There are many options available for trading in the market. Sometimes there are so many that it can be a bit overwhelming. But with basic knowledge, you’ll be able to understand a bit better everything related to the stock market.
One of those trading methods is options trading. This type of trading is a way some people use to add flexibility to their portfolio because of its uses.
Let’s take a look at what options trading is and how it all works.
What are Options?
Options are a type of derivative. They are contracts that give you the right, but no obligation, to buy and sell underlying assets before a set expiry date or set price. This gives you the ability to speculate what the future price of the financial market will look like.
Essentially you are putting a price on the probability of future events. It gives you the time to decide if the trade is right for you.
There are two types of options: call option and put option. The call option is the right to buy, whereas the put option is the right to sell.
Unlike with future or forward contracts in which you have not just the right but the obligation to at one point buy or sell, options have no obligation. That is why it is called an option.
How Options Work
Learning how to trade options does not have to be difficult. First, you want to know what influences the options price. There are three factors to consider.
The level of the underlying market compared to what the strike price is. If the strike price is closer the market, you will have lower premiums resulting in higher profits.
You also factor in the expiry date. If the expiry date is far away, the market has more time to hit the strike price.
Lastly, the volatility of the underlying market influences the options price. If the underlying market is more volatile, it is more likely that the market will hit the strike price.
In general, all these factors mean the same thing: if there is a better chance of the option moving closer to the strike price, the higher chance the premiums will be higher.
You must also understand the risks of trading options, or the Greeks. When you know each individual risk (Greek), you can take the necessary steps to mitigate the risks. There are six Greeks to pay attention to:
Ways to Trade Options
There are three ways of trading options. The first is through a broker. Since there are specific requirements to meet before you can buy and sell options on the market, a broker will be able to do that for you. Typically, though, that comes with a commission on the trade.
You could use a CFD (contract for difference) in which you don’t actually deal with the option itself. Instead, the CFD is a replicate of the underlying market.
Lastly, you can trade options through spread better. You bet a certain amount on the spread on the underlying market, rather than having the right to buy or sell.