Table of Contents
Introduction:
Even with the risk involved, there’s no denying that profit is possible from trading and investing in the financial markets. You can choose from Options Trading a range of stocks, bonds, commodities and currencies, there are various ways of investing too. Like through options, for instance.
Options are a form of derivatives trading, which give the right to buy or sell a security in the future at a specific price. This can be an advantage if the price changes over time. An option buyer pays a premium to avail of this possibility. If a price falls, then the buyer loses just the premium. But if the price rises, then they can profit. Read on for options trading explained.
Reasons to Trade Options:
In other words, the losses when trading options are limited to the premium. But the profit potential is unlimited. A buyer who is positive about a security, Options Trading can make bigger returns by buying options instead of buying shares of the company. It’s also useful for hedging bets, by using put options. Put options give the buyer the right to sell the share at a specific price in the future.
Options are becoming a popular way to trade, with trading platforms offering them increasingly. There is a broader range of choices of underlying assets to trade available and people are willing to take more risks too.
10 key Terms Used:
To understand how options trading works, it’s first essential to know the basic terms used. These are:
- Call: The option to buy at a specified price in the future
- Put: The option to sell in the future at a particular price
- Premium: Fee paid for buying the option
- Strike Price: The price at which the buyer can exercise the option
- Break-even point: A zero-profit, zero-loss situation, which equals the strike price plus the premium paid in the case of a call option. Or the strike price minus the premium in the case of a put option.
- Expiry: The termination date of the option
- In the money: In the case of a call option, when the security’s price is higher than the strike price, you are ‘in the money’. It’s the opposite for a put option.
- Out of the money: In case the security’s price is lower than the strike price in a call option, the buyer is ‘out of the money’. The same holds if the strike price is higher than the security’s price when the call option expires, the holder.
- At the money: When the strike price is equal to or at around the same level as the strike price, you are ‘at the money’. This holds true whether you have bought a call or put option.
- Holders and writers: An option buyer is a holder and the seller is a writer.
How Options Trading Works:
Now that we know the key terms in options trading, how it works can be explained with an example. Suppose a trader wants to buy Tesla stock at $150 per share, with $3,000. They can buy 20 such shares, ignoring any brokerage fee. If the price rises in a month to $200, the trader would make a $1,000 profit. Their total capital would rise to $4,000.
Now, consider instead if they had purchased call options at a premium of $15 per share. The 100 options provided in one contract, the holder now has 2 contracts or 200 shares worth $3000, which is the initial investment. If the price rises to $200, the holder is in the money and now earns a profit of $35 per share. This is because the break-even price is $150 plus the premium of $15 per share. However, in this case, since they hold 200 shares, the gains rise to $7,000 in total. The total capital rises to $10,000.
It works similarly for put options. There are other ways of trading options too like spreads and uncovered options. Various ways of options trading can be useful to a trader starting out on their journey with derivatives.
Give it a Shot:
While options are a potentially profitable way to trade, the key takeaway here is learning. It’s important to know how to trade in them. The information provided here is just a snapshot of what it takes to trade in options. But as you build confidence with enough knowledge, you can give it a shot. Many traders around the world are already doing it. And as we see from the example above, it can earn you a lot of money too.
