You don’t need to be some kind of Wall Street genius to get into options trading, or to make a tidy profit from such ventures. What you do need is the commitment to learning enough about it to make informed decisions and wise choices, and that’s what this article is all about.
So, if you are a complete novice or just getting into trading, the information, guidance and helpful tips here should help you make a success of it.
What exactly is options trading?
Options are also known as ‘derivatives’. Unlike a regular stock that has a definite (albeit fluctuating) value the price of an option is worked out differently. Options are traded in advance so this is considered a bigger gamble than a decision made at the actual moment of purchase.
Comparing different derivatives
There are different levels of risk involved in derivatives, so it’s worth looking at the choices available to make sure you are getting into the right trading market for you.
As the name suggests this is an agreement to trade a particular asset at some point in the future, but the price is agreed on at the point the contract is made. There are official exchanges for futures trading (first created back in 1973), and as the committee agreed on must go ahead this is quite a secure way to play the market. People use futures as a way to hedge against risks on other trades or to try to make a quick gain if they think a stock price may change drastically. It is also a good strategy when you believe the cost of something you must buy is likely to rise pretty soon, as you lock-in a better price for yourself.
These are not unlike futures but the trading is done over the counter rather than via an exchange. They are also riskier for all parties, as something like one of those involved going out of business would likely mean the value of the forward is wiped out.
Basically this involves switching between cash flow sources, say from a fixed-rate loan to a variable rate. They are very risky and have been blamed for several historic credit crises.
An official agreement is made between two parties to sell (or buy) a particular asset at an agreed price on an agreed date in the future. However, unlike a futures contract that cannot be broken an options agreement can be canceled at any point. Option agreements are useful if you want to follow hunches and test the waters while reducing the risk factor.
The plus points of options trading
· Costs are fixed
· They can be protected against risk
· They can usually be bought on borrowed money
· They are not as difficult to understand as popular culture would have you believe, but you do need to get familiar with the basics
· Equities are much riskier
· There’s a potential with options for excellent returns
· They are often more cost-efficient
The negative points of options
· Their very nature makes them difficult to properly value
· The way they work can be difficult to understand
· Sensitive to market changes
· Big gains are possible but big losses are too
Options trading is seriously flexible
Although it is often labeled as tricky, risky, complicated and like options trading has some good benefits, and one of the best in its flexibility. The initial deposit (premium) allows you to decide later of you actually want to fully exercise your option, and if that is a negative you have only lost that initial hold fee.
· You don’t have to exercise the option if you choose not to; there is no punishment, per se. When the expiration date comes, the option becomes null and void. Yes, this means that you lose the investment that you made for the option premium, but you won’t suffer any additional losses.
The options trading process
It’s always easier to see how things work through a meaningful example, so let’s do that here.
Person A has 100 shares in a stock that is currently worth $50 a share but they are confident this price will rise steeply at some point in the future. Person A may feel pretty positive about the entire thing but they are also sensible enough to know that all trades carry risks, so it makes sense to hedge their bet somehow. There are several types of options they can use for this.
– A PUT option, which could involve deciding on a specific number of shares which will trade at a lower set price onto the futures market. The ‘strike price’ here would be $50, and it will be held until the date agreed for expiry. If the value falls and the stock is still sold at the set price they lose the cost of setting the option up.
– A CALL option works when an investor spies stock on offer they think will rise above the set value. They can put an order in, and gain the profit from the rise in value of each stock (minus the admin fee.)
There are various scenarios that complicate these transactions, which could be why so many people avoid options trading. For example, if a stock happened to beat its stock price when the due date is reached the seller, (aka the option writer), keeps the expired premium, but if it is under the strike price it’s the call seller who gets to keep the payout.
If you would like to delve into the mysterious world of stock trading options further then you can find always read more on options trading strategies.
This is definitely a field of trading which too many people avoid, leaving some great opportunity out there for those that dare.