Exploring Options Trading Basics

Introduction

Options trading is a type of trading that lets you make profit from predicting how the price of an underlying asset, such as stocks, commodities, or currency pairs, will move in the future. It involves managing the risks associated with investments, and it helps ensure that you remain in control of your funds.

Options trading offers many advantages for traders looking to diversify their portfolios and reduce their risk. Some of the top benefits include:

• Potential to generate income while managing risks;
• Flexibility to buy and sell contracts with short-term maturities;
• Ability to produce large profits with a small amount of capital;
• Options contracts don't require upfront investments, which can reduce capital requirements;
• The ability to control a large amount of stock shares with a much smaller investment;
• Ability to create synthetic securities with customized risk/reward profiles;
• More efficient use of available capital.

Different Types of Options

Options trading offers investors and traders plenty of ways to make money, from hedging and speculation to arbitrage and taking positions based on market direction in the short-term, or midterm. All these strategies are made possible by different types of options available on the market. Here we explore the three main types of options available.

Call Options

Call options, also known as ‘buy options’, give the holder the right, but not the obligation, to buy a certain number of shares of the underlying asset at a specific price by the expiration date. This is the most popular options trading strategy and involves going ‘long’ the call option, otherwise known as ‘buying a call’. Call options are generally purchased with the expectation that the stock price will rise in the near future, allowing the investor to exercise the option and benefit from a gain.

Put Options

Put options, also known as ‘sell options’, give the holder the right, but not the obligation, to sell a certain number of shares of the underlying asset at a specific price by the expiration date. This is the opposite of a call option and involves going ‘short’ the put option, otherwise known as ‘selling a put’. Put options are generally purchased with the expectation that the stock price will fall in the near future, allowing the investor to exercise the option and benefit from a gain.

Special Options

• Spread Options: Spread options involve buying and selling different options strategies at the same time, such as a call option and a put option. This is done to offset certain risks associated with options trading and to reduce the overall exposure to the stock price of the underlying asset.
• Combination Options: Combination options involve a combination of different types of options, such as a call option and a put option. This type of strategy is used to hedge against the possibility of unfavorable price movement of the underlying stock.
• Synthetic Options: Synthetic options involve combining two different security types to create an options strategy. For example, a long stock position combined with a short put option on the same stock can be used to create a synthetic long call option. This type of strategy is generally used to make money in an uncertain environment, such as a volatile market.

Different Strategies for Options Trading

Options trading allows traders to control a large position size with a relatively small amount of money. Many investors use Options trading as an alternative way to build wealth and they often use strategies that minimize their risk. Here are some of the different strategies used in Options trading.

Credit Spread

A credit spread is an option strategy that involves the purchase of one option and the sale of another option at a different strike price. The goal of this strategy is to generate income in the form of a premium. The difference between the two premium amounts is the credit obtained, which is the maximum profit for the position. However, the credit received can only be unlocked if the spread settles beyond either of the two strike prices.

Butterfly Spread

A butterfly spread is a creative and advanced options strategy used to limit losses and achieve maximum gains for a particular price movement. It involves buying and selling three different options on the same asset at the same time. The goal is to profit if the underlying asset stays relatively stable, allowing traders to make a profit from the spread that forms from the three options.

Collar

A collar option strategy is a neutral strategy in which the optimal form of outcome is for the underlying stock to remain stagnant. The strategy involves buying a protective put and simultaneously writing a call option above the purchased stock. The goal of this strategy is to limit the amount of risk associated with the trade while providing some upside in the event the stock unexpectedly rises.

Option Contract Specifications

Learning the basics of options trading could be a complex process. One of the primary concepts to understand is the format of the option contract itself, which is the essential agreement made between two parties to perform a specific trade regarding an underlying security. A standard option contract contains key points within it, and it is vital to understand each aspect of the option's specifications before initiating a trade.

Options Expiration Date

The option's expiration date is the date when the contract will expire, and it dictates when the option can be exercised. Most options have standard expiration dates that take place on the last Friday of the month, although there are some exceptions to this. The expiration date affects the premium, which is the price of the option itself.

