This universe of investments is so vast, with thousands of financial instruments available to satisfy a wide variety of investment objectives and risk appetites, that options trading has emerged as the best-known and most versatile tool for investors looking to either maximize gains or minimize risks. It doesn't matter whether you're an investor for the first time or want to diversify a portfolio; knowing how options work can be very instrumental. In this book, we'll explain what options are, different strategies you can use, and the dangers that come with them. Let's get into the intriguing world of derivatives and options!
At its core, options trading involves contracts that confer upon an investor the right, not the obligation, to buy or sell the underlying asset on or before a specific date established for expiration. The security in question could be a stock, an index, a commodity, or any other financial instrument. There are basically two types of options-trading options: call options and put options.
Options are one type of a much broader group of financial products called derivatives - the value of derivatives is derived from an underlying asset. Unlike common stock or bonds, in which investors purchase an equity stake in a company, options traders bet on movements in price but do not buy an ownership interest in the underlying asset. Options represent substantial profit opportunities, but they also involve unique risks.
Before you discuss strategy options, you need to know some basic terms:
There are many benefits for newcomers who want to venture into the world of trading options:
Options trading is as simple or complex as the investor makes it, with many strategies available to match risk profiles and changing market conditions. For beginners, here are some of the popular strategies that one should know and understand:
Who should use it: Investors who expect a substantial price increase in the underlying asset.
One of the most straightforward options trading strategies is a long call. This strategy involves making a bet that the price of the asset will increase above the strike price by the time the option expires. When the asset's price rises above the strike price, an investor buys it at the lower strike price, sells it at the higher market price and captures this difference as profit.
Risk: The most you can lose with a long call is the premium paid. If the price does not move upward, the option expires worthless.
Who should use it: The investor who expects that the price of the asset will go down.
A long put is literally the opposite of a long call. Investors buy a put in the sense that they believe that the price of the underlying asset is going to decline. The right to sell the asset at the strike price provides them with the opportunity to profit if the market price falls.
Risk: Similar to a long call, the only risk is the premium paid. It expires worthless if the price does not fall.
Who should use it: Investors who seek additional income on stocks they already hold.
A covered call is when an investor buys an underlying stock and sells a call option on the same underlying stock. The premium received for selling the call is what generates the income in this strategy. If the stock price increases and the option gets exercised, then the investor will have to sell the stock at the strike price, missing further upside. If the stock does not move up but only stays stagnant or goes down, then the investor will end up holding the stock and the premium.
Risk: That is, an investor will miss further price movement upward if the prices of the stock jump.
Who should use it: Those investors who have the intention of hedging against a possible decline in the stock price in which they are interested.
A protective put is a defensive strategy. When an investor buys a put option, they cover against sharp losses when the price of the stock goes down. It is somewhat like insurance where the premium for buying the put is deemed as paying for protection.
Risk: The risk is strictly limited to the cost of the premium, but the strategy protects against significant losses in the underlying stock.
Although options trading is essential and has many benefits, it can go wrong, and its intrinsic risks cannot be overlooked, most notably by novice traders. The significant risks include the following:
The managing of risk in options trading is critical to any sort of long-term success. For instance, some strategies you could use to avoid putting too much capital into one option or strategy are diversification, stop-losses, position sizing, and hedging options for managing risk by using options as part of a more diverse portfolio for hedging against market volatility and protecting your portfolio.
Options trading is indeed a fascinating yet tricky opportunity for first-timers. As long as one has learned the essential elements and usage, be it call and put options, then investors can start entering this world of derivatives without being fully confused or at risk. Like any investment, however, research needs to be done patiently, learning must be continuous, and risk must be managed.
As you start your venture into options trading, keep in mind the concepts of patience and caution. Start with simple strategies, invest time in understanding the intricacies of the markets, and take nothing at risk that exceeds your ability to lose it. Good luck with trading!
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