Small Business Guides

An Inside Look at the Basics of Options Trading

Options trading is a prevalent form of investing that has become increasingly accessible to the public. It offers investors a way to speculate on the price movements of stocks, indices, commodities, and currencies without buying or selling them outright. Options trading can be used as a hedging strategy against market volatility and for speculation.

This article will provide an inside look at the basics of options trading, including what it is and how it works.

Introduction to options trading

Options are derivative financial instruments that give traders the opportunity (but not the constraint) to purchase or resell an underlying asset at a predetermined price by a specified date in the future. Traders use options to speculate on potential price movements rather than take physical ownership of the underlying asset. Options are typically used for hedging, meaning traders can minimise losses if the market moves against them.

An options contract is a legal agreement between two parties, the buyer, and the seller, to purchase or resell an underlying asset at a predetermined price by a specific date in the future. The buyer has the choice (but not constraint) to purchase or sell according to the terms of the option on or before the expiration date. If, at the expiration date, an option is “in-the-money”, the strike price is lower than the current market price and vice versa for “out-of-the-money” options. Options contracts are available with different expiration dates and strike prices, allowing traders to tailor their positions according to their objectives.

Types of options

Options are classified as either call or put options. A call option gives the buyer the opportunity (but not constraint) to buy an underlying asset at a predetermined price by a specific date in the future. Meanwhile, a put option gives the buyer the opportunity (but not constraint) to sell an underlying asset at a predetermined price by a specific date in the future.

Call options are typically used when traders expect an underlying asset’s price to rise, while put options are used when they expect it to fall. Put options are also popularly used as hedging strategies to protect against losses if the market moves adversely.

Options trading strategies

The range of options trading strategies available is almost unlimited. The most common and popular strategies include covered calls, long strangle, long combo, bull spread, and bear spread. Each of these has unique features, which should be carefully considered before investing.

Covered calls involve simultaneously buying an asset and writing a call option. This allows traders to benefit from the upside potential of the underlying asset while also receiving income from writing the call option. The long strangle is another famous strategy investors use when they expect large price movements in either direction but don’t know which direction.

The long combo is a strategy that combines both call and put options, allowing traders to benefit from a range of price movements instead of just one direction. A bull spread involves buying and selling two call options with different strike prices, while a bear spread involves buying and selling two put options with different strike prices.

Buying and selling options

Options can be bought and sold through online trading platforms and traditional brokerages. When buying or selling an option, traders must consider factors such as time value decay, implied volatility, liquidity, and market sentiment.

Time value decay is the change in an option’s intrinsic value over time. Implied volatility measures how much movement the market expects in underlying asset prices. Liquidity refers to how easy it is to buy and sell options, while market sentiment refers to how traders perceive future price movements.

Risks associated with options trading

Options trading carries potential rewards and risks that should be considered before placing any trades. It is essential to understand the various factors that can influence the price of an option before embarking on any position-taking activity.

Options are leveraged instruments, meaning they can provide more significant returns with smaller investments and carry increased risk compared to other forms of investing. Additionally, options expire at a predetermined date, meaning that traders must exit their positions by the expiration date to avoid losses.

All in all

Options trading has become increasingly popular since its introduction in the 1970s. Options offer investors an exciting way to diversify their portfolios and benefit from market movements without taking too much risk. However, traders must understand the various risks associated with options trading before entering any positions.

With careful consideration of all relevant factors and sound risk management strategies, options can be used as powerful components within an investor’s overall portfolio strategy.