The financial derivative known as an “option contract,” which represents the right to buy or sell particular assets at a predetermined price at a later date, gave rise to the derivative instrument known as an “option.” Like stocks and bonds, options are traded on stock markets. They grant its owners the option, but not the duty, to act on the underlying asset within a predetermined time limit.
Because the market can change drastically in a short period, traders should carefully weigh the dangers of engaging in such a contract. The value changes are greatly increased when you buy an options contract because it expresses your intent to buy or sell 100 shares at a specific price. As a result, the market for trading options is characterized as dangerous.
By understanding the different techniques and strategies out there when trading options. It will give you the upper hand in using a set of skills to make you money. Therefore, In this article, we will see how options trading can be simplified using basic option trading strategies.
Understand Options trading
To first understand how options trading work, it’s best for you to know more about the stock market first. Here is a Beginner Guide on how to invest in the stock market. By understanding how a stock moves at any point in time, especially during a government speech, company earnings, any negative news, etc. This will give you a better understanding of how the stock market moves from day to day. As what Warren Buffet calls it ” In the short term the stock market is a voting machine, in a long run it is a weighing machine.”
Options trading is considered to be a type of financial derivative contract. It’s a term used to denote the ability to purchase or dispose of an underlying asset at a predetermined price at a later time. There are two methods for trading options: “call” options and “put” options. While put give their holders the right to sell an asset, call to represent the right to purchase a certain asset.
The term “expiration date” describes the time frame in which the underlying asset must be traded. Whereas “strike price” refers to the price at which the contract is executed or settled. The option is said to have a limited life span before it expires because it is an agreement between the buyer and the seller.
How does options trading work?
Options trading is the process of buying or selling an option contract that gives its holder the right, but not the obligation, to either buy or sell an underlying asset at a predetermined price on a future date.
There are various contracts in the market including call and put options. The only way to execute an options trade is via a brokerage account where traders can enter into a call or put option trade whenever they want in accordance with their financial resources. The strike price represents the value at which the underlying asset is traded if the option is exercised.
However, depending on the type of options contract being traded, the expiration date, volatility, underlying assets, and other factors. Traders should be aware of the fluctuations and other factors that can affect the performance of an option contract. Hence, informed decisions should be made based on comprehensive research and analysis.
Benefits of Options Trading
The opportunity to make money is one advantage of trading options. The ability to trade the underlying asset at a specified price might yield large profits. On the other hand, thorough planning is necessary for advancement to ensure that the proper approach is being used to minimize the risks and maximize the advantages.
Less Risk
It is believed that trading options are less hazardous than buying equities. Unlike stocks, which represent a direct share in the company, an option merely represents the right to buy or sell an underlying asset at a fixed price. The option holder is not required to take on any corporate obligations and is not entitled to any dividends that the company may pay.
More Control
On a variety of underlying assets with varying pricing and volatility, options trading is possible. This provides you the choice, based on your risk tolerance, to purchase options contracts that represent a particular kind of underlying asset. It provides you more control over how much danger you expose yourself to. Allowing you to lower your risk and yet turn a profit.
Can be Calculated
Trading options enable you to make tactical choices based on the ideas and plans of market professionals. By doing this, you can trade using tried-and-true methods that investors and traders have developed. They might provide you with greater market knowledge, which could aid you in placing profitable trades.
Why is Options Trading Complex?
Because of the market’s extreme volatility and the difficulty of purchasing, selling, and controlling the actions in an options trade. Options trading is thought to be a complex activity. To effectively make decisions in the market, a greater comprehension of the strategies and processes at play is necessary.
The intricacy of options trading may be further exacerbated by the fact that different investors have varying levels of risk tolerance. Which leads to the use of various techniques. Options trading can be affected by a variety of risks, including those related to market volatility, rate variations, market depth, and the length of time given to traders to complete their contracts.
