Options allow traders to go beyond buying and selling stocks, bonds, or mutual funds. If you are seeking ways to diversify your portfolio, options are a good fit. Though the risks associated with trading options can be high likewise, the returns can also be high.
Though trading options can be challenging and presumed to be for advanced traders, anybody with the right know-how can try. This article explains the basics of optionstrading.
What is Options Trading?
An option is a derivative contract associated with an underlying asset, such as a stock. These conditional derivative contracts allow the purchasers, also known as option holders, to sell or purchase a security at a chosen price.
Options trading involves trading financial instruments, which allow you to buy or sell a specific stock or security at a specified price on a particular date. A period is set, which could be as long as a couple of years or as short as a day.
Once you purchase an option, you have the right to exercise the option, which means trading the underlying asset. However, you are not obligated to do so.
Different Types of Options
To understand what options trading involves, you need to understand the two basic types of options; the call and the put option.
The contract purchaser acquires the right to buy an underlying asset at a predetermined price within a specified period in a call option. The predetermined price is the strike or exercise price, and the end date at which the buyer can exercise the call option is the expiration date.
For example, a call option contract may give the option holder the right to buy 1000 shares of ABC stock at 1000 US Dollars up until an expiry period of six months. As the value of the stocks changes, the value of the contract also changes. The option holder may sell the option contract at any time before the expiry date at the prevailing market price. Alternatively, the option buyer may hold the contract until expiration and take delivery of the 1000 ABC stocks. If the price of the stocks rises above 1000 US Dollars, the option holder gains.
In a put option, the purchaser gets the right to sell the underlying asset at a predetermined price in the future. It is the opposite of a call option.
For example, an investor buys one 100 US Dollars put option of 100 XYZ stocks. The contract allows the investor to sell the 100 XYZ stocks at 100 US Dollars before the expiration date. The investor will realize a gain in price if the price falls below 100 US Dollars.
Call Option vs. Put Option
Call and Put Options are two sides of a coin, with their respective features essentially inverted. If an investor believes that an asset’s price will rise, they purchase a call option. On the other hand, if the investor assumes that the asset’s price will fall, they buy the put option.
Things to Learn Before Trading Options.
Trading options can be challenging, especially for newbies. Here are a few things that you must learn if you want to trade options successfully.
1. Options are based on Different Underlying Securities.
Though many options are based on stocks, they can also be based on other types of assets. Other common assets include Indexes and Exchange Traded Funds (ETFs). Therefore, it will be valuable to understand the nature of options and their underlying assets before getting into trading options.
2. Options Trading Involves Calculated Risks
To be successful in options trading, you need to learn how to measure and mitigate risk. You will need to understand implied volatility and historical volatility.
Historical volatility involves past asset price fluctuations over one year. Implied volatility deals with future price fluctuations of an asset. Furthermore, implied volatility will determine the type of option you will purchase.
3. Option Trading Terminology
When trading options, you should be well versed with options trading lingo. Call and put options are not the only terms you will come across. You should learn all the terms used in options trading because they will come in handy when making trading decisions.
Trading options can be challenging for every beginner. However, like any other financial market, investing time in research, understanding the market trends, and using various analysis tools and indicators pays off.