Options trading has become very popular in recent years because of its simplicity and accessibility to investors of all sizes. It also provides numerous benefits to traders, including higher return potential, access to leverage, and novel trading strategies. In this article, we will look at the basics of options investing, including how to take advantage of price movements in the market.
Options are contracts that give traders the right to sell or buy different investment assets at a specific price within a given period. When trading options, investors speculate on the movement of their prices. Options are traded using different underlying assets, including commodities, currencies, and stocks.
A call is an option to buy an asset at a given price before or on a specific date, and a put is the opposite; investors can sell their asset at a specific price before or on a specific date. Put and call options are exercised at a strike price—the price the investor thinks the asset will be at a specific time—and the price paid to buy an option is known as the premium.
Let’s say an investor thinks that the price of a commodity will rise from $1000 today to $1500 in the next six months. They buy a call option which allows them to buy the commodity at $1250 in the next three months. If the commodity's price rises above the strike price of $1250, they buy it at a discount.
If it falls below the strike price, they do not have to exercise the option and can let it expire. They also lose the premium paid to buy the option if they do this.
The following would happen with a put option:
An investor thinks a stock trading at $1000 today will fall below $750 in the coming year.
They buy a put option with a strike price of $800.
If the price falls below $800, they sell the stock at an above-market rate.
The three main decisions you must make when trading options are the option, the duration, and the price movement. You should always understand the underlying commodity when buying an option as that gives you a better idea of where the price is likely to go in the future. You can consult investment experts like James Cordier who will help you choose the right commodities whose options you can buy.
The second option is the strike price. What do you think the price will be after the set period? Remember that you only make money with a call option if the price closes above the strike price, and you only make money with put options if the price closes lower than the strike price.
Also, you cannot just set any strike price because strike price increments are standardized across the market and are usually based on the underlying asset's price.
The last decision is the duration, also known as the option time frame, i.e., the time between buying an option and its expiration date. As with the strike price, the options time frame is standardized across the market.
Both options are similar but have a critical key difference: when you can exercise them. You can exercise an American option on any day up to the expiration date, but you can only exercise European options on the expiry date.
This crucial difference means that American options give you a lot of advantages if you are the buyer, but it can be a disadvantage if you are the seller. They are, therefore, typically more expensive than European options for this reason.
Trading options provide investors with a lot more leverage than trading stocks. Leverage allows traders to gain significant market exposure with a smaller investment. Remember that leverage can amplify losses like it does profits, so you must use it carefully.
Options trading also has limited risk. It is crucial to understand that all investments come with some level of risk. However, options’ risks are clearly defined, and traders often risk much less than they would if trading stocks. In most cases, a trader can let their contract expire and lose their premium instead of losing a lot more money if they were trading stocks.
Investing is an excellent way of building wealth, and trading options is an accessible option for most beginners. They are easy to understand and require little capital if you use leverage to trade. However, always remember that leverage can increase your risks just like it does your profits.