This is why going back to the previous part why I recommend people to learn how to invest in stock first. An investor needs to learn more about investing by getting a taste of what investing is like. They will need to know what happens to the stock market in any micro and macroeconomic events. With more experience in the stock market, this will create a more seasoned investor that does not trade by emotion but rather by taking calculated risks.
Traders must be very confident in their abilities to make prudent decisions that are appropriate for their financial resources and risk appetite. Thus, the basic understanding and knowledge of an options trading strategy are important for any trader.
Strategies to follow to make options trading less complex
Basic option trading strategies can help a trader minimize the risks associated with options trading. However, it is important to follow the right strategy that is appropriate for you based on your financial resources, risk appetite, and goals. Some of these strategies are discussed below:
Covered call
In this type of strategy, traders hold a long position in an underlying asset or security while simultaneously contracting a call option on the same security to earn profits in the form of premiums. The premium received for this portion of the transaction is used to offset any potential losses incurred in case of an adverse market movement. It is considered to be a risk-free transaction since it only entails the sale or purchase of one security while at the same time, contracting another security in order to offset gains and losses.
Bull call spread
This strategy involves using two call options on an underlying asset, one with a lower strike price and the other with an upper strike price. While the purpose of this strategy is to benefit from a stock’s limited increase in price. Wherein, the bullish call spread helps to limit losses while at the same time, it caps the gains. The spread is generated by the difference in strike prices as well as the movement of the underlying asset. It is considered to be a moderately risky trade since it entails a limited upside and lower downside potential.
Protective Collar
Traders employ a protective collar that could offer protection against short-term losses while also offering a cost-effective approach to safeguard against losses, thereby enabling traders to profit from market increases. It entails holding a long position in the underlying assets, buying a put option to protect against stock declines, and selling a call option on the security to pay for the put purchase. Since this arrangement provides protection against the short-term downside risk, it is termed protective.
Iron Condor
In this type of strategy, a combination of two puts (one long and one short) and two calls (one long and one short), and four strike prices, while the expiration date should be the same for all. The iron condor helps traders to earn profits when the underlying asset is close and is in between the middle strike prices at expiration. The idea is to cover the short calls and puts that are in between the middle strike prices. It requires a deep understanding of the strategies being applied.
How do you trade options in an easy way?
Now that you know about the strategies that can be used to make options trading less complex. You may want to know how to trade options in an easy and effective way. Here are the steps to follow:
Create an options trading account
Before you can start trading options, you need to sign up for an options trading account. With a variety of brokers available in the market. It is important to choose a broker that offers you the highest level of trading features and services. Hence, filling in the required details in the registration process is very important. In order to get a trade account that works well with your preferences and level of trading activities.
Here are some of my Recommendations for Investment Brokerage to start from. Do click the link below and get a referral bonus which could be stocks, vouchers, or cash!
Choose options to buy or sell
To begin with, you must decide what kind of options will be traded. Any sort of transaction with an underlying asset may use options. They act like a contract that stipulates the amount a holder is willing to pay (premium) for the right to sell or buy an asset at a specified price (strike price). There are both call and put options.
Call options give the buyer an option to buy the underlying asset at a stated price sometime in the future. Put options give the buyer an option to sell an underlying asset at a stated price sometime in the future. To learn more about buying and selling an option. Do check out our article on How does the put and call options to differ from each other.
Predict the price
Apart from the type of options that you choose to trade, it is very important to constantly update yourself about the news and events that can affect your option. A good way to learn more about a company’s future price target is by watching Youtube, News, or companies earning that they will discuss their present and future outlook. From there, investors need to pick their price target for the company that they are comfortable taking a risk upon.
A continuous evaluation of risk factors and volatility is required in order to forecast how various factors will affect the price changes of your chosen asset. It is important to analyze the market trends and view the price movements of a particular asset to know if you have made your choice of options trading wisely.
