Steps To Follow While Options Trading was written by Wendy Carlota and originally appeared on Wealth of Geeks. Hashtag Investing is a financial media community for stock traders and investors alike. With articles on personal finance, stock analysis, trading research tools, & more. Hashtag Investing also provides a valuable weekly newsletter for 30,000+ traders every Sunday. It has been republished with permission.
62.58 billion. That's the total number of futures and options contracts traded globally in 2021, according to data released by the FIA (Futures Industry Association).
That's up 33.7% from 2020. Last year was the fourth year the “global exchange-traded derivatives markets set a record above the prior year in terms of total trading activity.”
These kinds of equities have seen rapid growth in recent years. Experts expect the numbers to grow in 2022 with interest in option trading.
Options trading has become one of the most preferred investment mechanisms in recent years. For newbies, it can be a daunting task. There's too much information available in the market, which often needs to be clarified. Getting lost in the sea of options is easy without proper guidance and knowledge.
Before embarking on your trading journey, you should first understand what options are. We have written this guide for beginners who are eager to enter the world of options but need more knowledge and want to improve.
What Are Options Contracts?
Trading options involves purchasing and selling an underlying asset at a pre-determined price by a specified future date. Options contracts are derivative contracts that give buyers the absolute right (but not the obligation) to buy or sell an underlying asset at a pre-determined price and by a specific future date. Underlying assets can range from stocks and bonds to market indices or derivative contracts. To obtain this right, the buyers must pay the sellers a premium known as an option's premium.
These derivative instruments are divided into “call” or “put” contracts. The buyer of the option gets the unconditional right to purchase the underlying asset at a future date at a pre-determined price, known as the exercise price or strike price, in the case of a call option. On the other hand, those who own a put option have the unconditional right to sell the underlying asset on the expiry date at the pre-determined strike price.
Buyers exercise their rights only if the market moves in a direction that increases the value of this right. If market prices are unfavorable to the holders, they do not exercise their rights, and the options become void.
Important Options Trading Terms
It is essential to understand these few terms about options trading:
- Strike Price: The pre-determined price agreed upon while purchasing the options contract.
- Exercise Date: The date until which the holder of the options has the right to exercise it at the exercise price. Beyond this date, the possibilities are generally rendered worthless.
- Intrinsic Value: The intrinsic value of an options contract is the difference between the option contract's strike price and the price at which the underlying asset is currently trading.
- Extrinsic Value: Extrinsic value usually considers factors other than those considered in intrinsic value calculation that affects the premium. That can include elements like how long the option is good.
- In-the-money Options and Out-of-the-money Options: This is to determine whether an option is profitable or not. The price gets determined by the underlying security and the time remaining for the expiry of the options.
- American Options: Investors can exercise these options at any point until the expiry date.
- European Options: These options can only be exercised on the expiry day.
Steps To Follow While Trading Options
If you intend to embark on your options trading journey, follow all the steps mentioned below:
1. Open an Options Trading Account
If you want to trade options, you must have an options trading account. Compared to a simple brokerage account for stock trading, an options trading account usually requires greater capital involvement. Besides, because of the higher complexity, brokers require more information about the trader (their income, liquid net worth, capital preservation or speculation, knowledge of investing, etc.) Therefore, an options trading account consists of a few more steps than a stock trading account.
The broker will assign the initial trading level based on risk levels, which will be the trader's key to placing certain types of options trades. If you want to trade in both stocks and options, you can select a broker who offers both services.
2. Select The Options Contract
After successfully opening the options trading account, you must decide on the type of options contract you want to enter. If you expect the market to increase, buy a call option or sell a put option. If the market goes down, sell a call option or buy a put option. However, you may sell a call or put option if the market is stable.
3. Predict The Strike Price
An option contract is valuable only if the underlying stock price closes the option's expiration period “in the money,” i.e., either above or below the strike price. (Above for call options and below for put options.) So, predicting the correct strike price is extremely important. Note: you cannot choose just any strike price. Option quotes, also called option chains or matrices, consist of a range of available strike prices based on the stock price, and their increments are standardized across industries. Moreover, the premium paid is also classified into intrinsic and time value.
4. Predict The Option Time Frame
All options contracts have an expiry date, ranging from days to months to years. This period, too, cannot be conjured up from thin air. Daily options generally possess a higher risk. If you are a long-term investor, the ones with more extended expiration periods will suit you better.
Basic Options Trading Strategies for Beginners
Selecting proper options trading strategies is very important as these strategies can decide if and how much profit you can make. There are several market strategies, most of which are pretty tricky. Beginners can start with the below-mentioned strategies.
- Long Calls: Traders who believe the underlying asset's price will rise can purchase a call option on that asset with less capital than the asset itself. This strategy is relatively safe because even if the asset's value falls, the loss is limited to its premium. However, the profit is limitless. Use this strategy only if you are confident in a specific stock, ETF, or index fund and want to limit risk.
- Long Puts: Traders who believe the underlying price will fall can purchase a put option on that asset. As a put option works precisely in the opposite manner compared to calls, the trader will gain from this strategy when there is a fall in the price of a stock, ETF, or index. The risk associated with short selling also gets mitigated with this. Traders must remember the risk with a short position is unlimited as there is no limit to how high a price can rise, and if that happens, the contract will turn worthless.
- Covered Calls: A covered call strategy involves purchasing and selling a call on the same underlying asset. Traders indulge in this strategy usually when there is almost no change or just a slight increase in the underlying price. The strategy helps investors earn a premium.
- Protective Puts: The protective put strategy involves buying a downside put to cover an existing position in the underlying asset. It puts on a lower floor so that the traders don't lose much money, although one has to pay the premium. It is ideally utilized by traders who own the underlying asset and want to take downside protection against the same.
Options Trading Benefits
Several benefits come with options trading. Some of them are listed here:
- Greater Flexibility: Traders can choose a specific strike price and expiration date based on convenience. In adverse cases, they are not obligated to execute the trade.
- Hedges Portfolio: Options are a hedging tool. If you own shares of a company, you can buy put options to mitigate potential losses.
- Cost-effective: Options provide a cost-efficient way to make a speculative bet while offering lesser risk.
Is Options Trading Suitable in The Current Economic Environment?
The current year has been bad for the financial market in general. Concerns like decades-high inflation levels, Russia's invasion of Ukraine, or rising oil prices have dragged down the performances of most growth stocks. Stock trading might seem risky in volatile market conditions, but options contracts usually thrive.
That happens because, in general terms, options contracts are speculative and are usually used by investors to protect the downside risk. It is easier to generate income using options when the market is falling. Following a credible option alerts service could be beneficial to learn and get trade ideas from more experienced traders.
As per the Options Clearing Corporation, around 943.7 million options contracts were traded in March 2022, and the figures this time are 4.4% higher than last year. As per records, March 2022 was also the second-highest trading month.