Options trading has been a great instrument that many investors and traders love to use to hedge against the volatile market. Yet, it is not simple and easy for novice traders. So, what is options trading? Please scroll down this article to learn the basics and crucial aspects to earn the best profits from options and undertake the least risks.
What Are Options?
Options are derivative contracts that enable the bearer to either buy or sell underlying assets. There will be a certain expiration date and predetermined price in the options. It is possible to process the purchase of options through brokerage investment accounts.
Investors can enhance trading portfolios thanks to options through added income, protection, and leverage. They love using options to hedge against risks amidst the tumultuous price actions.
Due to the characteristic of using options to hedge against downside risks, people usually take options as an insurance policy. Traders or investors can limit the downside losses no matter how volatile the market is.
What Are the Types of Options?
A call option offers the holder the right to purchase the underlying security at the predetermined price by the expiration date. So, its value will increase if the price of the security rises.
You can use a long-term call option to take risks on the rising price of assets. The reason is that you only have to pay the premium as the maximum loss while you can enjoy the unlimited possibility of profits.
The real estate market shows positive signals of growth. A potential homeowner wants to buy a home in the future only when certain developments are available.
It is time for the option of buying to step in. Let’s say a call option to buy the home is at around $400,000 in the next three years. The price of a call option is the premium. The deposit can be $20,000 that the buyer pays the developer to have the contract.
After two years, the developments are ready and zoning has got approval. The homebuyer can exercise the option and buy the home for $400,000 while the market value of the home can be at $800,000 then.
While call options offer the right to buy, put options enable the holder to sell the underlying assets. In each put option, there is a predetermined strike price and expiration date.
So, a long put option relates to a short position in the underlying security. It gains higher value as the underlying price falls or has a negative delta. Investors can buy protective puts as a kind of insurance with a price floor. So, they can hedge their positions to downsize the risks.
Assuming you own a home, you may want to buy an insurance policy to protect your home from damage. It costs you an amount called a premium for about a year. It can be the same as owning a stock or index investment.
Investors will buy put options as insurance on their S&P 500 index portfolio to protect themselves from losses. The fear of a bear market can lead investors to willingly pay more than 10% of their long position in the S&P 500 index.
The scenario is that the value of the S&P 500 is around $2,500. Investors can buy a put option that enables them to sell the index at $2,250 at any point in the next two years.
After six months, the market is heading towards crashes by 20% (equally to 500 points on the index). Investors with put options can sell the index at $2,250 while the market price is just $2,000. The worst case is that the market drops to zero, and the loss will only be 10% as the price is predetermined.
How Options Work
The success of an option contract heavily depends on the process of valuation. And the forecast of future price events plays an important role.
If a trend is more likely to occur, the price of an option can increase to profit from that event. Reversely, when it reaches the expiry, the value of an option will drop. The option strike that will expire in a year can cost more than the same strike for one month. Time decay can explain such a wasting feature of options.
Volatility is the factor pushing the price of an option up. Uncertainty of future price actions can increase the odds of an outcome, which encourages investors to buy options to hedge against risks and earn higher profits.
Benefits of Options Trading
- Cost-Efficiency Thanks to Leveraging Power
If an investor buys an option equal to a stock position, he/she can save a huge amount of money. For example, it is necessary to pay out $16,000 to own 200 shares of an $80 stock. Meanwhile, he/she only pays $4,000 to purchase two $20 calls per contract for 100 shares each.
- Less Risk for Fewer Losses
As mentioned earlier, investors and traders usually use options to speculate and hedge against risks. The reasons for its popularity include the requirement of a less financial commitment than equities and the substantial imperviousness to bad effects of gap openings.
- Possibilities to Generate Higher Returns
Combining the two characteristics above can help you form this advantage of an option. It can reduce costs and potential losses while bringing about almost the same profits.
- Various Strategies
There is a wide range of available options strategies. So, you can flexibly adapt to many different situations. It eases your trading process while saving you from tough trading conditions.
