Options trading is a rewarding but complex area of finance for two reasons: First, it uses complex terminologies, and second, it carries such a high level of perceived risk that it will set a beginner’s knees trembling. But with basic knowledge and the right strategies, you can delve into these potential enhancers of your trading portfolio. Our manual seeks to demystify the inherent complexities of trading options by introducing beginner-friendly strategies focused on key concepts, such as call and put options.
What Are Options?
Financial derivatives given to the investor are rights, not obligations, to buy or sell the underlying assets at a strike price within a certain period of time, terminating on an agreed expiration date. Generally, an option is described as one of two categories: call and put.
Therefore, call options are rights for the holder to buy an asset at a stated price, known as the exercise or strike price. The put option holder has the right to sell an asset at the prearranged price. Both kinds of options can be used in combination strategies to capture different market states.
The Basics of How Options Trading Works
Trading options involve dealing with contracts that usually have control over 100 shares of the underlying stock per contract.
Trading Strategy: One must choose an appropriate trading strategy based on one’s view of the market. Common strategies are buying calls or puts, selling covered calls, and more advanced strategies like spreads.
Pick the Expiry: Expirations vary from days to weeks to months to years. Generally, the shorter the options, the more risk is involved.
Strike Price Selection: Choose a Strike Price that suits your very best idea of market movement.
Pay the Premium: This is the cost that an investor pays for an option contract and tends to vary with volatility, time to expiration, and the difference between the current and the strike prices.
Easy Options Trading Strategies
Buying Call Options
Buying a call would be a basic starting strategy used by investors. This means that the investor expects the stock to go up in a specific period of time. One is buying the right to purchase a stock at a set price before the option expires. It is a form of leveraging your position with less up-front investment than buying the stock outright.
Purchasing a Put Option
You may have anticipated that the price of a particular stock would decline, and you already hold the stock. Buying a put gives you the right to sell that stock at a pre-agreed price within the contract’s expiration date. It can be a kind of insurance against losses on your current stock positions or a possibility to benefit from market declines.
Selling Covered Calls
It refers to selling a call option on an investor’s stock. The company earns income from the premium an investor receives from call option sales. However, there is always a certain downside: selling out one’s stock if it exceeds the strike price.
Important Points to Remember
Power: Options allow you to leverage a small sum of money, controlling a large number of stocks.
Volatility: The pricing of options is volatile. The higher number of volatile markets can make the premiums go higher, too.
Time Decay: All else being equal, the price of an option will generally reduce as the time to expiration draws closer, assuming the market price has not moved in a favorable direction relative to the strike price.
Conclusion
Options trading is very profitable and flexible, but one has to understand the market movements and the level of risk that the trade can bring. Beginners must start with fundamental strategies and gradually grow into more complex trades as their confidence and expertise grow. However, always ensure that you manage your risk and are comfortable with the outcomes of the trade. Options trading can be quite a beneficial addendum to your investment strategy if approached with education and caution.
