Options Trading: An Introduction to Derivatives
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Godwin UdoContent and scriptwriter
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In the financial market, Options trading has been making waves, and it seems to be better than the other options out there. In options trading, people can invest on whether a stock will go up or down, but with more twists and turns. More and more people are now getting more interested. Why? Because options trading lets you make money even when the market is shaky and not moving well.
What is Options Trading? Options trading is a type of financial trading that allows people called investors to buy or sell the right to purchase or sell an underlying asset at any fixed price at a future date. In Options trading, the buyer has the option to exercise the contract but is not under any obligation to do so.
If you are new to options trading or you are an investor, read this article to the end. This article will cover extensive details on options trading, its applications, and how to get started.
Understanding Options Trading
Options are basically what makeup Option trading; they are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. These are contracts that give you the right (but not the obligation) to buy or sell something (like a stock) at a certain price by a certain date.
Two Primary Types of Options
In order to enter into an option contract, the buyer must pay an option premium. The seller, on the other hand, receives the premium but must be prepared to honor the agreement if the buyer chooses to exercise their option. However, every trader should know about different types of options. The two types of options mostly used in trading are calls and puts options.
1. Call options
Call options give the buyer, who is the investor, the right but not the obligation to buy an underlying asset at the strike price as stated in the option contract.
The Investors buy calls when they believe the price of the underlying asset will increase and sell calls when they believe it will decrease. If you buy a call option, you're betting that the price of the asset will go up.
So, if the price goes up above the strike price before the expiration date, you can buy the asset at the strike price and sell it at the higher market price, making a profit.
For example. You see a call option with an underlying 50 shares, and you like the call, so you decide to purchase the shares for $50 per share at any time for the next three months. Also, to purchase the option, you have to pay a $1 per share premium. So, you have to spend $2,500 to buy shares plus a total premium of $1 ($1 x 50). The total is $2,550.
Remember you bought the call option because you are confident that it will rise soon. So let's say the stock price rises to $60 per share in two months. You then exercise your options and buy the 50 shares at $50.
You then sell your options (in option trading this means closing your positions) and take profits. You can then sell each share for $60 and earn $3,600 in revenue. After you subtract your capital, your profit will be $1,150. Sounds easy right? Let’s continue.
2. Put options
The next type of option is the put option. The put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price specified in the contract. This is the opposite of the Call option.
Investors buy puts when they believe the price of the asset will decrease or fall and sell puts if they believe the price of the asset will increase. If you buy a put option, you're betting that the price of the asset will go down.
So, if the price goes down below the strike price before the expiration date, you can buy the asset at the lower market price and sell it at the higher strike price, making a profit.
Let me explain further with this example. Assume you are considering buying it because you see the possibility of the stock price falling. Remember, Call options allow you to sell 50 shares for $50 per share with a premium of $1 per share.
Say the share price falls to $40 per share. You decide to buy the stock, so you spend $2,000 ($40 x 50). With the total premium of $50 ($1 x 50), your total spending becomes $2,050.
You then exercise the put option and sell the stock at $50, getting $2,500 ($50 x 50). Your total profit is $450 ($2,500 - $2,050).
key Terms Associated with Options Trading
Strike Price
You must have seen strike prices a couple of times, so what does it mean? Strike prices are predetermined prices at which the option owner decides to buy or sell the underlying asset. This price is fixed and remains unchanged during the contract.
Expiration day
Every option contract has an expiration date. The expiration day is when the option's contract no longer carries value. It is usually the last day of trading, which is the third Friday of every month.
Premium
This is the price, like a transaction fee, which The buyer pays the seller for the option. This is like the cost of buying the right call or potentially making a profit later.
Intrinsic value
Intrinsic value occurs if the strike price is below the current market price for calls and above for puts.
Getting Started with Options Trading
Now that you know what option trading is, it’s best to have a very solid understanding of it before you start trading. Before diving into options trading, it's important to understand how it works and the risks involved. Many brokers offer educational resources, webinars, and virtual trading accounts where you can practice trading without risking real money.
