Investor portfolios are typically built with various classes of assets, including ETFs, mutual funds, stocks, bonds, etc. Options are another asset class, and when applied appropriately, they offer numerous benefits that trading stocks, bonds, and ETFs alone cannot. They can make you rich!
Options trading is one of the most lucrative ways to trade the financial markets. Traders only need to reasonably invest a small amount of money to benefit from options power to make profits, allowing them to multiply their money multiple times, typically in weeks or months.
However, options trading may be exhausting initially, but you will eventually make it if you understand a few concepts or vital points. Interestingly, this article comprehensively covers these concepts, including what exactly options trading is, the benefits and risks of trading options, the basic options trading terms that beginners should know, and how options trading works. Let’s get right in!
First, What Are Options?
Options are contracts that offer the bearer the right—but not the compulsion—to either purchase or sell a specific amount of asset at a determined price on or before the contract ends. Like most other assets, options can be bought with brokerage investment accounts.
An option has a fixed life, with a specific expiration date, after which its value is established among options traders, and then, the option stops existing. The option ends either with a fixed value or valueless, making options a high-risk, high-reward trade. Simply put, an option is a right to sell or buy an asset at a particular price by a specific date. It is not an obligation.
Now, What Is Options Trading?
Options trading is purchasing and selling options on or before a specific date at a particular amount. When you trade an option, you procure the right to acquire or sell an underlying asset, depending on whether it calls or puts options. So, for instance, purchasing a call option lets you buy the underlying asset.
In the same way, if you acquire a put option, you are purchasing the right to sell the underlying asset. Since options are also fiscal instruments, they can be traded between buyers and sellers just like other securities.
While options trading is a little more intricate than stock trading, it can help you make larger incomes if the security’s price rises, as you don’t need to pay the security’s total price in an options contract.
Similarly, options trading can reduce your losses if the security’s price drops; this is called hedging. Therefore, the right to purchase a security is called ‘‘Call,’’ while ‘‘Put’’ is the right to sell a security. These two terms can be used as leverage and hedging.
- Leverage: Options trading helps you gain from share price fluctuations without putting down the total share price. With that, you control the shares without outrightly purchasing them.
- Hedging: They can also guard against share price fluctuations and allow you to purchase or sell the shares at a fixed price for a stated period. One of the vital parts of protecting yourself against market changes is to perform fiscal planning.
Basically, options trading is about forecasting market future movements — if you think the market will rise, set a lower price to purchase your asset; if you predict the market will drop, set a higher price to sell the asset. If the market moves according to your estimate and you perform the option, you’ll make a profit.
For instance, assuming you predicted a drum of US crude oil price to increase from $50 to $60 over the next few weeks. Then, you can buy a call option that offers you the right to purchase the market at $55 per drum within the next month. The amount you pay to acquire the option is called ‘‘premium’’.
If US crude oil increases over $55 (the ‘strike’ price) before your option ends, you’ll get the chance to buy the market at a markdown. But if it stays below $55, there’s no need to perform your right, and you can allow the option to end. In this case, the premium you paid to open your position is all you’ll have to lose.
Common Terms Beginners Should Know When Trading Options
- Premium: This is the option’s price; either you’re the buyer or the seller.
- Underlying Asset: The asset represented by the option; each asset has its own distinct set of options.
- Expiration: This is an option expiration date. The option is established at the end and will cease to exist.
- Strike Price: The amount the option allows you to acquire the underlying asset. An asset might have numerous options with different strike prices.
- Options Contract: Options are usually sold in what’s known as a contract, which signifies 100 shares of the underlying asset. Options are quoted in the asset price per share rather than the actual contract price.
Advantages Of Options Trading
Options can be very beneficial as leverage and risk-hedging source. For instance, a bullish investor who wants to invest $1,000 in a company could possibly earn a far higher return by buying $1,000 worth of call options on that company rather than buying $1,000 of that firm’s shares.
In that regard, the call options offer the investor a way to leverage their position by escalating their buying power. Inversely, suppose that the same investor has already been exposed to that company and wishes to limit that exposure (the amount an investor can lose from the risk unique to assert class.
Therefore, options are a flexible investment tool that can help you benefit from any market situation. Aside from the ability to make a profit, help reduce risk, or benefit from your bearish or bullish prediction, options can help you attain your investment goals.
Here are other benefits of trading options:
- Options trading tends to use capital proficiently by participating in an underlying asset’s price fluctuation without typically having a position in it
- You can potentially generate revenue with options trading by selling options for premium
- Options can provide high profits over a short period, allowing you to increase your money if your wager is speedily accurate.
