Options is a contract between two parties where the buyer gets the right to trade in the asset at the pre-decided price.
There are some essential elements in an options contract. These are:
- Underlying asset: Options contract may be done for different types of assets like stocks, commodities, currencies, indexes, etc. The contract derives its value from the underlying asset.
- Strike price: It is a price at which buyer and seller of the contract agree to trade. Even if the price of the asset changes in future, trade is done at strike price, and not at market price.
- Expiration date: It refers to the date after which the contract will expire. For example, a 3 months options contract will expire after 3 months.
- Lot Size: Lot size refers to the number of underlying assets contained in options contract. For example, if the lot size is 100 for a stock option, it means that 100 stocks equal one options contract.
Options are being widely used for hedging purposes. However, they can be used to gain profits from speculation as well, if you are a pro in options trading.
This article will take you through the following aspects:
- Types of Options Trading
- How Does Options Trading Work?
- How to Carry Out Options Trading
- Factors to Keep in Mind
- Strategies for Options Trading
- Beneficial Resources
Let’s get started!
Types of Options Trading
There are two kinds of options that investors may trade namely, call and put options.
In a call option, an investor has the right to purchase a fixed quantity of an underlying asset at the strike price throughout the contract. Buyer of a call option wishes that price of the asset rises in future above strike price. As a result, the buyer can make profits either by selling the options contract for a profit or exercising contract by buying the asset at strike price.
A put option gives you the right to sell a determined quantity of an underlying asset at strike price on or before the maturity of the options contract. A trader buys a put option in the hope that the price of the underlying asset will fall below the strike price. If the price moves down, the trader can either sell the option for a profit or exercise the option by selling the shares at strike price.
How Does Options Trading Work?
One of the best ways to learn the intricacies of how options trading works is to take up a course at the Knightsbridge Trading Academy. Their courses are designed to give you all the knowledge you need to understand the nitty-gritty of trading in all forms.
However, for now, let us explain. Options are priced based on the likelihood of changes in the future price of the underlying asset. For example, the value of a call option will go up as the price of the underlying stock increases. Similarly, the price of a put option goes up if the price of the underlying security goes down.
The expiry period also plays a significant role in the determination of the values of options. An option that is close to its expiry date has less value. This is because there will be less ambiguity regarding the price of the underlying asset and fewer chances of price movements, as the expiry date comes near. This would, for example, mean that an option that has an expiry period of one month would carry less value than an option contract having an expiry period of three months.
One other important factor that influences the prices of options is volatility in the underlying asset. The more volatile the underlying asset, the more fluctuations it will cause in the options’ prices.
How to Carry Out Options Trading?
Buying a call option means buying the right to purchase the underlying asset at the strike price within the contract period. To make profits, you should buy a call option for assets that are likely to rise in price during the contract period. If the price of the underlying asset rises during the contract period, you have two ways to make profits:
- By selling your options contract for a margin, or
- By buying the underlying asset at strike price, which is lower than the market price.
Similarly, buying put options means that you purchase the right to sell the underlying asset at strike price before the expiry of the contract. If you expect the price of an asset to fall within the duration of the contract, you should buy a put option. You can make profits on put options by:
- Selling your options contract for a margin, or
- Selling the underlying asset at strike price, which is higher than the market price.
For analyzing the expected price movements, you may deploy MarketXLS which will give live as well as historic data for stock prices. Another good option is TradingView, which contains all charting tools that are required for technical analysis.
If you take a short call in options trading, which means you give the right to the other party to either buy (call option) or sell (put option) the underlying asset, then your return will be the amount of premium.
Factors to Keep in Mind
It is a well-known fact that options trading is risky. It requires in-depth knowledge about the structure and working of options and years of experience. If you are a newbie to options trading, try some of the training courses provided by DayTraderPro. It allows you access to a live trading room with experienced professional traders.
Here are some things to keep in mind while getting into options trade:
- Check the level of volatility of the underlying asset. If the asset is less volatile, it will become difficult for you to exit the trade.
- Understand whether the option that you are trading in, is in or out of the money. An options contract is said to be “in the money” when current price of the asset is more than strike price. On the contrary, options contract is said to be “ out of the money” when current price of asset is below strike price. The basic principle is that ‘in the money’ options are suitable for options buyers and ‘out of the money’ options are apt for option sellers.
- Use probability to analyze the profitability of earning profits at the strike price that you wish to deal at. Try out some of the interactive chart features in TradingView to get meaningful analysis. Another useful alternative is MarketXLS, which is easy to use since it is an Excel-based software and provides live data of stocks and securities.
- Follow a strategy for trading in options. If you don’t have much idea about forming a strategy, you may take help of the experts. That is what Motley Fool is all about; it offers advisory services to its users which comes right from the experts.
Strategies for Options Trading
Here is the list of some mostly used strategies which you may consider.
- Long Call
- Long Put
- Covered Call
- Protective Put
- Long Straddle
- Long Strangle
- Married Put
- Protective Collar
Curious to know what these mean? The trading courses on DayTraderPro are designed to explain exactly what these mean and how you can use them.
Investing in options is deceitfully easy but fraught with risk. Don’t invest unless you know exactly what you’re doing, or you may get into some serious trouble.
If you’re going to invest, you need to be updated with the latest news regarding the assets or financial instruments you’re dealing in. It is nearly impossible to monitor all of them personally, so using applications like AlgoSignals is a good idea. It provides real-time notifications that can be of great importance to those who invest in options.
Before you enter into the world of options trading, make sure that you are ready for it. It is important to do intensive research to buy yourself a profitable options deal.