What is options trading?
Options trading is simply trading options on the options market.
Options are contracts that give the bearer the right, but not the obligation, to buy or sell amounts of underlying assets at a predetermined price before a date the contract expires. Thus, unlike futures, holders of options do not have to exercise their right to buy or sell if they do not want to.
Likewise, a currency option is a type of options contract that offers the holder the right, but not the obligation, to buy or sell a currency pair at a predefined price before a set date of expiry.
Key terms in options
Underlying asset
Options are derivatives, meaning they derive their price from the value of an underlying asset, also referred to as an underlying security.
There is a whole range of underlying assets. For instance, stocks, bonds, indices, commodities, like gold and crude oil, and foreign currencies. There are even basket options where the underlying asset is a collection or basket of different assets.
Parties involved in options contracts
An options contract constitutes two parties: the holder and the writer. The holder (bearer) is in effect the buyer of the contract, while the writer is effectively the seller.
The holder has the option to effectuate the transaction that is specified in the options contract, while the writer is obliged to honour the contract should the holder wish to proceed with the transaction.
Should the holder not exercise his/her option at any point before the expiry date, then the contract will in due course expire and be terminated.
Paying a premium
When buying an option, the buyer pays the seller for the right to trade at a predetermined price before a predefined date. This payment is commonly referred to as the premium.
The premium is essentially the cost of buying the option contract which will allow you to eventually buy the underlying asset. In this sense, the premium is sort of like a down payment for a future purpose.
Strike price
The strike price is the price at which the transaction, specified in the options contract, is to be carried out should the holder choose to exercise the option. It is also known as the exercise price.
Put differently, it is the price at which the holder can buy, regarding a call option, or sell the underlying asset, with regard to a put option.
For example: You have an option contract that gives you the right to by platinum at $700 an ounce for the next two weeks. If the platinum price increases to $720 an ounce, you can exercise your option and buy for $700, $20 less than the current market price.
However, if platinum stays below $680 an ounce, you are not obliged to buy it for $700. Although, by not exercising your option, you will lose the premium you paid for the option.
In the money
It is when the underlying asset’s price is above the strike price (for a call option) or below the strike price (for a put option), implying the holder can exercise the option at a better price than the current market price.
Out of the money
Is when the underlying asset’s price is below the strike price (for a call option) or above the strike price (for a put option), indicating that exercising the option will incur a loss for the holder.
At the money
Is when the market price of the underlying asset is equal or close to the strike price.
Expiry date
The duration of options is relatively short term and last typically just a few weeks. Although they can last longer, for a few months or even up to a year. Regardless, the duration of option contracts, they all have an expiry date.
If a holder has not exercised his/her option at the expiry date, then the contract expires worthless.
Option types
There are basically two main types of options: call options and put options.
Call options
Call options (calls) allow the holder to buy the underlying asset at or above the strike price over a certain amount of time.
You will get a long position on the underlying asset when buying a call option. A long position, also referred to as long, is the buying of an asset, like a stock or currency, with the expectation that it will increase in price. The goal is usually to generate a profit by selling it immediately after exercising the right to buy. The more the market’s price rises, the more profit you can make.
Put options
Put options (puts) give the holder the right to sell an underlying asset at or below the strike price over a certain time span.
With a put option you have a short position, also known as short, on the market of the underlying asset. A holder may decide to go short on an asset when he/she wants the price of the underlying asset to drop in the near future in order to make a profit. The further the market plummets, the more profit can be generated.
The holder does not have to actually own any of the underlying asset to buy a put option. However, if you choose to exercise your option to sell the underlying asset you will, theoretically, have to buy the underlying asset at that stage.
Some advantages of options
Cost efficiency
Options provide great leverage to the trader when used with caution. As such, an investor can acquire an option position similar to a stock position, but at a cost efficiency that will not be like investing in stocks.
Limited risk
Although there are times when trading in options are riskier than owning equities, there are also situations in which options can be used to reduce and limit risk. Trading in options, an investor requires less financial commitment as compared to equities. Therefore, the overall risk of losing capital is reduced.
Options are also the most reliable form of hedging, which makes them less risky than stocks.
Eventually, how much your financial risk is limited by options, depends on how you use them.
Higher potential returns
It is not rocket science to figure out that options trading provides higher potential returns if you spend less money and generate almost the same profit.
More strategic investment alternatives
Another major advantage of options is that they work as strategic investment alternatives. Options are a flexible tool and can be used in many ways, inter alia, to recreate other positions and to convey different market opinions, such as bearish or bullish.
Some disadvantages of options
Complicated
Options are extremely complicated to beginners. To obtain potential profits, technical analyses have to be performed consistently. There are many strategies to work on which require much of your time.
Higher spreads
Basically, a spread is the difference between where a trader may buy or sell an underlying asset, while an option spread is a strategy involving two ore more options on the same, single underlying asset.
Options tend to have higher spreads due to the lack of liquidity. This implies it will cost you more in indirect costs. Compared to equity investments, the investor trading in options pays more indirect costs for both sides because of high spreads.
Time decay
In buying options, many options buyers lose the value of an option due to time decay when closing to the expiry date. There are no exceptions to the rule that with time, the value of options falls consistently.
Less information
Trading options can be difficult because it is demanding to get quotes or other standard analytical information.
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