Determine the time period
Once you have chosen the option type, you must decide on the time period. The expiration date is important because it defines the period that which the option is valid. It’s crucial to understand that an option’s pricing will change depending on when it is scheduled to expire. This is why it is important to crunch the numbers and see if you can get the best prices for your options.
Options Trading Myth
Well, there are a few myths about options traders that make it difficult for newbies to start off trading. However, if you know the right factors and follow the rules, it is possible to become a profitable options trader. Following are the myths that you need to know about:
Options are complex
This is a myth that is widely believed among people. While it is true that options involve advanced trading techniques, it does not mean that they are complicated. In fact, with the right knowledge, analysis, and experience, it is possible to earn a decent amount by trading options. The most important thing about this trade is the proper management of risk and the correct use of currency.
Receiving free money by selling options
This myth goes to the idea that options are free money. While it is true that many people make money trading options. This is mostly because they have the skills and ability to make good profits. However, traders are not always given free money. Every deal carries a certain amount of risk, thus it’s critical to estimate the potential profit before making the trade.
Option Sellers make money only
This myth tells people that it is better to sell options rather than buy them because there will be more profitable if they choose to do so. However, while there are many options sellers who succeed, it does not mean that it is always profitable to sell options. There are times when trading options will not be profitable and it is important for traders to be able to determine this before making any trade.
Managing Expectations when Trading Options
Options trading is a great and powerful way to earn profits by using stock price movements. With the right mindset, thorough analysis, and the presence of risk management, you can earn a lot from this field. Traders generally use call-and-put options to get access to a variety of strategies that allow them to profit from the movement of stock prices.
Given trading options can be risky if you are not aware of how and when to use these strategies, it is important that you follow the right rules and make the right decisions. Using the concepts discussed in this article, you may achieve significant profits from your options trading activities. However, it is subject to your ability to use your knowledge and skills.
Reminder!!!
Before trading any options, it is important that the investor know how to do it on their investment brokerage. Do try out trading options using a paper account first to get a better understanding of how options works.
Making it Passive
The end goal of trading options to make an income is to eventually make it as passive as possible. So the common question people would usually ask is ‘how can I make options trading passive?’
The answer to that question is “Sell LEAPs”. LEAPs are long-term equity anticipation securities, which are options contracts with expiration dates that are longer than one year, and typically up to three years from issue. They are functionally identical to most other listed options, except with longer times until expiration. With this longer expiration, the premium of a LEAP is generally a lot higher.
For example, selling a put with an expiration of 1 month for TSLA would provide a premium of $30.21 ($3,021 since it is 100 shares). While selling LEAPs with an expiration of 2 years would provide $87.51 ($8,751 since it is 100 shares). Generally, investors purchase LEAPs of a company that has good future potential and already good business earnings. This is to ensure that the chances of the investor forcing to purchase the options will be slimmer.
Depending on how much premium you are aiming to achieve, an investor can purchase LEAPs far out the money to have a higher probability of it expiring worthless. LEAPs are generally safer (if you know what you are doing!) as 80% of all options contracts expire worthless. Hence, most seasonal investors believe that the most passive way of investing option is selling LEAPs.
Q&A
Here is some common question people would usually ask when starting out options trading.
As a Beginner with zero knowledge of the stock market, how should I start?
To all beginners start investing from scratch. Do check out my Beginner Guide on How to Invest in Stock to learn about how the stock market works. Once you are comfortable and have reach a certain amount of asset invested in the stock market. That is when you should start trading options.
I would like to know more about Investing, what books should I start reading?
There are countless personal finance books but only a few I would classify as the best books to read. Here are my top 5 personal finance books to read to understand more about money.
Where can I learn more about Options trading?
I recommend reading the book “The Complete Guide to Option Selling”. Unlike many other options trading books. This book makes options easy to understand and provides analogies for the reader on how the option works. Most importantly, it goes through the number of scenarios an investor will have to face. How he/she needs to properly navigate safely during tough economic times.
