Options Trading: How To Start The Journey?
Options are the contracts that allow bearers to buy or sell several underlying assets. You can do this before the contract expires or at a predetermined price. Purchase options with brokerage investment accounts. In this article, you will learn about options trading. Before understanding this trading methodology, you should know about options.
Table of Contents
Must Explore – What is Options Trading?
What are Options?
Options enhance an individual’s portfolio, achieved through added income, leverage, and protection. These are assets that generate recurring income. Options do involve risk in trading. As an investor, you should be aware of the associated risks. Options are a part of securities called derivatives since their price is linked to the cost of other securities. The value of these derivatives depends on other assets’ prices. There are two basic types of options: the ‘Call’ option and the ‘Put’ option. The ‘Call’ option gives the right to buy a certain number of shares of a stock or an ETF at the strike price until the contract ends. ‘Put’ option allows holders to sell at the same time certain shares of stock or ETF at the strike price until the contract expires.
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What is Options Trading?
Options trading can be performed in over-the-counter transactions, exchange-traded in live and orderly markets in standardized contracts form. Options trading helps in growing your income. It limits your risk and hedge against market fluctuations.
If you plan to start options trading, you should choose a broker offering a low per-contract fee. You should also research tools that can guide you with strategies that you choose along the way.
Those who want to buy options have to pay a premium to sellers for such a right. If in case, the market conditions are unfavourable for option holders, they will allow options to expire rather than exercising this right. It ensures that potential losses do not exceed the premium.
Options Trading for Beginners
- Most brokers offer options trading online.
- You will have to apply for options trading and need approval. You will need a margin account as well.
- Once approved, you can enter orders for trading similarly to stocks.
- Here, you will have to use the option chain to identify the underlying expiration date, strike price and if it is a ‘call’ or a ‘put’.
- You can now place limit orders or market orders for that particular option.
Option Trading Strategies
If you plan to invest in options, you can start with calls and put options to limit the risk. There are four things that you can do while trading options:
1. Buying Calls (Long Calls)
If you believe that the price of an asset will increase, you can buy the call option using capital less than the asset. There is no particular limit to the profit. In case, the prices decrease, you will have to bear a lossless or equivalent to the premium paid.
Bullish traders can opt for this strategy to buy a particular ETF, stock, or index fund. Those who want to use leverage in times of rising prices.
2. Buying Puts (Long Puts)
A put option gives the holder the right to sell the asset at a fixed price. Bearish traders with less risk tolerance and short-selling strategy can try buying puts. Traders who want to leverage when prices fall can use this strategy.
As the underlying prices increase, the put option gains value. Traders profit from falling prices due to short selling. There is an unlimited risk with a short position since there is no limit to how high the price will go up. If the underlying value rises above the option’s strike price, the option becomes worthless.
Here, the potential loss on the long put can be as much as the premium paid. The maximum profit from the position is also capped since the underlying price cannot be below zero.
3. Covered calls
Covered calls are an options trading strategy overlaid on an existing long position in the underlying asset. It is an upside call sold in an amount to cover the existing position size. Covered call writers collect option premiums as income and limit the upside potential of the underlying position. Traders who do have no expectations related to price change and are ready to limit upside potential in lieu of downside protection.
Here, the trader buys 100 shares of the underlying asset and sells a call option against those shares. The premium is collected when the trader sells the call. It lowers the cost basis on shares and provides downside protection.
In return for selling the option, the trader agrees to sell underlying shares at the price of the option’s strike. It caps the upside potential of a trader.
You can exercise a short call if the share price exceeds the strike price before expiration. Traders will be required to deliver underlying shares at the option’s strike price even below the market price.
The covered call strategy offers limited downside protection as the premium while selling the call option.
4. Protective puts
Protective puts involve the purchase of a downside put within an amount that covers the existing position in an underlying asset. You will have to pay the options’ premium, which is an insurance policy against losses. It can be considered an insurance policy against losses preferred by traders who want downside protection against their underlying assets.
The option becomes worthless when the price of the underlying increases above the put’s strike price at maturity. Although the trader benefits from the increased underlying price, the trader loses the premium. If the price of the underlying decreases, the position of the trader’s portfolio loses value. The gain from the put option position majorly covers these losses.
There are four different levels of options trading based on risk and complexity. Customers need approval for options trading up to a level and should maintain a margin account.
Level 1: This level includes covered calls and protective puts. It is the level for those investors who own underlying assets.
Level 2: At this level, long calls and puts options come in. This includes straddles and strangles
Level 3: These are the options spreads that involve buying and selling one or more different options of the same underlying asset.
Level 4: These are selling naked options that have the possibility for unlimited losses
FAQs
Is options trading better than trading in stocks?
The prices of options are more volatile in comparison with stocks. This makes Options an attraction for traders who seek significant gains. It is risky but offers good returns.
Is trading in Options free?
Options trading does involve fees or commissions. This can be a fee-per-trade plus commission per contract.
What are call and put options?
A call option gives the holder the right to buy an underlying asset at a set price before the contract expires. A put option gives the holder the right to sell an underlying asset at a set price before the contract expires.
What is the strike price?
The strike price is the price at which the holder of an option can buy or sell the underlying asset when exercising the option.
What does 'exercising an option' mean?
Exercising an option means implementing the right to buy or sell the underlying asset as specified in the options contract. Not all options are exercised; many are traded or allowed to expire worthless.
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