Options trading can be a cost-effective and risk-free way to place a speculative wager. Along with a more planned approach to investment, options also have the potential for big profits.
A study by Research Gate publications on the “Impact of the Options Market on the Underlying Stock Market”, states that “In the past 30 years, options have become an important financial instrument, and now they account for a substantial percentage of total trading activity“
Before deciding on the value of options, it is crucial for the individual investor to consider all available information right from the basic terminologies, and concepts, to options trading strategies. This detailed guide will help you learn just that!
What are the Options?
Options are a type of agreement between two parties whereby
- The stock option buyer (holder) buys the right (but not the obligation) to purchase or sell shares of the underlying stock at a predetermined price from or to the option seller (writer) within a specific time frame.
- The party writing the contract is obligated to purchase or sell the stock underlying the contract, as needed.
Options are derivatives in the trading world, which implies that their price is derived from something else, most commonly stocks. An option’s price is inextricably related to the value of the underlying stock. Strike prices and expiration dates lock-in options trading prices that traders select. If they are mistaken, the trader is under no obligation to carry out the trade.
Important Options Trading Terminologies
There are some important terminologies in options trading that you should be aware of. Namely:
- Strike price
The contract’s strike price is the price at which the underlying stocks can be purchased or sold. In options trading, the Strike Price for a Call Option denotes the price at which the seller can buy (on or before its expiration), whereas the Strike Price for a Put Option denotes the price at which they can sell.
The term “premium” refers to the cost of buying an option. The premium is calculated by several factors, including the underlying stock price, market volatility, and the number of days until the Option expires. One of the key factors in options trading is selecting the premium.
- Underlying Asset
Options are a type of derivative because the underlying asset determines its value. The underlying asset in options trading can be stocks, futures, an index, a commodity, or a currency.
- Expiration Date
The expiration date is the last day that the option holder can use their right to buy or sell their held options. Depending on the market and the rules, options expiration can range from weeks to months to years.
- Call Option and Put Option
With a call option, you can purchase security by a particular date at a predetermined price. In contrast, to call options, a put gives the holder the option, but not the obligation, to sell the underlying stock at the strike price on or before expiration.
- Intrinsic value and extrinsic value
The difference between a contract’s strike price and the underlying asset’s current market value is known as intrinsic value. Extrinsic value refers to factors other than the intrinsic value that affect the premium, such as how long the option is valid.
- Bullish and Bearish
The main distinction between bullish and bearish is a stock market attitude or belief. When acting, a bullish person believes that prices will rise, whereas bearish investors believe that prices will decline.
- Moneyness (ITM, OTM & ATM)
Amounting to the difference between the strike price and the underlying security’s price at expiration, an option may be considered to be in-the-money (profitable) or at-the-money (stock price is equal to the strike price), or out-of-the-money (not good)
Common queries about options trading
There are often queries and doubts that go unaddressed for options trading. Below are some of the most popular questions that will resolve your questions about options trading once and for all!
Can one use options for hedging?
Trading options is appealing as a means of hedging. For example, if you own stock in a company, you could purchase put options to limit your losses if the stock price falls.
Why do traders prefer options trading strategies?
Options trading strategies are popular with traders who want to limit their exposure to a specific asset for a shorter period of time because options contracts have an expiration date that can be anywhere between a few days and several months.
Is options trading risky?
Options trading can be risky, but despite the high volatility in the Options market, some options techniques can be relatively low risk and even boost your results as a stock trader.
Is options trading reliable?
Setting price alerts and keeping a close eye on the market will help you make money with options trading by letting you know when a trade turns profitable. In addition, you must be aware of the risks and trading fees associated with various options strategies.
How to evaluate the value of options contracts?
When you buy or sell options, commissions can range from a flat rate to a per-contract fee. Therefore, when evaluating the profitability of an options strategy, options traders must take these fees into account.
Identifying the probabilities of future price events is fundamental to valuing option contracts. An option’s value decreases as the expiration date approaches. This is because as expiration nears, the likelihood of a price change in the underlying stock decreases.
How to trade options as a beginner?
Before you dive into options, it’s best to have a good foundation in trading. Your investment goals should be outlined, such as capital preservation, income generation, growth, or speculation.