Drawbacks of Options Trading.
- Not for the Faint of Hearts
Options trading relates to complicated strategies and techniques. So, it is a playground for novice traders. There are rules and jargon that you need to know to earn the best profits from options.
- Higher Potential Losses for Sellers
The sellers might undertake greater losses than the income you earn and have to pay for the contract’s premium. Don’t worry as your trading knowledge and experience can save you from costly pitfalls.
How to Start Trading Options
The fundamentals of options trading are what any traders need to kick off their career. There are four basic things you need to know to put your options trading on the roll.
- Buy (long) calls
- Sell (short) calls
- Buy (long) puts
- Sell (short) puts
Buying a call option offers you a potential long position in the underlying stock. Meanwhile, short-selling a stock provides a short position. Also, selling a naked or uncovered call generates a potential short position in the underlying security.
Buying a put option enables you to access a potential short position in the underlying stock. Selling a naked or unmarried put provides you with a potential long position. It is crucial to gain an intimate understanding of these four scenarios.
The holders are those who buy options while the writers are those who sell options. The following content covers some primary differences between a holder and a writer.
- A call holder and put holder (buyer) do not have to buy or sell, but can choose whether they exercise their rights or not. They suffer from the limited risk of the pre-paid premium.
- A call writer and put writer (seller) must exercise the purchase or sale of the option when it reaches the expiration date. So, the risk that they have to expose is kind of unlimited due to higher commitment to their promises to buy or sell the option.
The Step-by-Step Process
- Set up an options trading account
It requires some information and a large amount of capital to open an options trading account. For the best outcome, you should prepare such information as the investment objectives, trading experience, personal financial information, and desired options types.
- Choose your wanted options for purchases or sales
The forecast of future price actions decides whether you should choose to buy or sell options at any specific price and date. Instead of following your instincts, you can check out some useful principles below.
When you expect the stock price to rise, you should buy a call option and sell a put option.
When you forecast the stability of stock prices, you should sell either a call option or a put option.
When you find the stock price signal of decline, you should buy a put option or sell a call option.
- Pinpoint the option strike price
This step has its weight in the success of an option contract. You can apply technical analysis for the recognition of price patterns. So, you can enhance the accuracy of market forecasting.
- Identify the option time frame
There are two styles of options, including American and European options. Holders of an American option can execute at any point by the expiry date while the holders of European options can only implement their purchase or sales on the expired date.
Reading Options Tables
You can find an options database through online sources. Yet, you should learn to spot the essential components to gain insights into the options trading markets.
- Volume (VLM) indicates how many contracts of a particular option people have traded during the latest session.
- The “bid” price refers to the price level at which a market participant wants to buy a specific option.
- The “ask” price shows the latest price of a particular option at which a market participant sells.
- Implied Bid Volatility (IMPL BID VOL) is like the future volatility of price action and speed. It is the result of an option-pricing model, such as the Black-Scholes model, to represent the level of expected volatility on the option price.
- An Open Interest (OPTN OP) number showcases the sum of contracts in which a particular option has been opened. The decrease of open interest will decrease as people close open trades.
- Delta is like a probability. Besides, this metric shows the option’s sensitivity to the price changes in the underlying. For example, a 30-delta option means that it has a 30% chance of expiring in the money. Also, it will change by 30 cents if the underlying asset changes its price by $1.
- Gamma indicates the speed at which the option moves in or out of the money. People also take it as the movement of the delta.
- Theta is a Greek value showing how much value an option will lose after a trading day passes.
- Vega represents the changes in the value of an option based on a one-point change in the market volatility.
- The strike price indicates the price at which the buyer can buy or sell the security if they choose to exercise the option.
Options trading is not easy, yet it is an effective way to earn consistent profits no matter how volatile the market is. There are many aspects that you should learn and take notice of to become the master of this trading instrument. Hopefully, you find our walkthrough of the options trading guide above useful.