In this comprehensive guide of options trading, we will walk you through the basics of options trading, from the types and key components of options trading to exploring real-life examples and the pros and cons of it.
It doesn’t matter if you are an experienced trader or just a beginner, you will come to know how options trading works and how it can help you make smart financial moves in your journey.
So, let’s dive into the exciting comprehensive guide of options trading and unfold its potential for your financial success.
What is Options Trading?
Option trading is a special type of trading in the financial world that involves buying and selling options contracts. These contracts allow traders to buy (call option) or sell (put option) a specific asset at a pre-set price (strike price) within a specific period of time (expiration date). Option trading is mostly done for hedging, speculation, and income generation.
Here are some of the components you should know before starting out:
Types of Options:
- Call Option: This allows the holder to buy the asset at the strike price or before the expiration date.
- Put Option: This allows the holder to sell the asset at the strike price or before the expiration date.
Key Components of an Option:
- Underlying Asset: The asset such as stocks, commodities, currencies etc. upon which the option is based.
- Strike Price: Set price at which the underlying asset can be bought or sold.
- Expiration Date: The specific date on which the option contract expires.
- Premium: Price paid to buy an option contract.
Option Pricing:
Price of an option is called the premium. There are several factors which influence the premium pricing:
- Strike Price: The difference between the strike price and the current market price of the underlying asset.
- Time to Expiration: The longer the time for the expiration, the higher the premium is, as there is more time for the option to get more profitable.
- Volatility: High volatility in the underlying asset’s price leads to high option premiums.
- Interest Rates: Changes in interest rates can affect option prices.
How Options Trading Work?
Here’s a detailed explanation of the process:
1. Buying Options:
- When a trader buys an option, they pay a certain amount (premium) to the seller (writer) of the option.
- If a trader buys a call option, they get the right to buy the underlying asset at the strike price before expiration time.
- If a trader buys a put option, they get the right to sell the underlying asset at the strike price before expiration time.
2. Selling (Writing) Options:
- When a trader sells (writes) an option, they get a premium from the buyer.
- If they sell a call option, they will have to sell the asset at the strike price if the buyer exercise their right.
- If they sell a put option, they will have to buy the asset at the strike price if the buyer exercises their right.
3. Option Expiration:
- Options have expiration dates. It all depends on the underlying asset and exchange.
- When the expiration date comes, options contracts lose their worth if the strike price is not favorable,
- But if the strike price is favorable for the option holder, it can be exercised.
4. Exercising Options:
- Option holders can decide to exercise their option by telling their broker before the expiration date.
- If they decide to exercise the call option, they will buy the asset at the strike price.
- If they decide to exercise the put option, they will sell the asset at the strike price.
5. Settlement:
- Physical settlement, the exchange of the asset if the option is exercised.
- Cash settlement means the transfer of an amount.
6. Closing Positions:
- Before expiration, you can terminate the options early by making another transaction that cancels them.
- Closing positions can result in making you money or costing you money.
Options Trading Strategies with Examples:
Example 1: Buying a Call Option (Bullish Outlook):
- You believe that the stock of a specific company which is currently trading at $50, will rise in the next few months.
- You buy a call option with a strike price of $55 for a premium of $3.
- If the price of the stock gets above $58 ($55 strike price + $3 premium) by the time of the expiration date, you can exercise the option to buy the shares at $55 and profit from the price difference.
Example 2: Buying a Put Option (Bearish Outlook):
- You believe that the stock of a specific company which is currently trading at $75, will decrease in the next few months, you buy a put option.
- You buy a put option on that company with a strike price of $70 for a premium of $4.
- If the price of the stock gets below $66 ($70 strike price – $4 premium) by the time of the expiration date, you can exercise the option to sell the shares at $70 and get profit from the price difference.
Example 3: Writing (Selling) Covered Calls (Income Generation):
- You own 100 shares of a specific company, which is currently trading at $60.
- You sell a call option on your 100 shares of that company with a strike price of $65 for a premium of $2.
- If the price of the stock stays below $65 by the time of the expiration date, you can keep the premium as income. But if it gets above $65, you will have to sell your shares at $65, but you can still keep the premium.
Pros and Cons of Options Trading:
Pros:
- Options has strategies for different market conditions, which allows traders to get profit in both rising and falling conditions.
- In options trading, you can manage the value of an asset with a small upfront cost, reducing potential losses.
- It can be done to earn through strategies such as covered calls or cash-secured puts.
Cons:
- Options trading is complex, requires better understanding of the market and trading strategies, which might not be suitable for all the traders.
- Options have an expiration date, and the chances of depreciating in value over time, which leads to losses if the market does not move to the desired point.
- Although limited risk is an advantage but it is also important to remember that options trading can result in big losses if not properly managed.
Final Verdict:
Now, with going through “Options Trading: A Comprehensive Guide”, you will now have a clear understanding of its basics, strategies, pros and cons through which you can make informed and confident choices. Options trading is one of the most valuable additions to your investment toolbox.