Even as that, there are many courses online when it comes to options trading. And you’ll need to find one that matches your experience level, budget, and schedule. To help save you time, money, and energy when making this decision, I have selected three top courses every beginner and advanced trader should learn.
- Udemy - The Complete Foundation Stock Trading Course
- Udemy - Options Trading for Rookies (Part 1-3): Understand Options Completely
- Coursera - Investment and Portfolio Management Specialization
After Learning more about Options trading, you should start planning how to start trading. First, you should outline what your investment objectives are and how much you want to invest. How much do you intend to make? And other things.
Brokerage Accounts
Once you are done learning and setting your objectives, you should choose a Brokerage account for your Trading.
Opening a brokerage account for options trading is like signing up for a service that lets you buy and sell options, which are financial contracts giving you the right to buy or sell assets like stocks at a certain price by a certain date.
Here's a simple breakdown of the process of getting a brokerage account.
Research and Choose a Broker
First, you need to pick a brokerage firm that supports options trading. This is very important because if you choose a bad Broker, you will keep having problems.
So, to avoid that, Look for one that fits your needs in terms of fees, security, Financial Stability, platform usability, educational resources, and customer service. Read reviews from other users to know which one is best.
Application
Once you've chosen a broker, you must register and create an account with them. You'll need to complete an application form, mostly online, through an app or website. You'll provide personal information, like your name, address, Social Security number, and other basic information.
Verifying your account:
Due to some regulations guiding the trading industry, Brokers must verify new members. So, the brokerage will verify your identity using the information you provided. And this might also involve providing additional documents, like a driver's license or bank statements.
Funding Your Account
After your account has been approved, you must deposit money into it. This is normally called funding in trading. It is usually done through bank transfer, check, or wire transfer.
Options Trading Approval
Not all brokerage accounts automatically allow options trading. In that case, You may need to request approval for options trading, and the broker will assess your financial situation and experience with trading before granting it. As a beginner, it is advisable to choose brokers that will automatically allow options trading.
Risk Management in Options Trading
As a Trader looking to make as much profit as possible, Risk management is an important part of trading that should not be ignored. It can help traders minimize their potential losses and maximize profits.
This is because trading involves many uncertainties and unpredictable market conditions influenced by various factors like economic indicators, geopolitical events, and even unexpected news. If not managed properly, these can lead to huge or small unexpected losses.
There are several risk management strategies that traders can use to reduce the risk of losing their funds.
1. Stop-loss orders
Stop-loss orders, mostly denoted with SL, are one of the most common risk management strategies used by traders. These orders automatically close a trade if the price reaches a certain level that you set. For example, if you were trading with $10$ and you set a stop loss at $8$, once your investment reduces to $8$, the trade closes automatically.
2. Position sizing
Position sizing is another important risk management strategy that involves determining the appropriate size of a trade based on the trader's risk tolerance and the size of their trading account.
3. Diversification
Diversification is another important risk management strategy that involves spreading investments across different assets or markets to reduce the impact of any one investment on the overall portfolio. It goes with the saying “Don't put all your eggs in one basket”
4. Hedging
Hedging is a risk management strategy that involves taking a position in the opposite direction of an existing trade to reduce the impact of potential losses.
Conclusion
Options trading is a type of financial trading that allows people called investors to buy or sell the right to purchase or sell an underlying asset at any fixed price at a future date.
In Options trading, the buyer has the option to exercise the contract but is not under any obligation to do so. This Article highlights the fundamentals of options trading, such as understanding calls and puts, strike prices, expiration dates, and option premiums.
For Newbies and Advanced traders who want to know more about options trading, the journey doesn't end here. Continued learning and research are important because the market is dynamic. It keeps moving and changing, So with More knowledge, practical experience, staying updated on market conditions, and developing a disciplined approach to risk management, you will get to the top.