How to Trade Options - A Comprehensive Guide
Options were once traded in unregulated, face-to-face, over-the-counter transactions. That all changed in 1973 with the formation of the Chicago Board of Exchange.
Today, options represent a very liquid, well-developed segment of the financial derivatives market. In other words, options have become a very attractive investment. Learning how to trade options is therefore increasingly relevant to investors who are ready to dive into the trading world. Here’s a quick overview.
What Are Options?
If you’re going to trade options, it’s probably best if you know what they are. An option is a derivative financial instrument that gives the owner the right but not the obligation to buy or sell an underlying asset at an agreed-upon price - the strike price - on or before the date of maturity.
The maturity date is the last day the option can be sold. The maturity date of an option contract can range from one month to three years after the option was created.
Underlying assets can be commodities, currencies, securities, interest, futures contracts, and stock indices. The price of the underlying asset is defined when the contract is bought or sold. The strike price of most traded options is usually very close to the asset’s current market price.
The strike price of the underlying asset should not be confused with the option price, often referred to as the option premium, which is defined by factors such as the type of the underlying asset, its current price, volatility rate in the last several years, current interest rate, and the time remaining until the option expires.
Once you know what options are, the next step is to get acquainted with the obligations of the contracting parties.
The seller of the option is known as the writer or issuer. It is the seller who creates the option. The seller has an obligation to sell if a buyer accepts the offer to fulfill a contract.
On the other hand, the buyer of the option is the party who has the right, but not the obligation, to execute the trade. This means that the potential buyer does not have an obligation to accept the contract and conclude an options trade. This may sound a bit confusing, but don’t worry, we’re not done with our explanation just yet.
To understand the essence of buying and selling this financial derivative, it may help to consider an everyday-life example that is more or less familiar to everyone: selling real estate. In this contractual relationship, the buyer pays a down payment, which gives him the right but not the obligation to buy the real estate within a certain period at the agreed price.
If the buyer doesn’t fulfill the contract with the seller by the agreed date, the seller retains the down payment without any obligation to return it.
In our options trading scenario, the down payment is the premium on the call option, the deadline by which the buyer has the right to buy the property is the maturity of the option, and the price of the property is the strike price. The only difference between the down payment and the option premium is that the down payment is part of the agreed-upon property price, while the option premium isn’t part of the strike price.
When trading in financial markets, you’ll encounter myriad strategies that traders use to make as much profit as they can. We can’t tell you which would suit you the most, but we can offer a list of the most basic options strategies so you can decide for yourself.
Buying a Call
A trader who buys a call is buying the right to purchase certain assets at a specified strike price on or before the maturity date. Traders employ this strategy when they want to protect themselves from the asset’s price increase, while at the same time retaining the possibility of acquiring the asset at a lower price if an opportunity presents itself.
A trader can speculate as well. Speculating, in this scenario, means anticipating a rise in the asset’s price and making a profit from it. If the asset’s price rises, the options trader will buy the asset at the lower strike price, after which they can sell it for a higher price and earn a profit from the difference. In the event that the trader’s assessment was wrong, they have limited their loss to only having to pay the option premium.
Buying a Put
In this case, the trader buys the right to sell a certain asset at a specified strike price before the maturity date. This strategy can be implemented when you want to insure yourself against the risk of falling asset prices but wish to have the possibility of selling the assets at a higher price. You’d have to cancel the execution of the options contract to sell the assets.
If you’re speculating, you will be looking to make a profit from the asset’s price drop by buying the same assets on the market at a lower price and then selling them to the option writer at the agreed-upon higher price.
Selling a Call
When you sell a call option, you are selling another trader the right to buy a certain asset under specified conditions. As the seller, you are obligated to execute the option at the request of the call option buyer.
Selling a Put
An option trader who sells a put option is selling the right to sell a certain asset under specified conditions. This strategy is similar to the previous one in that it obligates the seller to execute the option.
Keep in mind that the last two actions are high-risk strategies in terms of potential losses and profits, so beginners might want to steer clear of them. Only those with a great deal of knowledge regarding this complex financial instrument and plenty of trading experience should consider them.
Futures vs Options
It’s quite easy to see why many new traders tend to confuse futures with options. Both options and futures fall under the category of financial derivatives because their value is based on an underlying asset. Options and futures don’t exist without the underlying assets.
