Options trading is a fascinating and complex field that has captured the imagination of investors and traders for decades. Options allow their holders to potentially profit from the movement of an underlying asset, without having to actually own that asset.
With the ability to profit from changes in the prices of stocks, currencies, commodities, and other financial instruments, options offer a versatile and powerful tool for those who are willing to learn how to use them.
But options trading is not for the faint of heart. It requires a deep understanding of market dynamics, risk management techniques, and advanced strategies that can take years to master.
In this article, we will explore the fundamentals of options trading and provide you with the knowledge and skills you need to navigate the markets with your head confidently held high.
What Is Options Trading?
Put simply, options trading involves buying and selling contracts that give the buyer the right, but not the obligation, to buy or sell a particular underlying asset at a set price by a fixed date.
Options have a range of uses that appeal to investors. They can be used to speculate on market direction, hedge against potential losses, generate income, or optimize portfolio returns. This explains their widespread popularity among so many market participants
The two main types of options are puts and calls, which give the buyer the right to sell or buy the underlying asset at the set price, respectively.
How Do Options Work?
The question on everyone’s minds would be, exactly how do options work? At their core, options essentially work by giving its holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a particular date.
Call options give the buyer the right to buy the asset, whereas put options give the buyer the right to sell the asset. Every options contract, therefore, is either a call or a put.
The buyer pays a premium to the seller for the option, which is influenced by factors such as the current asset price, the strike price, the time until expiration, and market volatility. Each of these factors impacts the inherent value of an option.
If the buyer chooses to exercise the option, they can buy or sell the asset at the strike price, depending on the type of option. If the option is not exercised, the contract is expired as worthless and the holder loses the amount of premium paid for it.
Short-Term Options vs. Long-Term Options
The difference between short-term options and long-term options is quite straightforward. As the name suggests, they differ in their expiration dates, with one category expiring in the short term, and the other in the long term.
Short-term options have expiration dates within weeks or months, while long-term options can expire several months or even years in the future. This seemingly simple difference completely shifts the function of each type of option, and the trading strategies they are employed towards.
For instance, short-term options tend to be more volatile and require frequent monitoring and adjustments to account for changes in the market. Alternatively, longer-term contracts are best used for long-term market hedging and those with longer investment horizons.
The choice between short-term and long-term options depends on the trader’s goals, risk tolerance, and market outlook. This is crucial to understand when exploring options trading for beginners
Each can be used for investment strategies that involve holding the option for an extended period, such as generating income through covered call strategies or hedging against market risks.
Short-term options can offer quick profits, but they also come with higher risks and require more frequent monitoring. Long-term options can provide more stability and flexibility but may require a larger upfront investment and a longer holding period.
Types Of Options: Puts And Calls
As mentioned above, the two primary types of options are puts and calls are two types of financial contracts that are traded on markets.
Because a put option gives the buyer the right (but not the obligation) to sell an asset at a specific price (the strike price) before a certain date, they are great for those who are bearish on a particular commodity.
This means the put option would allow one to sell an asset at a higher price than the market currently values it. As long as the underlying price is below the strike price, the holder can profitably exercise the put.
On the other hand, call options are great for those who are bullish, and expect a price rise to be sustained in the future.
The buyer can potentially make a profit if the asset price increases above the strike price, by buying the asset at the lower price and then selling it at the higher market price.
Puts and calls can be used for different purposes, such as hedging against market risks or making speculative trades to generate profits.
Put Options Examples
The best way to explain a put example is through an example. So let’s dive right ahead
Let’s say you are interested in buying put options for the electric car giant Tesla Inc. (NASDAQ: TSLA). The current market price for TSLA stock is $190 per share, but you think the price is going to go down in the near future due to EV industrial challenges.
You decide to buy one put option contract, which typically covers 100 shares of the underlying stock. The strike price for the put option is $170 per share, and the expiration date is one month from now.
If the stock price falls below the strike price of $170 per share before the expiration date, you can exercise your put option and sell 100 shares of XYZ Company’s stock at the strike price of $170 per share, regardless of the current market price.
For example, if the TSLA stock price drops to $150 per share before the expiration date, you could exercise your put option and sell 100 shares at $170 per share, even though the current market price is only $150 per share.
Due to the put option, you would be making a profit of $20 for each TSLA share sold, by selling it for $170, rather than $150. For 100 shares, this profit would total $2000.
Call Options Examples
We now explain call options in a similar manner by illustrating an example, looking at a market player bullish on the tech giant, Apple Inc. (NASDAQ: AAPL)
We assume you are interested in buying AAPL calls. The current market price for AAPL stock is $160 per share, but you think the price is going to go up in the near future due to some positive news that is expected to be released.
You decide to buy one call option contract, which typically covers 100 shares of the underlying stock. The strike price for the call option is $180 per share, and the expiration date is one month from now.
If the stock price rises above the strike price of $180 per share before the expiration date, you can exercise your call option and buy 100 shares of AAPL stock at the strike price of $180 per share, regardless of the current market price.
For example, if the stock price rises to $200 per share before the expiration date, you could exercise your call option and buy 100 shares of Apple stock at a bargain of $180 per share, even though the current market price is $200 per share.
This means you would make a profit of $20 per share, or $2,000 in total, minus the cost of buying the call option contract.
How to Trade Options
As illustrated in the previous examples, an investor might buy a call option on a stock if they think the stock price will rise, and sell a put option on the same stock if they think the stock price will remain stable or rise slightly.
The following steps must be taken for anyone looking to trade options:
Open A Brokerage Account
You will require a brokerage account with a reputable broker that offers options trading before you can engage in options trading.
Choose A Strategy
Determine the trading strategy that fits your investment goals and risk tolerance. This would depend on whether you are bullish or bearish on a particular stock or underlying asset.
Place Your Trade
After you are certain of your strategy and have weighed the risks, you may place your trade through your brokerage account.
Select the option contract you want to trade and specify the number of contracts you want to buy or sell, the expiration date, and the strike price.
Monitor And Manage
Options trading can be volatile, with put and call prices jumping wildly. It is important to monitor your trades and manage your risk by setting stop limit orders or shifting your position as needed.
Close Your Trade
When it’s time to close your trade, you can sell your options contracts back to the market, exercise your option if it’s in the money, or let the option expire if it’s out of the money.
Options trading is a very useful approach to navigating the market, allowing investors to enhance their profits, manage their risk, and make sustained speculations in the market in a systematic manner.
Both calls and puts are terrific ways for any investor to add flexibility to their trading strategies, while effectively achieving their financial goals through workable combinations.
Options allow for a wide range of sophisticated strategies to be put into action which can deliver a greater degree of control to market participants. They allow exposure to gains without actually holding the underlying assets going through those gains.
Is Options Trading Better Than Stocks?
Options trading and stocks are preferred by different groups of people in the market. Some investors prefer trading options for their flexibility and potential for higher returns, while others prefer stocks for their simplicity and long-term stability.
What Are The Best Option Trading Strategies?
The best option trading strategies depend on an individual’s goals and risk tolerance. Some popular strategies include buying calls or puts, selling covered calls, and using spreads to limit risk and maximize profits.
Where Do Options Trade?
Options trade on various financial markets, including exchanges such as the Chicago Board Options Exchange (CBOE) and the New York Stock Exchange (NYSE), as well as electronic trading platforms like the NASDAQ OMX PHLX.