- With options, it can be cheaper to get the same exposure to an asset’s price fluctuation than to purchase the asset directly.
- Options trading can be used to help protect against adverse market conditions
- Options prices can be unpredictable, providing traders the prospect of gaining on the price movement, even from a reasonably small price change of the underlying asset.
- Options methods, such as the covered call, are safe and can boost your investment return.
- If an asset increases for any cause, option owners can benefit from that prospective upside.
- Options are usually flexible, meaning that you’ll typically be able to trade them for money every time the market is open; however, you may lose money on them.
- Options charges are the lowest they’ve ever been, meaning trading options at the best brokers for options traders is more economical than ever.
Disadvantages Of Options Trading
- Options prices are highly volatile and can move significantly daily — even within the same day. However, some traders see this as a plus.
- Unlike other securities, where most online brokers’ commission is zero, options cost more to trade.
- With options strategies, traders can certainly lose more than they invest.
- If the underlying asset price moves negatively in the short term, the option price may never improve before expiration, leaving the option worthless.
- Because the government does not approve options, you can lose a substantial amount on them.
- Options have lifespans. Therefore, they are not ideal for buy-and-hold investors.
The core con of options trading is that they are intricate and hard to price. This is why options are considered the most suitable security for qualified expert investors. Recently, they have become progressively well-known among retail investors due to their capacity for outsized profits or losses.
Therefore, investors should ensure they fully know the potential consequences before taking any options positions. Failure to do so can result in shocking losses.
Types Of Options
1. Call Option
The ‘Call Option’ offers the holder of the option the right, but not the compulsion, to buy a particular asset at the strike amount on or before the expiration date in return for a premium paid ahead to the seller. Call options typically become more valuable as the underlying asset worth increases. In online quotes, call options are shortened to ‘‘C.’’
When the asset price increases, the call option value increases, all else equal. When purchasing a call option, you usually expect the asset price to escalate. If you’re selling a call option, you’re likely expecting the asset to remain even or reduced.
2. Put Option
Opposite to call options, a put option gives the holder the right to sell a specific asset at the strike price anytime on or before the expiration date in benefit of a premium paid ahead.
Since you can sell a security at any specified period, if a security spot price declines during the contract period, the holder is secured from this price reduction by the pre-determined strike price. This is why put options become more valuable when the underlying security amount reduces.
Likewise, if the security price increases during the contract period, the seller loses only the premium amount and does not lose the total asset price. In online quotes, put options are shortened to ‘‘P.’’
When the asset price decreases, the put option value increases, all else equal. If you’re procuring a put option, you usually expect the asset price to drop. If you’re selling a put option, you’re likely expecting the asset to remain even or increase.
How Does Options Trading Work?
Options are a derivative product that allows investors to predict or protect against underlying asset instability. Options are classified into call options, which would enable buyers to gain if the asset’s price increases, and put options, which allow the buyer gains if the asset’s price falls. Investors can also shorten an option by selling them to other capitalists. Shorting or selling a call option would imply gaining if the underlying asset falls while selling a put option would mean earning if the asset value rises.
To illustrate how options trading works, let’s go through a couple of scenarios.
- Call Option Example
Assuming you purchase a call option for a Large Tech Firm with a $500 strike price and a month expiration date from now. The lesser this strike price is about the Big Tech Firm’s current price, the more the premium you’ll need to pay.
Supposing your premium is $10 per share, and the options contract is for the typical 100 shares, meaning you’ll need to pay a $1,000 total premium for the option. Nevertheless, if the Large Tech Firm shares increase to $600 before the expiration date, you’ll gain $100 per share, or $10,000 in total (minus the $1,000 premium).
- Put Option Example
On the other hand, purchasing a put option means counting on the Large Tech Firm’s price reduction before the expiration date. If you have the same $500 strike price, thus the Large Tech Firm shares drop to $400, you’ll earn $10,000 again, aside from your premium, because your strike price ends up being more than the actual expiration.
Not to mention, if the underlying asset doesn’t decrease or increase the way you expected, meeting or above your strike price, you allow your options contract to expire. Remember, the option didn’t compel you to buy or sell anything; it only offered you the right to. So the one thing you will have lost would be the amount you paid for the premium.
The Bottom Line
Trading options can be highly profitable for those who know what they’re doing by making extra income through investing in the short term. Still, depending on how you structure your options trading, it can be risky for those who don’t understand its concepts or even those who just get caught in a bad trade.
Options can offer opportunities when used correctly and can be detrimental when misused. That’s the reason it’s essential to know the risks you’re running for those potential rewards and choose whether trading options is something you want to go into.
Still have further questions, do leave them in the comment session below. Happy Trading!