An option is an instrument which gives its holder (buyer) the right, but not the obligation, to carry through a certain transaction at or until a given date in the future at preset conditions. The seller of the option is committed to accepting the transaction at the preset conditions during the period of validity of the option, if the holder so wishes. Options can in principle be written on almost anything, but here we are mainly concerned with stock options.

As an example, a call option on a stock gives the holder the right, but not the obligation, to buy the stock for the exercise price of the option at the expiration date (for a European style option) or any time until the expiration date (for an American style option) . During that time the seller of the option is obligated to delivering the stock for the exercise price if the option holder so desires. After the expiration date all rights and obligations disappear. Similarly, the seller of a put option on a stock is obligated to buying the stock at the exercise price of the option from the option holder if the holder so desires.

Options can be a very profitable investment object, but to avoid severe losses it is of paramount importance that the properties of options are well understood before trading. The "original purpose" of options is to provide a means of distributing risk between parties. Basically, the seller of an option takes a risk for which he/she gets paid, the buyer reduces risk and consequently has to pay a price for it. So what does it mean that the buyer reduces risk, aren't all kinds of option trading associated with risk, whether buying or selling? Sure, but the point is that buying an option reduces risk compared to dealing with the underlying asset directly. Also, the obligations of the buyer are limited, whereas selling options puts you in a position with a potentially unlimited loss. Selling "naked" options is extremely risky, and should probably be avoided unless you are very well aware of what you are doing (and also then it might not be a great idea). By combining buying and selling of options into properly structured positions any risk/return profile may be achieved. The tips on this page are derived from our own experience. They may not work in every situation (see also disclaimer below).

The current tips are:

• Don't be too greedy. If you have a market belief, act in line with it. If you "believe in" a certain option, buy it, at any reasonable price. The (natural human) desire to buy cheaply, often results in missed opportunities. Likewise, if you believe that time has come to sell, do it, at any reasonable price.

• Don't be misled by the price. Really cheap options are normally way out of the money. In some cases they may generate huge relative profits, but in most cases they are closer to lottery tickets than to real options. Best value for money, i.e., the most reasonable risk-return "ratio" is found with options at the money or close to it.

• Lock in profits. If an option has increased significantly in value, and you think it will continue to increase, you may consider selling it, and buy new, cheaper, options with a different strike price. Granted, you lose on transaction costs, and differences in time value, but, you put less money at risk, and may sometimes "lock in" a net profit while keeping the possibility to make even more money.

• Accelerate your profits. If you have a strong belief in the continuing performance of a given option, the above idea of switching to "cheaper" options can also be used to "accelerate" your profits, since it permits you to buy more options for the same money. This, however, counteracts the "profit locking" discussed above. As always, risk-return trade-offs are necessary.

• Save on transaction costs. Instead of buying a call option ratio spread you may consider selling a put option ratio spread. Assuming identical strike prices, the difference between the positions is that if the underlying asset goes up, which was probably your assumption when taking the position, both call options will be in the money at expiration, whereas both put options will be out of the money. Thus, the latter will just expire at no cost, whereas the former will have to be closed or exercised.

• But, don't carry it too far. Inasmuch as saving on transaction costs is tempting, it shouldn't be carried too far. Given the volatility of options, buying the right options, at the right time, for the right price is much more important than avoiding transaction costs.

As we said above, more tips & hints will follow. Check back later. Or post questions and/or start a discussion on options-related topics in our Investors' Forum .

You may also wish to visit our Literature Corner , where you find a bibliography of literature on stock, options, futures, trading, etc. You also have the possibility to order on-line any books you find interesting, from a well-known discount bookstore.