Here is some advice, to begin with, stick to an asset you’re familiar with and wager an amount you’re willing to lose. Start small when you’re ready to begin trading options. Options trading begins with opening your own trading account with the right broker according to your needs and convenience.
The best thing one can do before beginning to trade in options is to have some knowledge of what they are all about and how they work.
Steps to trade options
These are the steps to help you get started with options trading.
Step 1: Get an options trading account with a broker
The majority of online brokers today offer to trade in options. Typically, in order to trade options, you must apply and receive approval. Once authorized, you can place orders to trade options in a manner similar to how you would for stocks.
Brokerage firms evaluate potential options traders based on their investment objectives, trading experience, personal financial information, and the types of options they want to trade. These specifics will be listed in an options trading agreement that you’ll use to ask your potential broker for permission.
The broker typically assigns you an initial trading level based on the level of risk based on your responses (typically 1 to 5, with 1 being the lowest risk and 5 being the highest).
Step 2: Choose your options
Choosing the right stocks is something you can only learn through experience. That being said, here are a few tips to follow when selecting stocks for options trading.
- Make sure there is enough liquidity to allow you to enter the trade and exit it whenever you want, without incurring significant slippages.
- Take note that your strategy aligns with your perception of the stock.
- Keep track of the figures for volatility and implied volatility.
- As a beginner, learn the basic actionable steps such as
|Condition||Call Option||Put Option|
|If you think the stock price will move up||Buy||Sell|
|If you think the stock price will stay stable||Sell||Sell|
|If you think the stock price will go down||Sell||Buy|
Step 3: Establish an option strike price prediction
Only if the stock price closes the option’s expiration period “in the money” does an option purchased remain valuable. That is, above or below the strike price. (In the case of put options, it is below the strike; in the case of call options, it is above the strike.) The strike price of the option you purchase should reflect your forecast for the stock’s price over its entire life.
Step 4: Analyze the timeframe of the options
Options are traded by identifying the underlying, expiration date, and strike price using an option chain. After that, you can use market orders or limit orders for that choice. Expiration dates can be as short as a day or as long as a year.
For experienced options traders, daily and weekly options are preferable as they are the riskiest. Monthly and yearly expiration dates are preferred for long-term investors. Longer expirations give the stock more time to move and give your investment thesis more time to materialize. Longer expiration periods make options more expensive
As expiration draws near, an option’s time value depreciates, and options buyers don’t want to see their investments lose value and possibly expire worthless if the stock closes below the strike price.
Options trading strategies
There exist three types of options: calls, puts, and digital options. Trading strategies for these options can be based on different factors such as time, price, volatility, size and risk tolerance.
Options trading strategies are a way to control the risk when you business trade options. There are different strategies such as buying a put option and writing a call option or buying a call option and writing a put option.
In the current trading environment, there are a variety of options trading strategies that can be employed.
There are four main types of option trading strategies: covered call, protective put, short straddle, and short strangle.
- A covered call is an investment strategy where the investor buys shares of stock and simultaneously sells an equal number of calls on those shares.
- A protective put is an investment strategy where the investor buys shares of stock, buys an at-the-money put option that expires in one year, and sells shares to cover any potential losses from the position if the price drops below the strike price by the expiration date.
- Short straddle comprises selling both a call option and a put option with the same strike price and expiration date.
- Short strangle is an investment strategy where the trader short-sells both a call.
Although there are many options trading strategies out there, some of the most popular options trading strategies are:
- Iron Condor
- Covered call
- Long call
- Married put
- Protective Put
According to a report by Options Clearing Corporation (OCC), “Total Volume for March 2022 Second Highest Month on Record, Up 4.4% Year-Over-Year”. Compared to March 2021, 939 million options contracts were traded in March 2022, an increase of 4.5%. This indicates the growing popularity of options.
Despite not requiring a high level of expertise, trading options do require some knowledge before you begin. Protecting yourself from market volatility can be an excellent tool for hedging your bets. In contrast, playing the volatility as a speculator to generate disproportionate returns can be a good medium. They enable you to safeguard against a volatile market while gradually boosting your gains if managed in a planned way.
There are many other aspects to options trading besides this. To be successful in futures & options trading, one needs to learn to develop option pricing models, option greeks, and various strategies.