Options trading is a way for investors to speculate on the future direction of a financial market or individual instrument, such as stocks or bonds. The great thing about options contracts is that they give people a choice but not the obligation to buy or sell an underlying asset at a specified price by a predetermined date. In this article, we take a look at what options are, key terms to know when trading options, how trading works and what are the benefits of trading options. Keep reading below to learn more.
What are options
Options are a financial instrument that is based on the value of its underlying security – such as a stock. An options contract offers the buyer the opportunity to buy or sell (depending on the kind of contract they hold) the underlying asset. Unlike futures, the holder is not required to buy or sell the asset if they decide against it.
Each options contract has a specific expiration date on which the holder must exercise the option. The stated price on an option is called the strike price. Options are typically bought and sold through online retail brokers.
Key terms to know when trading options
To understand options, traders need to know a few key terms that will often crop up. Here they are explained below:
- Derivative: Options are known as a derivative, meaning they derive their value from another asset. For instance, with stock options, the price of a given stock dictates the value of the options contracts.
- Premium: This is the price to buy an option. It is calculated based on the underlying security’s price and values.
- Intrinsic value and extrinsic value: Intrinsic value is the difference between an option contract’s strike price and the current price of the underlying asset. The extrinsic value represents other factors outside those considered as intrinsic value that affect the premium. For instance, this includes how long the option is good for.
- In-the-money and out-of-the-money: Depending on the underlying security’s price and the time remaining until expiration, an option is said to be in-the-money (profitable) or out-of-the-money (unprofitable).
Types of options
Calls
A call option gives the holder the right, but not the obligation to buy the underlying security at the strike price on or before expiration. A call option will become more valuable as the underlying security rises in price.
A long call can be used to speculate on the price of the underlying rising, as it has unlimited upside potential. The maximum loss is the premium paid for the option.
Puts
Opposite to call options, a put gives the holder the right but not the obligation to sell the underlying stock at the strike price on or before expiration. A long put is a short position in the underlying security, as the put gains value as the underlying security’s price falls. Protective puts can be bought as some kind of insurance, as they provide a price floor for investors to hedge their positions.
How options pricing works
Simply put, when trading options, a trade must pay a premium upfront. This will then give them the ability to buy or sell the underlying asset at the designated strike price by the expiration date.
Traders must keep in mind that a lower strike price has more intrinsic value for call options as the options contract lets traders buy the underlying asset at a lower price than what it is trading for currently. If the asset’s price remains at the current price, the call options are considered in-the-money, and traders can buy the asset at a discount.
On the other hand, a higher strike price has more intrinsic value for put options because the contract allows traders to sell the asset at a higher price than where it is trading currently. The option is considered in-the-money if the asset stays at the current price. That said, traders still have the right to sell it at a higher strike price.
How options trading works
Options allow traders to deploy a range of options trading strategies, from the straightforward to the complicated. Broadly speaking, trading call options is how to take advantage of rising prices, while trading put options is a way to take advantage of falling prices.
While options contracts give investors the right to buy or sell the underlying asset, there is no obligation to exercise the option in the event the trade is not profitable. If a trader decides not to exercise an option, the only money they stand to lose is the premium. As a result, options trading can be considered a relatively low-cost way to speculate on a whole range of asset classes.
Options trading allows traders to speculate on:
- Whether an asset’s price will rise or fall from its current price
- By how much an asset’s price will rise or fall
- By what date these price changes will occur
If the asset’s price moves in the opposite direction than desired for either a call or a put option, traders can simply let the contract expire. Their losses will only be equal to the amount paid for the option (the premium and other associated trading fees).
Benefits of trading options
Trading options offer several benefits to investors. Below we have listed a few key advantages when it comes to trading options.
Flexibility
Options provide flexibility in terms of investment strategies. Investors can use options to speculate on the price movements of underlying assets, potentially generate an income, protect their existing positions, or hedge against potential risks. Options allow investors to design strategies that align with their specific investment goals and risk tolerance.
Leverage
Options provide leverage for traders. This means that traders can control a larger position with a smaller upfront investment. This amplifies any potential returns on investment if the trade ends up going in the desired direction. However, it is important to remember that leverage also magnifies potential losses, so proper risk management is crucial when trading options.
Diversification
Options offer an additional tool for diversifying an investment portfolio. By incorporating options into trading or investment strategies, investors and traders can gain exposure to various asset classes, sectors, and market trends. This diversification can help to reduce risk and potentially enhance a trader’s overall portfolio performance.
Limited risk
Another key benefit of trading options is the ability of traders to limit risk. Unlike trading stocks, where losses can potentially be unlimited if the price of a stock continues to decline, options have a defined maximum loss, which is the premium paid to enter a trade. As such, this feature allows traders to have better risk control and plan their trades accordingly.
Hedging
Options can be used as a hedging tool to protect against potential losses in an existing position. For instance, if an investor holds a portfolio of stocks and anticipates a market downturn, they can buy put options to hedge against this potential loss. If the market does move in an unfavourable direction, the gains from the put options can help offset the losses in the stock portfolio.
Liquidity
Options are generally considered highly liquid, meaning there is a robust market with ample trading volume and tight bid-ask spreads. This liquidity provides traders with the ability to enter and exit positions quickly at fair prices, ensuring efficient trade execution.
Versatility
Options offer a wide range of strategies and combinations that can be tailored to various market conditions and investor objectives. Traders can also employ strategies such as buying or selling calls or puts, spreads, straddles, or condors, amongst others, to take advantage of various market scenarios.
Bottom line
As with any other type of investing, it is best that traders educate themselves thoroughly before they begin. Traders should also try to use demo accounts and simulators to paper trade to get a feel for how options trading works before trying to live trade for real.
When traders first start options trading, it is best they start small. Traders can always try more aggressive options strategies when they have accumulated more experience. In the beginning, however, it is best to focus on a well-known asset and only trade with funds on the line that you are prepared to lose.