Exercise Style

The exercise style indicates the manner in which an option can be exercised. Options can either be American-style or European-style. American-style options can be exercised at any time throughout the duration of the contract until expiration, while European-style options can only be exercised on the expiration date itself.

Strike Price

The option's strike price is the set price used to determine when the option can be exercised. Also known as the exercise price, it is used to compare the underlying asset's market value to the strike price in order to calculate the potential profit (or loss) of a contract. If the current market value of the underlying asset is higher than the strike price, the contract will yield a profit, and vice versa.

Premium

The option's premium is the cost of the contract itself. It is set in accordance with the underlying asset's current market value and other factors, such as the duration of the contract and its expiration date. Additionally, the size of an option's premium can be used to indicate the current market sentiment that is associated with the underlying asset.

Account Requirements for Trading Options

In order to understand the basics of options trading, one must understand the account requirements related to it. This section will cover details about the account minimums, fees, and commissions related to trading options.

Account Minimums

One of the primary requirements to begin trading options is having the minimum account balance in the broker's platform. Depending on the broker, the account minimum required to trade options may vary. Generally, most brokers set a minimum balance of $2,000 - $5,000 for those looking to trade options.

Fees and Commissions

The fees and commissions in options trading will depend on the broker you have chosen to place your trades. Generally, online brokerages offer lower fees and commissions for options trading compared to traditional brokerages. Some online brokerages may even offer commission-free options trades. Additionally, fees may vary with the type of trading strategy used. Therefore, it is important to do your research when selecting the right broker.

Fees and commissions shouldn't be the only consideration when choosing a broker, and they are usually only a part of a larger comparison. Make sure to consider the reliability and customer service offered by the broker, in addition to their fees and commissions.

6. Understand the Risks of Trading Options

Options trading carries a number of risks that should be looked at carefully before investing. This article will take a look at three of the most important risks associated with options trading: volatility, leverage, and time decay.

A. Volatility

Volatility is a measure of how much the price of a security can fluctuate over a certain amount of time. When trading options, the price of the underlying security can have a large impact on the value of the option. For example, an option on a stock may double or half in value depending on the stock’s price. If the stock is highly volatile, it can make the option’s price even more difficult to predict.

B. Leverage

Options trading involves leverage, which means that a trader can control a large position with a relatively small amount of money. Leverage is attractive to some traders, but it can also be dangerous. A small move in the underlying security can have a large impact on the value of the option and therefore the trader’s profits or losses.

C. Time Decaying

Options contracts have an expiration date and the value of an option decreases as the expiration date approaches. This is known as time decay and is an important concept to consider when trading options. If a trader buys an option and the underlying security does not move in the desired direction the trader may not be able to recoup the full value of the option before it expires.

Conclusion

Learning the basics of options trading can be a powerful tool to help investors grow and protect their portfolios. With a solid foundation, investors will be able to take advantage of growth opportunities and reduce their risk exposure. By understanding the structure and key moving pieces, investors can determine the best course of action to maximize their potential gains.

Summary of Options Trading

Options trading can provide investors with the flexibility to maximize short-term profits, create long-term income, and hedge against market risks. When trading options, investors will use calls and puts, understand volatility, and manage volume and margin requirements. As investors gain more experience, they should consider incorporating more advanced strategies like spreads and delta neutral positions.

Review of Benefits of Options Trading

Options trading can provide numerous benefits for experienced investors. Leverage is provided to increase returns even with a smaller capital, which reduces the risk of significant losses. Investors have the opportunity to adjust their strategy as market conditions warrant and the ability to benefit from price movements in either direction. Additionally, strategies like hedging can help protect against significant losses due to changes in market price.

Call-to-Action

Options trading can be a powerful tool for successful investors, and with careful analysis of the markets and strategies, investors who understand the basics can gain a greater advantage. If you want to start options trading, take the time to learn the fundamentals and build your skillset. There are numerous online resources and tutorials to help you become a proficient options trader and start turning a profit quickly.