which means it derives its value from something else.

There are a few things to consider before trading options:

• There’s no obligation: When you buy an option, you are under no obligation to buy or sell the underlying asset. You are buying the right to do so, if you so desire.
• Take a loss: If you buy an option but do not utilize it, you are at a 100% loss, or whatever you paid for the option.
• Options give leverage: An option gives you leverage, as well as a hedge, or a limit to the risk you are exposed to.

Options, puts and calls are quite sophisticated investment practices and should be used with a strategy and with an understanding of what is going to take place.

For more stories about options, visit our ETF 101 category.

Tags: ETF 101, Options