A Beginners Guide to Options Trading
One way to take your investing game to the next level is to look at the options market. Options trading is a lot different from trading stocks, as options have distinct characteristics. Thus, it’s important to take the time to understand the concepts and terminology involved with options before trading them.
An option is a financial contract that gives you the right to either buy or sell a security at a pre-determined price by a specified date. Instead of owning the shares outright, you are speculating on the future price of a stock within the time frame specified by the option. What makes options unique is that you have the freedom to choose whether or not to exercise them. If your prediction doesn’t pan out, you can simply let your options expire.
Types of Options
There are two basic types of options. These include the call options and put options. When you buy call options, you have the right to buy a stock at a set price before the expiration date of the option. When you buy put options, you have the right to sell a stock at a set price any time before the option’s expiration date. While you have the right to exercise your option, you are not obliged to do so.
What Are the Benefits of Options Trading?
There are several reasons why trading options can be a great compliment to your existing investing strategies:
- Cost efficiency and capital outlay: You can make significant profits out of options trading without investing a significant amount of money.
- Less risk: Options reduce risk at a reasonable cost. Options work like an insurance policy. Just as you insure your house or car, options can be used to protect your investments against a downturn.
- Flexibility: Before an options contract expires, there are lots of strategic moves you can deploy. You can exercise the option and buy the shares to either add in your portfolio or sell some or all of them, or sell the options contract to another investor before it expires.
What Are the Risks of Options Trading?
Here are some of the drawbacks of trading options:
- Potential losses: Because options trading is considered high risk, making significant losses is possible.
- Complicated: While it’s not really that hard to understand the basics, some aspects of options trading and the strategies you can use are much more complicated.
- Lower liquidity: Some options don’t trade that much, which means there’s little liquidity. If there’s no liquidity, the bid-offer spreads can be extremely wide, making it almost impossible to generate profit.
- Time decay: The time decay—the reduction in the value of an option—accelerates as the option’s expiration date draws closer, as there’s less time for an investor to make a profit from the option.
Options trading doesn’t have to be difficult to understand once you learn the basic concepts. It can provide you with lots of opportunities when done correctly and can be harmful when done incorrectly.