What is Options Trading?
An option is a financial derivative. I am sure for many this phrase will not say anything significant, so I propose to sort it out in a more specific and simpler language, for a better understanding of what the concept of an option still means. Option (from English option) – translated from English – choice.
This name implies the main quality of option contracts, namely, the fact that the trader has the opportunity to choose when determining the terms of the option contract of interest to him.
What are the options?
Let’s try to understand what an option is using an everyday example.
Let’s say we want to buy a car, the price of which is now $ 100,000. The price suits us, and we want to “fix” it, that is, to make sure that it does not change. We go to the owner of the car and sign an agreement according to which he will keep the car for us for three months. During this time, regardless of how the price of such cars on the market will change, we will have the right to buy a car at a pre-agreed price. It is precisely such a contract that is called an option contract, or simply an option.
A reasonable question arises: what is the interest in this contract for the owner of the car? The seller is ready to accept the described conditions in the event that he receives a certain compensation (premium), as a rule, a small percentage of the transaction value. For example, 2%. Thus, for the right to buy a car for no more than $ 100,000 within the next three months, we now have to pay the owner $ 2,000.
What are the options for the further development of events?
Option one: the cost of the car rises to $ 120,000. We can buy it for $ 100,000, as previously agreed. It turns out that our paper profit as a result of this transaction amounted to $ 18,000. We can turn paper profits into real ones, for example, by selling our contract to another buyer and collecting a premium from him in the amount of slightly less than $ 20,000. Thus, he buys the right to purchase a car at price slightly below the market and save, and we get the difference between the premium paid by the US and the premium paid to the US.
Option two: the cost of the car dropped to $ 90,000. Since the option contract speaks only of our right to buy (or sell), we are not obliged to make it. We simply refuse, but we lose the $ 2,000 premium we paid. Whatever happens, the seller of the car will receive this award. And if we canceled the deal, the contract will expire and the owner will be able to put the car up for sale again.
In our example, we consider a deal to buy/sell a car, although the object of the deal can be anything.
The main advantages of trading options
There are three main benefits to option trading.
- First, options can be used to generate a fixed income. When we sell options, we receive a premium. We’ll talk about risk insurance when selling options a little later.
- Secondly, options can be used to ensure their investments. In fact, this is the original reason for creating this type of contract.
- Thirdly, options belong to the class of derivatives, which makes it possible to analyze prices not only and not so much of the underlying asset (stock, car, food, etc.), but also to analyze changes in derivatives from these assets. In the case of options, the first derivative is volatility, predicting changes in which is an order of magnitude easier than predicting the prices of underlying assets. In other words, we do not need to guess where exactly and at what point in time the price of the asset we have chosen will be. We will be able to profit when the market rises, falls, or even stands still.
An important consequence of the above properties of options is that options trading noticeably – a) increases the potential profit/risk ratio; b) reduces the requirements for the quality of forecasts – if trading is not “naked options”, and various combined strategies are developed.
Options trading risks
There are two types of options: Put and Call. The Put option gives its buyer the right to sell the underlying asset at the price specified in the contract. The call option entitles its buyer, on the contrary, to buy the underlying asset at an agreed price after a certain time.
Thus, when we buy a Call option, we expect the market to go up. When we buy a Put option, we benefit from a decrease in the price of the underlying asset in the market. With that in mind, let’s take a look at a few basic strategies.
Speaking about the risks of working with options, it is worthwhile to return once again to the essence of these contracts: options, first of all, are effective as a tool for controlling (reducing) risks in exchange trading. But combining various instruments of the derivatives market is not a trivial task. To understand the principles of working with options contracts, we will describe the main strategies.
- Selling Covered Call Options
In this case, we sell the rights to the underlying asset that we own. Selling Covered Calls can be considered an ideal strategy for those looking to generate additional income on stocks already in their portfolio. If we are just starting to study options trading, then such a strategy will be a good and, most importantly, a fairly safe option. It is also used to sell stocks that we no longer need despite some upside potential in the near future. We sell shares at the current price, but with a slight delay and additional commission for us.
Risks: The price of the shares we own could drop significantly. In this case, the buyer has the right to withdraw from the transaction, and we remain the owners of the shares that have fallen in price, which we expected to sell at a higher price.
- Buying Calls or Puts
Another option is to buy options. In this case, we acquire the right, while we can refuse the transaction.
This is a popular strategy among speculators who are good at predicting medium-term movements in the market of the selected asset. The advantage of the strategy is the fact that we are not obliged to guess the price at the time of the options expiration. Even with a slight movement in the direction we need, the premium of our option grows, and we can safely sell it in the market at a profit.
Our risk is the loss of the premium paid if the analysis of the price movement of the selected asset was made incorrectly.
- Purchase of protective Puts
In addition to speculative purposes, we can buy Put options to protect existing open long positions in the stock market. For example, if we predict that stocks in our portfolio may fall in price in the next two to three months, we can buy Put options as insurance against the fall.
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