You may have already discovered that there is a wide range of choices for anyone who would like to invest in securities. Options trading is one of the many that you can consider. You have probably heard or read about it. If you would like to learn more about trading in options, then you are in the right place.
What are the options? What does the process of trading in options entail?
The term option refers to a contract that gives an investor the liberty of buying or selling an underlying instrument over a specified period, and at a price determined by both parties (investor and client). The financial instrument may be a security, index or better still, an EFT.
Trading in options is usually done at licensed options markets. The contracts are traded based on underlying securities.
1. Trading in options is not as complex as many people imagine
Options trading, just as the term suggests, is the process of buying or selling underlying instruments over a specified period, and at prices agreed upon by both clients and investors. Options are not a representation of ownership or stake in a company. They are not like shares or debentures.
Both options and futures make use of contracts. However, the former is thought to be less risky given that you (the client) can walk away from the contract whenever you want. The price/premium of an option is, therefore, a percentage or fraction of the underlying financial instrument.
Trading can only be done through a brokerage firm. When purchasing a call option, for instance, the strike price is calculated depending on the current price of that particular stock. If the share price of Facebook, Amazon or Microsoft Corp is $2.000, any strike price that rises above it is considered out-of-the-money. On the other hand, if the price is below the current share price, it is described as in-the-money.
The converse is true for put options. Any price that is below the current share price is described as in-the-money, and vice versa. It is important to note that any out-of-the-money options are valueless upon expiration.
You may have read or heard about bulls, bears, and stags (in the context of finance). Call options and put options can also be described using the two terms. The former are generally bullish, whereas the latter is usually bearish.
2. Various strategies can be used to trade options
You can make use of a wide range of strategies when trading options. The approaches have various risks and potential rewards, among others. Even though there are more than ten of them (most of the strategies are relatively intricate), this article will only focus on a few.
i. Straddles and strangles
Straddling is a tactic whereby a trader expects the asset to be extremely volatile, with absolutely no idea of the direction that price will take. Essentially, the trader purchases call and put options at similar strike prices, same expiry date, and same underlying price as well.
On the other hand, strangling is an approach that entails the simultaneous purchase of out-of-the-money call and in-the-money put options, while the underlying financial instrument and expiry date remain unchanged. The investor assumes that the stock or other underlying assets would enjoy a spectacular upward price movement. However, the price can also go downwards.
ii. Covered call
This is an interesting strategy whereby a trader, for instance, purchases 100 shares of standard stock and then goes ahead to sell one call for every 100 shares of the same stock. It provides the trader with a perfect opportunity to make a substantial profit. Additionally, it can help minimize risk.
iii. Selling iron condors
In this case, the risk taken by a trader ranges from moderate to extremely high. The trading position is generally non-directional. The asset price can either shoot through the roof or significantly reduce, depending on various factors. Therefore, the probability of making a profit is high.
Other strategies are also applied when trading options. Please note that the list provided above is not exhaustive.
3. Traders can make mistakes when purchasing or selling options
Brokers occasionally make mistakes while doing what they are paid to do in options markets. For this reason, you should be careful when choosing an intermediary. Some of the factors that you should consider are educational background, reputation, skills, experience (or lack thereof) and area of specialization, among others.
One of the mistakes that a trader can make is to cling to their option until it expires. If the underlying stock price increases overnight, for instance, you should execute the contract right away and reap the gains, rather than wait for something better than you may never get.
Failure to formulate a proper exit strategy for your option is another mistake that many people make, especially those who are still novices in the game. Plan to exit the stage once you make a certain amount of profit, for instance, or suffer a certain amount of loss.
Do not go for options that appear cheap. This is one of the worst mistakes that you can ever make. In most cases, the price of an option is directly proportional to profit potential. On the other hand, price is indirectly proportional to the level of risk.
4. There are various benefits of investing in options
Securities markets offer a wide range of options to investors. You can choose to buy shares from any reputable company. You can also opt to invest your money in debentures. You can invest in options as well.
Why do people invest in options? Are there any benefits of doing so?
The first reason why you should invest in options is that they allow you to speculate. Speculation mainly refers to the aspect of wagering on the direction that price would take in the future. Based on technical analysis, you can invest with the hope that stock prices will shoot through the roof after a certain period.
Many invest in options because it enables them to hedge funds. As a matter of fact, options were invested with the primary objective of hedging money. Call and put options help to minimize risks, and this is done at a minimal cost. An option can be compared to a good insurance policy. Your mind would be at peace every time. Nothing will keep you awake at night.
Options allow you to spread risks. If you opt for spreads, for example, you can make use of multiple positions of options of similar classes. They are a perfect combination of speculation and hedging.
There you have it. Trading in options is not very complicated, and neither is it as simple as you may have thought. To become an expert, you must learn how to buy and sell, and then practice whenever you can. Would you like to have an option trading mindset? Well, the facts described in this article can help you have that mindset and even become an expert.