An option is a financial contract that allows the investor to buy or sell the underlying instrument or asset at a certain price. What does that mean exactly? Well, with options trading, you have the ability to buy or sell any security available on the market of your interest—from stocks to currency pairs. Interesting, right?
Just the Nuggets
- Options are one of the most popular investment options on the market today.
- Two of the most common positions you can open are called call and put, and there are many strategies you can combine until you find a perfect fit.
- American and European markets are significantly different when it comes to options trading.
- Options trading can come in handy with speculation and hedging.
- The elements of options trading are expiration date, value, and liquidity.
Options are otherwise known as derivatives since they derive their value from the underlying asset in question. They can significantly diversify your portfolio by adding features such as income, protection, and even leverage.
The price for buying and selling the security is called the strike price. This term is used to describe a previously determined price of the asset, and it can be decided based on the market conditions and other factors that can affect your daily trading.
Options can also be quite helpful for speculating on a trend a certain stock or asset will take next. Still, one of the most popular examples of options functionality is hedging. Hedging with options can help you limit the losses against the declining stock market.
Call vs. Put Options
Options give you a lot of choices when it comes to the period until expiration, value of an underlying asset, and its availability for buying and selling. Still, the market creators have decided to make things a bit easier for us by creating two main types of options contracts.
The first one is the call option. A call option is concerned only with buying. It allows an investor to buy a certain asset during a certain period of time at the strike price. For example, a call option for stocks allows you to buy 100 shares of a company at a certain price. Another requirement for the investor is to do so until the set expiration date.
On the other hand, the put option gives the holder the right to sell a certain asset at the strike price during a period of time before the expiration date. The value of the put option can go up as the value of the underlying asset drops. Similarly, as the expiration date approaches, the value of the put option goes down.
How Options Trading Works
Options are the most beneficial and useful way to determine a certain movement in the future when it comes to an underlying asset. There are several motions that can be determined here, and you can do so by assessing the characteristics of your position.
For example, if the call value goes up, so does the value of the underlying asset. Similarly, the value of the option decreases as the expiration date of the position approaches.
One of the most important things that can add to the value of an asset is volatility. Usually, volatility only adds to the risk when it comes to any asset. However, with options trading, you can use it to your advantage and determine the movements by using speculation.
Options are traded through brokerages, just like any other security on the market. There are many broker companies and intermediates you can choose from today. It all depends on your personal goals, trading proficiency, as well as how much money and time you are willing to invest in this journey.
Overall, there are four things you can do while options trading.
1. Buying a Call Option (Long Call)
When you buy a call option, you are deciding to buy the asset until the expiration date. Important factors to note are patterns, trends, risk, leverage, and other market conditions. The risk here is, you can lose everything if you’re not able to finish the purchase of the asset before the expiration.
2. Selling a Call Option (Short Call)
This position is the opposite of the previous one since you are selling the underlying asset. That has to happen before the set expiration date, as well. This option is quite risky since you can lose a significant amount of profit in case the stock price goes higher than the one you’re expecting in your position.
3. Buying a Put Option (Long Put)
A put option does not require you to own the underlying asset. Instead, you’re just speculating on its price, which takes a lot of the pressure off during trading. However, the amount of profit you can earn is a lot lower.
4. Selling a Put Option (Short Put)
In this case, you’re deciding to close your position on an asset. You’re also not owning it like in the previous type. However, the underlying asset can affect your portfolio in many ways since its value can be quite unpredictable until the expiration date.
European vs. American Options Trading
It is important to note the difference between trading options on the American and European markets. Though they’re similar in their core, there are some differences you should keep in mind in case you’re switching between the two.
One of the main distinctions here is, the owner of the American-style option can exercise their right to buy or sell at any time until the expiration date of the position. On the other hand, in Europe, the owner of the same position can do so only on the day of expiration.
When it comes to American-style options, there are a lot of stocks and exchange-traded funds considered to belong to this group. On the other hand, there are only a few of those that are broad-based indices. The official closing price of the asset on the day of the expiration is called the settlement price. It will be automatically exercised on the expiration date unless the owner specifically requests otherwise. This way, there are certain surprises you can expect on the expiration day.
With European options, the main difference is regarding the settlement price, which is a lot more difficult to determine here. First, we should note that European index options stop trading one day earlier than the expiration date. Also, the settlement price takes a while to be published—sometimes even a couple of hours after the next trading day is opened. As a result, there are a lot of variables here that can come into action during that time.
Why Trade Options?
There are several important reasons why options trading was invented in the first place. It is considered that options have been present since ancient times in Greece when people used to predict the olive harvest for the season. Even today, the basics of options trading lingo are noticeable by their similarity with the Greek Alphabet—Delta, Gamma, and Theta. Later, the options trading has spread across Europe, reaching the most advanced levels of the Amsterdam and London Stock Exchange. So, how did they become so popular?
One of the first reasons options were introduced was due to their ability to predict certain movements on the market and in everyday life. Speculation as a narrative is widely used and present in all sectors of the market—from stocks to currency pairs and commodities. Speculation as a method is used for fundamental and technical analysis, as well as price movements, patterns, and trends.
With hedging, you are able to significantly reduce risks at a much lower cost. This way, options procure another important role in the world of trading as a type of insurance policy. Options are generally used to limit the potential losses on your positions.
The 3 Elements
Aside from the basic distinction between the American and European options, there are also exotic options representing a variation of the well-known option types with a twist that can turn into something entirely different and beneficial in the hectic trading environment.
Then there are the binary options, which have a simple payoff structure, particularly useful to first-time options traders. There are also many subtypes of these options, such as the Asian options, Bermudan options, etc.
