Basics of Options Trading

Introduction

Options trading is a popular form of trading which involves the buying and selling of various kinds of option contracts. A contract gives the holder the right, but not the obligation, to buy (or sell) a particular asset at a set price, on or before a specified date. Options trading is a way of generating additional income or leveraging existing positions.

At its core, options trading is about predicting the future direction of a particular asset or the market in general. Traders can buy an option if they believe the asset's price will rise, or sell an option if they believe the asset's price will fall.

Types of Options

There are two main types of options: calls and puts. A call option gives the holder the right to buy the asset at the stated price, while a put option gives the holder the right to sell the asset at the stated price. Traders can use either type of option depending on their strategy.

• Calls: A call gives the holder of the option the right but not the obligation to buy the underlying asset at the agreed upon price before the expiration date.
• Puts: A put gives the holder of the option the right but not the obligation to sell the underlying asset at the agreed upon price before the expiration date.

Pros of Options Trading

Options trading offers a number of advantages that can significantly boost the profitability of your investments and provide you with greater flexibility in managing risk. Here are some of the main advantages of options trading:

Increased Flexibility

Options give you much more flexibility than traditional investments such as stocks and bonds. With options, you can create a variety of strategies to reflect your investment objectives, such as buying out-of-the-money calls and puts, creating covered call and covered put strategies, and creating protective collar strategies. These strategies give you the ability to do more with your investments than you would be able to do with traditional investments alone.

Potential for Greater Profits

Options trading gives you the potential for greater profits than traditional investments. With options, you have the potential to make profits from both rising and falling prices and from different strategies that take advantage of the underlying asset's volatility. Depending on the strategy you choose and the underlying asset's price movement, you can take advantage of price changes to generate profits even in a stagnant market.

Limit Losses

Options trading also gives you the advantage of limiting your losses. With certain strategies, such as buying puts or writing covered calls, you can set a maximum possible loss in advance. This gives you the flexibility to manage your risk and to limit your losses even during periods of market volatility.

Cons of Options Trading

When it comes to trading options, there are certain drawbacks that investors need to consider. Before taking on this form of trading, it is important to understand and weigh the risks in order to make an informed decision.

Can be Risky

Options trading is generally considered to be a high-risk strategy, despite the potential for high reward. Options trading involves using contracts to enter into a purchase agreement, and these contracts are subject to market volatility and can decrease in value rapidly. Therefore, investors need to understand and consider the risks associated with this strategy before investing their capital.

Potential to Lose All of Your Original Investment

Options trading carries the risk of completely losing your original investment. In addition, any losses at expiration can exceed your initial investment. Therefore, it is important to practice proper risk management when trading options.

It is imperative for investors to do their due diligence when trading options to understand the risks and potential rewards associated with the strategies they are considering. With a clear understanding of the potential profit and losses involved, investors can then decide if options trading is a suitable strategy for them.

Types of Options

Options trading is a popular investing strategy to the savvy investor. This type of trading involves an agreement between two parties that gives one side the right to buy (Call option) or sell (Put option) a financial asset at a predetermined price. It is a useful way to speculate on the market, make profit and hedge against potential losses. There are two primary types of options: Call options and Put options.

Call Options

Call options grant their holder the right to buy the underlying asset of the contract at the predetermined price, also known as the strike price. If the market price of the underlying asset is higher than the strike price, the option holder is able to buy the asset at the lower strike price, resulting in a gain. For example, an investor holds a Call option on a stock with a strike price of $50. If the stock is trading on the market for $60, the option holder could buy the stock for $50 and sell it for $60, resulting in a profit of $10.

Put Options

Put options grant their holders the right to sell the underlying asset of the contract at a predetermined price. If the market price of the underlying asset is lower than the strike price, the option holder is able to sell the asset at the higher strike price, resulting in a gain. For example, an investor holds a Put option on a stock with a strike price of $50. If the stock is trading on the market for $40, the option holder could sell the stock for $50, pocketing the $10 difference.

Options Trading Strategies

Options are contracts that give the buyer the right to buy or sell the underlying asset at a certain price, known as a strike price, and on or before a certain date, known as the expiration date. Trading options are a great way to manage risk and capitalize on market opportunities. To do this, you need to understand the fundamentals of options trading as well as different strategies that you can use.

Covered Calls

A covered call is a strategy in which an investor holds a long position in an asset and writes (sells) call options on that same asset to generate income. The strategy is considered to be “covered” because the investor is protected from downside risk due to owning the underlying asset. This is the most basic and popular of all options strategies. The investor earns a premium, which is the income generated by selling the call option, but may also be at risk of losing the full value of the asset, if the stock price rises significantly beyond the strike price.

Protective Put

A protective put is an options strategy in which an investor holds a long position in an asset and buys put options on that same asset to protect against losses. This strategy is considered to be “protective” because the investor is protected from downside risk due to owning the underlying asset. The investor pays a premium for buying the put option, which limits their potential gains if the asset rises in price. However, this protection is valuable if the stock price falls significantly beyond the strike price.

Bull Call Spread

A bull call spread is an options strategy in which an investor buys call options at one strike price and sells the same number of calls at a higher strike price. This strategy differs from a traditional covered call in that the investor is not buying the underlying asset; rather, they are using the spread to take advantage of potential gains when the price of the asset rises without having to buy the underlying asset. The investor pays a net debit for this strategy, which limits their risk to the extent of the net debit.

Bear Put Spread

A bear put spread is an options strategy in which an investor buys put options at one strike price and sells the same number of puts at a lower strike price. This strategy differs from a traditional protective put in that the investor is not buying the underlying asset; rather, they are using the spread to take advantage of potential gains when the price of the asset falls without having to buy the underlying asset. The investor pays a net debit for this strategy, which limits their risk to the extent of the net debit.

Brokers

In options trading, a broker is an individual or entity that facilitates trades on behalf of the investor. When it comes to options trading, it is important to select a broker that is reliable, knowledgeable and offers competitive commissions and fees.

When selecting a broker, it is important to look at the following points:

• Commissions and fees – what is the trader being charged for each trade?
• Reliability – is the broker reliable in terms of executing trades and providing data?
• Account minimums – what is the minimum amount an investor needs to open an account?
• Capital requirements – what are the capital requirements for executing trades?
• Experience – how many years of experience does the broker have in the industry?
• Research capabilities – what types of research tools are available to help with trading?
• Customer service – what type of customer service is available to answer questions?

Thinkorswim

Thinkorswim is one of the most popular platforms among professional options traders. It offers competitive commissions, a wide variety of research tools and data, and access to Level II quotes. It also comes with a host of advanced trading tools and customizable charts.

Conclusion

Options trading is a unique approach to investing. By allowing the investor to control a large position with a much smaller capital outlay, it can yield a higher return than investing in the underlying stock. By understanding the basics of options trading and the underlying principles of supply and demand, traders can become more successful.

Summary

Options trading provides investors with the opportunity to enter contrats to buy or sell stock at specified prices and times. They are trades with a defined risk and can provide a hedge against the downside risk of investing in the underlying stock. To become a successful trader it is important to understand the principles of option pricing and the supply and demand dynamics of options.

Key Points to Remember

• Options are contracts that give the buyer the right to purchase or sell a stock at a specific price and time.
• Traders can purchase call options (to buy the underlying stock) or put options (to sell the underlying stock).
• Options are less expensive than the underlying stock, meaning that traders can allocate less capital for a larger position.
• Options prices are affected by supply and demand, along with the underlying stock price, time, and volatility.
• To become a successful trader it is important to understand the dynamics of supply and demand.