Options trading is not a new concept, but it is one that takes time to learn and demands precise strategy above all else. For traders, it has a whole load of potential in terms of hedging their bets and raising their investment capital, but this is only possible if there is research, knowledge growth, and general engagement. So, what do you need to know before diving into options trading?
What a Derivative Is
Options are a type of security known as a derivative. The value of a derivative is determined by how the underlying asset moves and fluctuates on the market. To understand options, you must first understand what a derivative entails. There are three major takeaways to get to grips with.
Number One
The underlying assets to any given derivative can be bonds, shares, stocks, digital currencies, regular currencies, indexes, commodities, or interest rates. This is a wide scope. Options are connected to shares in a company above anything else. However, they are not actual shares, just the option of buying x amount at x date for x price if the call/put goes through.
Number Two
Derivatives are a complicated sphere. It is not as straightforward as buying and selling; instead, the trader holding the derivative can hedge, empower and speculate.
Number Three
The complex nature means there is an inherent risk to be observed. They require a certain amount of knowledge in order to navigate this field effectively and if that is not present, things can and will go wrong quickly.
How to Be Careful with Out-Of-The-Money Options
One of the major risks with options trading is the out-of-the-money options. When an option is categorized in this way, especially the further out-of-the-money it is, putting any money into it is not a smart move. There is too much potential for a loss here, but for the novice trader, seeing the cheaper price tag will be a big draw-in. Think smart and don’t be lured in by false potential.
A Good Strategy Will Count
It doesn’t really matter what you know, of course, if you don’t have a strategy or two to go along with it. Developing the one for you will take time and practice, but it will all be worth it in the end. Read through the most common plans of attack for options trading below.
Long Call/Short Call
A long call option makes it possible to plan for the future price. It is the standard practice in option trading and allows the purchaser the right to go through with the trade at a strike price on the stipulated date. The difference between long and short call to think about is a short call option strategy means the seller is agreeing to sell at a strike price for a set date in the future.
Long Put/Short Put
A put gives the buyer a right to sell the option at a certain date. Long put means an investor has a hunch that the strike price is set to go down and it is a highly protective strategy in the long run. A short put, conversely, is set into action when a future seller thinks the price of the underlying asset will go up by the date set forth in an options contract.
Covered Call
A seller in a position of any security may offer a covered call to investors. There will be a set price plus expiry conditions for the trade and it does have some benefits. This is a strong strategy for complete beginners as it is a potentially profitable way to learn the ropes and create a successful first move.
Bear Call Spread
If you expect a price to go down by the expiration date, you can initiate a bear call spread. This is where you both buy and sell a call option at a strike price which is typically higher and is a way to offset potential risks while still actively trading.
Married Put
Married put strategies are a popular method for counteracting potential price decreases. They are implemented on at-the-money options. Remember, a put contract gives the holder a right to sell at a certain date for a certain price, so holding onto one of these and balancing it with the married put strategy means your asset will be protected if the timing is right.
Liquidity Is Important
Liquidity is defined as the rapidness to which an option can be bought or sold. So, when it comes to options, the two big things to think about are the overall open interest in the option and the volume on the current market on any given day you are trading.
Why Is Volume a Factor?
Volume can be measured by the number of times an option has been sold or bought and if the volume is high, the option has more favorable liquidity.
What About Open Interest?
Open interest concerns how many options are yet to be purchased/sold during each market day. If the open interest is high, the option can be considered as high liquidity.
Who to Listen To
There are thousands of stock analysts, CTAs, self-pronounced trading gurus, and everything else in between out there that may or may not be credible. Learning who you can trust is a strong move because it will enable you to make not just better decisions but lucrative trades in the long-run and short term as well. Take James Cordier’s complete guide to option selling as a great example of an option selling guide. It has the best strategy for option buying put neatly on the table for you to browse through and absorb. These are the sort of places you should be looking at and the type of advice to follow.
Ultimately, when you get into options trading, you have to look at the whole picture and consider your moves with caution. There is a lot of gain to be found, but an equal (if not greater) amount of risk to manage as well. Therefore, any trader considering their next move and trying to break into the options market will need a firm sense of their trading identity and understand how to convert their intentions into tangible movements.