Regardless of the type, there are three most important elements of options trading.
As mentioned, the expiration date is one of the key features affecting your options trading. Depending on the market type (American or European), they can determine the amount of profit you can acquire by holding a certain position.
The value of an underlying asset depends on the position you are choosing to open (long call, short put, etc). Based on this, the value of an asset will go up or down, but your position is just one of the many factors affecting it. You should assess the broader trading environment and try to determine the patterns that can affect the value of the asset in question.
The liquidity of each asset depends on many factors—from the position you are taking to the everyday market movements. For certain positions, for example, the liquidity of the asset decreases as the expiration date grows closer.
Advantages of Options Trading
1. Lower risk
One benefit is the lower risk that comes with opening a position for trading options. Namely, the time until the position expires can help you create a solid trading plan, as well as give you the means necessary to use the tools the market has at its disposal. These include occurrences such as movements, trends, and patterns.
As an option trader, you are reduced to a certain amount of time during which you can act. As a result, there are only so many outcomes that can be brought into action, so your speculation skills can come into a full effect.
2. Lower needed capital
The amount of capital you need to invest in an options position is lower than investing in a different type of asset or security. When you compare an options trader with a stock trader, for example, you will notice that an options trader can join the same environment as a stock trader at significantly lower costs.
Disadvantages of Options Trading
1. Limited potential
You can say that each advantage has the potential to turn ugly and affect your trading in a negative way. For example, a limited amount of time can also limit the potential you can achieve. This implies that you will have to pick the perfect timing for each one of your positions which most traders are just not able to do.
2. Unpredictable additional costs
These costs can come up during your trading period, depending on many factors—from the evolving market requirements to the changing structure of the company you’re investing in or the asset you’re trying to benefit from.
How to Trade Options
Your unique way of trading options depends on many factors, including the goals you wish to achieve in your trading journey, the amount of time and money you’re willing to invest, and the depth of knowledge you have on this topic.
1. Do your research
Learning about the basics of options trading is key before deciding to open a position and join in on the action. Thankfully, a lot of trading companies today are well aware of this fact and are able to regularly update you with all the latest information about this exciting activity. This is how you can differentiate a good trading company from a misleading one.
2. Choose the right broker company
There are many trading companies today offering admirable conditions for options trading. They also provide you with a lot of benefits and features suitable for your trading strategy. From better trading conditions to lower requirements for opening a position, all you need to do is choose the best one.
3. Make a strategy
Before you begin trading options, you should assess your goals and the market requirements you need to fulfill for a successful trading journey. You can also choose from a few strategies explained further below. There are several ways to create a successful strategy. The most important thing to note before you start is your own features, qualities, and flaws, which are going to determine your trading experience later on.
4. Choose the expiration date and strike price
As mentioned, these are two of the most important features of each position in options trading. They can determine your success rate, as well as allow you to apply your own unique skills. You can also use the try-fail method, where you try out several different options until you find the one you are most comfortable with.
5. Open a position
After you’ve chosen a brokerage and created a strategy, you can finally start trading! During this part, you should go back to reviewing your goals so you can decide on the right position.
Options Trading Strategies
The strategy for trading options depends on many factors—from your personal preference to the latest market conditions. Here are some of the most popular strategies suitable for traders, regardless of their market proficiency.
Buying Calls Strategy
Suitable for high-rollers and investors who are confident in the underlying asset they are choosing, this strategy is great for profiting off of leverage since the prices of the assets are rising in this kind of environment. This allows you to bet on an unlimited profit with low risks since, in the worst-case scenario, you can only choose as much as you paid in the beginning.
Buying Puts Strategy
This strategy is the opposite of the first one. Here, the investors who like to keep it safe are trying to benefit from the falling prices of the less reliable assets. With this strategy, unfortunately, the profit you can achieve is limited but the loss is significantly greater.
Covered Call Strategy
This strategy is suitable for traders who do not expect any or rather, expect small volatility and flexibility of the underlying asset’s value. With this strategy, the investors are willing to lose something to get something else. Namely, they are limiting their profit potential in an exchange for much lower risks in the process.
Protective Put Strategy
This strategy is mainly used by investors who own the underlying asset and want extra protection from risks and losses during their trading. This is best used for the long-term, so investors would need a lot of patience and dedication.
Common Trading Mistakes
Still, no matter how proficient and skillful you are in any type of trading, there are a lot of things that can go wrong down the road. After all, trading in its core is unpredictable, which makes it exciting. Here are common mistakes you can make with trading options.
Imagine this—you’ve dedicated a lot of your time and skills to create a suitable trading strategy that would diversify your portfolio. Now, as things progress on the market, you find yourself lost with strategic tools that do not match the current market outlook. This is quite common in trading options, which is why it is helpful to think a few steps ahead. Try to create a Plan B and keep it in the back of your mind, just in case.
There are a lot of investors out there tending to disregard the powerful impact of volatility. After all, volatility is a crucial ingredient of each trading experience. So it is only natural that you should take it under consideration when creating a trading strategy.
Choosing the Wrong Options Element
The most common mistake with trading binary options is choosing the wrong expiration date or type of position for your trading. There are no right or wrong answers here—each investor tries and fails until they find the perfect position. So just be patient with yourself and keep on learning!
Presented to you are the most important features of options trading. As you can conclude, this activity is quite challenging. But it can also be very exciting for you, not to mention beneficial for your portfolio. All you need to do is arm yourself with knowledge and patience, and you will be on your way to a successful options trading adventure.
Our References and Further Readings