What is Options Trading?

Options trading is a contract where the bearer can sell or buy an underlying asset before the contract expires. The price is predetermined, and traders trade options through an options trading platform.

Investors and traders can read this in-depth guide for the best options trading platforms. Since options trading is a bit complex, brokers choose who they allow to trade on their platform (we’ll dive deeper into this shortly). However, you should also choose the right broker for you.

Since there are many brokers to choose from, finding the perfect options trading partner will be easy.

Options trading contracts aren’t legally binding, meaning you can buy or sell the underlying asset.

Although options trading is pretty straightforward, there are some caveats. For example, with stocks, you only need to decide how many stocks you want. If you’re working with a broker, they’ll fill orders for you according to the stock market price.

However, you’ll need to use the right tactics with options trading. There are multiple moving parts that traders need to keep in mind. But it isn’t impossible to learn – even if you’re a beginner.

Options can also be used for speculations. Speculating in the trading and investing space means you’ll speculate on whether the stock price goes up or down. Experienced speculators use fundamental and technical analysis tools to speculate on options.

Options are derivative security. If investors and traders play their cards right, options can be a powerful addition to their portfolios. They can increase wealth, protect your portfolio, and provide leverage. No matter what kind of investor you are, there’s likely an options trading opportunity that suits you.

Types of Options: Puts and Calls

There are two major types of options trading – puts and calls. Put options allow you to sell options. In contrast, call options will enable you to buy options. Calls are like down payments, and traders can use them for future purchases.

Remember, even though options are a derivative, options contracts aren’t an obligation. You don’t have to buy or sell the underlying asset. Let’s dive into more detail about the types of options.

Put Options

Put options allow you to sell the underlying stock. A long put can be seen as short because they aren’t obliged to sell the underlying stock at the strike price (before expiration, of course). The put will gain value as the price decreases.

Investors can also purchase put options as insurance. Another name for these is protective puts. It gives you a price floor that investors use to hedge their positions.

How Can Traders Use Put Options?

Both put and call options can be used in different ways. There are some similarities in their uses. Here are some brief examples of how put options are used:

• Foreign manufacturers can put options in the US dollar, allowing them to hedge against a drop in the value of their native currency
• Exporters can use put options for the US dollar to hedge against rising selling costs
• Put options can be used to hedge against current rising prices for commodities or security.
• Since the stock’s price never falls below zero, short-selling traders get limited gains.

Call Options

These are the opposite of put options. It gives the right to buy the underlying asset at a strike price before the expiration. So, when the asset price rises, the call options’ value will increase. Therefore, call options have a positive delta.

Investors can use long calls. This is done to speculate on the rising price of assets. The maximum loss is only the premium or the price that the investor paid for the option. However, they have unlimited upside potential.

How Can Traders Use Call Options?

In some ways, call options are the inverse compared to put options. Here are some of their use cases:

• Buyers can use call options to hedge against positions when prices are declining.
• Traders can use it to hedge against positions when short selling.
• In the case of the declining purchasing power of US exporters, they can use call options against the US dollar to hedge against it.
• ADR holders may use call options to hedge against declining dividend payments.

Short-Term Options Vs. Long-Term Options Vs. Leap Options

Besides the type of options, traders can differentiate options based on the time period. Options can be short or long-term.

Short-term options have a time frame of only one year. In contrast, long-term options have a time frame of more than a year. Some options are also called long-term equity anticipation securities or LEAPS. These are similar to regular options but have more extended time frames.

Short-term Options Characteristics

• Short-term duration is the leading risk.
• They are primarily used during catalyst events like news announcements.
• Extrinsic and time values go down very quickly since these are short-term.
• Not expensive to purchase.
• Taxed as capital gains rate.

Long-term Options Characteristics

• Expensive to purchase.
• They are mainly used as proxies for holding shares.
• Taxed at long-term gains rate.
• Unlike short-term options, time value doesn’t decay quickly.
• Leverage is the main component.

LEAP Options Characteristic

• Time value decay is minimal since the expiration date is very long.
• The main risk component is mistakes in assessing the stock’s future value.
• Underpriced due to the difficulty of estimating the performance of the stock.
• American style only. In comparison, others have both American and European style options.
• They are taxed the same as long-term options.

Options Trading: American Vs. European

The difference between American and European options is based on more than just location. It comes down to how they’re exercised. American options can be exercised anytime between purchase and expiration dates.

In contrast, European options can only be exercised at the end of their lives. More specifically, when the end of life is nearing the expiry date. American options are more valuable and command a premium.

This is because they can be exercised early and thus is desirable to most. However, most of the options are European options. That’s why you’ll often see American options having a premium over the matching European option.

Step By Step Guide On How to Trade Options

Starting to trade options is easier than you think. You can begin options trading in four simple steps. Here’s how you can start trading options:

Step 1: Open an Account

For complete beginners, options trading can be difficult. Compared to other forms of trading, options trading requires more capital.

You need to know what you’re doing. Fortunately, plenty of high-quality resources like Trading for Beginner can help you become a successful trader.

The brokers also have a say on whom they give permission slips. Therefore, it is more complex than just opening an account and starting trading. Brokers require some background on the investor, and they prefer those who have some time to observe the market.

Options trading can be tricky because there are a lot of moving parts. It is more complicated to speculate on them correctly all the time. When opening an account, the broker will ask you to provide certain information about yourself.

Brokers assign levels to traders at the initial level. These range between 1 to 5 based on risk level. One is the lowest risk, while five is the highest. Remember that this goes both ways. It helps if you also choose a broker that works for you.

Here is the typical information you’ll need to provide your broker:

• Investment objectives – Think of this as a set of goals. Things you want to achieve when trading options, such as growth, capital preservation, and income.
• Financial Information – This one is important. Brokers will likely want to see some financial information as well. Things that include annual income, net worth, liquid on-hand cash, and employment information are typical questions brokers will ask.
• Trading experience – As we mentioned, options trading is better for experienced traders compared to complete beginners. Therefore, brokers will want to know what kind of experience you have with trading. Specifics like how long you have been trading, size, and frequency of trades.
• Type of options you want to buy and sell – A broker will want to know what options you wish to trade. This allows them to serve your needs better. Besides, you should know what options you want to trade beforehand. This brings us to our next step.