A futures contract obligates both the seller and the buyer to fulfill their agreed-upon responsibilities regardless of market conditions on the future’s maturity date. This dual obligation is quite different from what faces the buyer and seller in an options contract.
With futures, the seller estimates that the price of the underlying asset will fall and that it is, therefore, best to sell before that happens. If market movements are contrary to the seller’s expectations, the seller will lose money because he is obligated to execute the futures contract nevertheless.
On the other hand, the buyer of the future will be at a profit because he bought the underlying asset at a price lower than the risen market price, which increased after the sale of the futures contract.
Unlike options trading, which can be done on both the securities exchange and in the over-the-counter market – a decentralized marketplace where people can trade financial instruments directly without any intermediaries – futures trading can take place on a regulated securities exchange. The reason is that futures contracts are highly standardized and thus have strictly prescribed characteristics and rules of trading.
If you’re wondering which of these two instruments you should trade, we’d have to say that even though futures offer plenty of advantages, including increased liquidity and greater margin use, we consider trading options the better choice for beginners. Options carry minimal financial risk because the amount of loss or gain is determined in advance: the option premium, which is fixed and can’t be changed under any circumstances.
The preceding information has probably whetted your appetite. Are you ready to jump into the market? Excellent. The next section offers step-by-step advice on precisely what you must do to start trading options. We’ve divided our overview into two main steps.
Step 1: Learn
Before you begin buying and selling options, it is necessary to study this financial instrument carefully. No matter how appealing trading may seem, it can lead to losses (albeit limited) for those who take it lightly.
Trading in this financial instrument should be based not only on expectations regarding price movements of the underlying asset, but also on a very detailed analysis of the historical price movements of the underlying assets as well as on models of volatility assessment.
This means you need to acquire extensive knowledge to be successful and not waste your money. Learning about options trading isn’t enough. You must also become an expert in the underlying asset.
Step 2: Choose
Whether you decide to have a broker trade options on your behalf or to do it yourself via an online trading platform, you have to do your homework and choose wisely. Here’s are the features you should pay attention to when choosing a broker or trading platform:
Look for companies that have built up a strong reputation for providing top-notch services. See if they’ve won any awards over the past year or two and how long they’ve been in business. Seek out customer reviews and read as many as you can.
You’ll be charged a commission for every options trade you make. Don’t settle for a company that charges too much. Also, don’t forget to examine additional fees that you may have to pay such as account maintenance charges or broker-assisted trading fees.
Trading online comes with unique risks like having your money stolen by a hacker. You shouldn’t entrust your funds to any company that doesn’t have the latest security measures in place.
Whether you’re conducting your own trades or relying on a broker, you want to conclude contracts quickly. You can miss out on opportunities - and profits - if your broker is slow to execute your option strategy or if your trading platform takes forever to load.
Customer service may not be as high on our list of priorities as some of the other factors we’ve mentioned, but odds are that sooner or later you will encounter an issue that you can’t resolve on your own. That’s when you will learn that quick, accurate responses from knowledgeable representatives are of vital importance.
Ease of Use
Choosing a trading platform is tough because there are many competitors on the internet, each designed with particular kinds of users in mind. Before you start reviewing trading and analysis tools, set aside a few minutes to assess whether the platform you’re considering is user-friendly. Learning how to trade options is hard enough without the daily headache of struggling with a complicated user interface.
This is a difficult question because the money you’ll need depends on the type of option you plan to trade. To be more precise, it depends on the price of the underlying asset, which can be practically anything. In theory, you could start trading with only $100, but if you’re serious about all of this, you ought to start with at least $5,000.
In a certain way, trading with options can be viewed as some sort of financial gambling, seeing as you’re “betting” on a financial outcome. Finance experts prefer to say they are “speculating.”
Simply put, yes. Trading these financial instruments can make you rich. It’s hard work, however. You’ll need an exceptional amount of skill and knowledge. Even though options are low-risk investment products, mishandling them can still lead to losses.
To start, you’ll need to get a good grasp of options and what trading them entails. Once you’ve got a handle on the basics, you can choose a broker or a trading platform. This How to Trade Options guide can answer many of the questions you are sure to have.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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