“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.” ~ Warren Buffett
Options are financial contracts whose values are tied to another underlying asset.
Options trading can be an appealing way to build wealth or manage risk, especially if you’re looking beyond just investing in stocks, bonds, and other assets in your portfolio.
But options trading can be a complex and challenging endeavor. The key to success in options trading is understanding the basics, including knowing what options are and the risks and rewards involved.
Options Basics
Options are contracts giving the purchaser the right to buy or sell a security, like a company stock or exchange-traded fund (ETF), at a fixed price within a specific period of time.
Options holders can buy or sell by a certain date at a set price, while sellers have to deliver the underlying asset. Investors can use options if they think an asset’s price will go up or down or to offset risk elsewhere in their portfolio.
Options are financial derivatives because they’re tied to an underlying asset. Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as S&P 500 or oil futures, are also popular among traders and investors.
A stock option typically represents 100 shares of the underlying stock. Stock options are common examples and are tied to shares of a single company. Meanwhile, ETF options give the right to buy or sell shares of an exchange-traded fund.
An option is a contract between the holder and the writer. The holder (buyer of the contract) pays the writer (seller of the contract) a price – the premium – for the right to buy or sell the underlying asset.
Option holders can buy or sell the underlying security by a specific date (called expiration date) at a set price (called the strike price). If the option holder exercises the contract on or before the expiration date, the option writers must deliver the underlying asset.
Many investors get interested in options trading because it can be a way to generate income, speculate on the price movements of securities, as well as a way to hedge against losses. However, with these possibilities, they are downsides to options trading too.
Before diving into the world of options contracts and options trading, it’s essential to understand the benefits and risks of this investment strategy.
Some of the main advantages of options trading are:
- Options give you the chance to make money whether the market is going up, down, or sideways.
- Options may be an inexpensive way to participate in the market without tying up as many funds as stock or bond trading requires.
- Options provide investors with leverage, which can help magnify returns.
Some of the main drawbacks of options are:
- Options trading is a complex and risky strategy and one that requires a great deal of knowledge and experience to succeed.
- Options involve a great deal of leverage, which can amplify losses if the trade goes against the trader.
- Options contracts are not always as liquid as other securities, making them harder to buy and sell.
Options are a complex, risky market and may not be suitable for everyone.
“Successful trading depends on the 3M`s – Mind, Method and Money. Beginners focus on analysis, but professionals operate in a three dimensional space. They are aware of trading psychology their own feelings and the mass psychology of the markets. Each trader needs to have a method for choosing specific stocks, options or futures as well as firm rules for pulling the trigger – deciding when to buy and sell. Money refers to how you manage your trading capital.” ~ Alexander Elder
References: