When it comes to trading options, there are a lot of different strategies and methods that you can use. However, finding the right method for you can be a challenge, especially if you’re new to the game.
That’s why we’ve put together this simple guide to options trading. Whether you’re a complete beginner or you just need a refresher, this guide will walk you through everything you need to know to get started.
We’ll cover the basics of what options are and how they work, and the different types of options trades you can make to get you started. By the end, you’ll have a good understanding of how options trading works and be ready to start making your own trades.
What are Options?
Options trading is the process of buying and selling options contracts.
An options contract is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specific date. Options trading can be a great way to make money, but it also comes with a certain amount of risk.
Benefits of Options Trading
Options trading can be a great way to make money, but it’s not for everyone. Here are a few benefits of options trading:
1. Options Trading Can be Very Profitable
If you have a portfolio of stocks or other assets that you’re looking to generate income from, options trading can be a great way to do it. By selling call options, you can collect premiums from other investors who are betting that the price of the underlying asset will go up. And by selling put options, you can collect premiums from investors who are betting that the price of the underlying asset will go down.
2. Hedge Against Risk
If you own a stock that you’re worried might go down in value, you can buy a put option to hedge against that risk. Put options give you the right to sell the underlying asset at a predetermined price, so if the stock does go down in value, you can sell it at a higher price and limit your losses.
3. Speculate Future Price of Assets
If you think the price of a stock is going to go up, you can buy a call option. And if you think the price of a stock is going to go down, you can buy a put option.
4. Flexible Mode of Trading
Options trading allows you to tailor your investments to your specific goals and needs. Whether you’re looking to generate income, hedge against risk, or speculate on the future price of an asset, options trading can help you achieve your investment goals.
Risks Involved in Options Trading
When it comes to trading options, it’s important to be aware of the potential risks involved. Here are a few things to keep in mind:
- Volatility-Options prices can be very volatile, which can lead to sizable losses in a short period of time.
- Liquidity-There may not be a lot of buyers or sellers available at certain times, which can make it difficult to exit a position.
- Margin requirements-Because options are leveraged instruments, you may be required to post margin in order to trade them. This can add to your risk if the market moves against you.
- Assignment risk-If you buy an option, and you may be assigned the underlying contract at some point. This is generally a risk with call options, but it can also happen with puts.
- Expiration risk-Options expire and become worthless if they are not exercised before the expiration date. This is especially a risk if you are holding an in-the-money option that is about to expire.
Different Types of Options Trading
If you’re new to the world of options trading, it’s important to know that there are different types of options contracts you can trade. Here’s a quick rundown of the different types of options:
1. Call Options
A call option is an agreement that gives an investor the right, but not the obligation, to buy a stock, bond, commodity, or another asset at a fixed price within a certain period of time.
The buyer of the call option pays a premium to the seller for this right. The premium is a function of the strike price, which is the price where the underlying asset will be bought or sold if the option is exercised, and the time until the expiration of the option.
The buyer of a call option hopes that the price of the underlying asset will rise so that the option can be exercised for a profit. The seller of the call option hopes that the price of the underlying asset will stay the same or fall so that the option expires worthless and the seller keeps the premium.
There are many different types of call options, and each has its own specific terms and conditions. The most common type of call option is the stock option, which gives the holder the right to buy shares of a particular stock at a set price within a certain period of time.
Other types of call options include options on futures contracts, bonds, and commodities. Call options can also be used to hedge against losses in other investments.
The key to making money with call options is to correctly predict the future price of the underlying asset. If the price of the asset goes up, the option will be worth more than the premium paid for it. If the price of the asset goes down, the option will expire worthless and the investor will lose the premium.
To be successful, investors must have a good understanding of the factors that can affect the price of the underlying asset, such as economic news, company earnings, and global events. They must also be able to time the market, buy options when prices are low, and sell them when prices are high.
Options are a risky investment, and most investors will lose money on them in the long run. However, for those who are willing to take the risk, call options can be a profitable way to make money in the stock market.
2. Put Options
A put option is a contract that gives the holder the right to sell a certain asset at a specified price within a specified timeframe. Put options are often used as a hedge against a decline in the value of the underlying asset.
For example, let’s say you own 100 shares of ABC Corporation stock. You are worried that the stock might fall in value, so you decide to buy a put option that gives you the right to sell your shares at $50 per share within the next month.
If the stock does indeed fall to $50 or below within the next month, you can exercise your option and sell your shares. You will make a profit of $50 per share, minus the cost of the option.
On the other hand, if the stock does not fall to $50 or below within the next month, you will simply let the option expire. You will have lost the cost of the option, but you will still own the stock.
Thus, put options can be a way to protect the value of your stock portfolio from a decline in the overall market.
3. Straddle Options
A straddle means holding both the call and a put option on the same underlying asset, with the same strike price and the specified same expiration date. The goal of a straddle is to profit from large price movements in either direction, regardless of which way the market actually moves.
One way to think of a straddle is as a bet on volatility. If you expect a stock to make a big move but you’re not sure which way it will go, then a straddle may be the right strategy for you.
There are two main types of straddles:
- At-the-money (ATM) straddle: This is a straddle where the strike price of the call and put options are equal to the current price of the underlying asset.
- Out-of-the-money (OTM) straddle: This is a straddle where the strike price of the call is below the current price of the underlying asset, and the strike price of the put is above the current price.
Straddles can be used in a variety of different situations. For example, if you expect a company’s earnings report to cause a big move in the stock price but you’re not sure which way the price will go, then an ATM straddle may be a good choice.
Or, if you expect a stock to make a big move but you’re not sure which direction it will go, then an OTM straddle may be a good choice. By buying an OTM call and an OTM put, you’re essentially betting that the stock will make a big move, but you don’t care which direction it goes.
The key to profitable straddle trading is to correctly predict how large the price move will be. If you expect a big move but the stock only moves a little bit, then you will likely lose money on your straddle.
On the other hand, if you correctly predict a big move, then you can make a lot of money. For example, let’s say you buy an ATM straddle for $100.
If the stock moves up 10%, then your call will be worth $110 and your put will be worth $0. Your profit would be $10. But if the stock moves down 10%, then your put will be worth $110 and your call will be worth $0. Your profit would again be $10.
As you can see, with a straddle you can make money regardless of which direction the stock moves, as long as the move is large enough. The main risk of a straddle is that you can lose money if the stock doesn’t move enough. For example, if you buy a straddle for $100 and the stock only moves 5%, then you will lose $5.
Another risk is that the stock could move sharply in one direction or the other and you could end up with your call and put both being in-the-money. This is called getting “run over” and it can lead to large losses.
4. Spread Options
A spread option involves buying and selling two different options contracts at the same time. The two contracts can be either call options or put options, and they can be for the same underlying asset or for different assets.
The most common type of spread option is the call spread. It involves buying a call option with a lower strike price and at the same time selling a call option with a higher strike price. The goal of a call spread is to make a profit if the underlying asset’s price increases, while limiting the potential loss if the asset’s price decreases.
Another type of spread option is the put spread, which involves buying a put option with a lower strike price and selling a put option with a higher strike price. The goal of a put spread is to make a profit if the underlying asset’s price decreases, while limiting the potential loss if the asset’s price increases.
5. Index Options
Index options are contracts that grant the holder the right, but not the obligation, to either buy or sell the present underlying asset at a specified price on or before a specific date. The underlying asset is typically a stock index, such as the S&P 500, but can also be a single stock, exchange-traded fund (ETF), or commodity.
Index options are typically American-style options, which means they can be exercised at any time up to and including the expiration date. European-style options are only exercised on their expiration date.
The price at which the underlying asset can be bought or sold is called the strike price. The premium is the price of the option contract. It is the amount that the option buyer pays to the option seller for the right to buy or sell the underlying asset.
There are two different types of index options:
- Call Options
- Put Options
Call options simply give the holder the right to buy the underlying asset at the strike price on or before the expiration date. Whereas put options offer the holder the right to sell the underlying asset at the strike price on or before the expiration date.
The payoff for a call option is the difference between the strike price and the price of the underlying asset at expiration if the underlying asset is above the strike price. If the underlying asset is below the strike price, the option expires worthless and the option buyer loses the premium.
The payoff for a put option is the difference between the strike price and the price of the underlying asset at expiration if the underlying asset is below the strike price. If the underlying asset is above the strike price, the option expires worthless and the option buyer loses the premium.
6. Currency Options
A currency option is a type of derivative contract that gives the holder the right, but not the obligation, to buy or sell a specified currency at a specified price on or before a specific date. Currency options are used by investors as a way to hedge against currency risk or to speculate on the movement of currency exchange rates.
The terms of a currency option contract are determined by the underlying currency pair, the strike price, the expiration date, and the premium. The underlying currency pair is the currency pair on which the option contract is based. The strike price is the price at which the holder of the option can buy or sell the underlying currency pair. The expiration date is the date on which the option contract expires and the option is no longer valid. The premium is the price of the option contract.
Currency options can be either European-style or American-style. European-style options can only be exercised on the expiration date, while American-style options can be exercised at any time up to the expiration date.
Currency options are traded on the over-the-counter (OTC) market and are not traded on exchanges.
7. Commodity Options
A commodity option is a contract that grants the holder the right, but not the obligation, to buy or sell a specific quantity of a commodity at a specified price on or before a specified date.
The price at which the option can be exercised is called the strike price, and the date on which the option expires is called the expiration date.
If the option is not exercised by the expiration date, it expires and becomes worthless.
If the underlying commodity is not traded on a regulated exchange, the option is considered to be an over-the-counter (OTC) contract.
The above guide should help you get started in trading options. Remember, options trading is a speculative venture and you should never risk more than you can afford to lose.
With proper research and a solid understanding of the risks involved, options trading can be a profitable way to invest for you.