Various investment strategies exist tailored to different risk appetites and objectives. One of them is options trading. This article will discuss the fundamentals of options trading—its meaning, process, types, and beyond.
What is options trading?
Options are tradable contracts. Investors use these contracts to guess whether a certain asset’s price will increase or decrease at a certain future date.
Options trading allows you the right (but not the obligation) to purchase a certain asset (like a stock) at a certain date (expiration date) for a certain price (strike price).
You have to pay a premium to buy an option. The premium depends on the volatility of the market, the expiration date, and the asset’s price.
When buying an option, you have the right to trade the asset, but you don’t have to. If you do buy it, you are “exercising the option.”
If you are selling an option, you have to fulfill the contract. Selling options is more complicated than buying and carries higher risks.
How does options trading work?
There are two main types of options:
- Call option: You buy the asset at the strike price, hoping that the price increases before the expiration date.
- Put option: You have the right to sell the option at the strike price, hoping that the price goes down.
Here’s an overview of the options trading process:
- Choose an option: Pick an asset, like a stock or ETF. Decide whether you want to “call” (if you think the price will increase) or “put” (if you anticipate a decrease). Then, set the strike price. A higher strike price equals a cheaper premium but less profit. Lastly, choose an expiration date.
- Buy the option: Once you pay the premium to the seller, the option becomes your property.
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- One of two things can happen next:
- Favorable price: If the price moves in the predicted direction (up for call options, down for put options), the option becomes more valuable than the premium. You can then exercise the option by buying it at the strike price or selling it to another buyer at a higher price. Or, you can let the option expire and lose the premium.
- Unfavorable price: In this case, the option becomes less valuable to you. You can exercise the option and be paid the premium and further losses (buy high, sell low = extra loss). Or, you can sell the option at a lower price, making a loss likely greater than the premium. Lastly, you can let the option expire, losing the premium.
Types of Options Trading
Below are some of the main types of options trading:
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- Buying calls or puts: This basic strategy revolves around speculation of price changes at a set future date.
- Covered calls: When you sell a call option while owning the underlying asset.
- Protective puts: Buying a put option while owning the asset.
- Long straddles: Buying options on both sides in the case of a price drop or increase.
Options Trading Platforms
There are plenty of options trading platforms that can simplify options trading. These platforms are perfect for beginners since they offer valuable resources, commission-free trades, and easy-to-use interfaces. Just make sure you do your research before picking one.
While options trading can be a lucrative venture, it also comes with inherent risks. The key lies in having a solid understanding of the process. Do thorough research, plan, and stay abreast of market trends. This way, you can navigate the dynamic world of options trading successfully.