Traders and investors have different kinds of investments and markets to put their funds in. But selecting the right one is a challenge for them; the financial markets are huge with several instruments to trade. There are many products like futures, options, CFDs, and ETFs, etc., which could be best investments if a trader knows the market well.
Readers of the article will understand the trading of options and how to trade options? in the markets and what advantages the trading of options brings with it. Most forex and other market investors prefer options trading for a profitable investment.
So, let’s begin and understand what are options? and how to trade options?
What are the Options?
Options are the contract in the financial markets that are traded between the parties for earning good market returns over the assets or security. The contract provides the owner/holder of the option with a right to trade in the underlying security at a certain price and time without any obligation. The traders have their style of trading options, and they can set the rules accordingly.
The options are purchased by the traders in the form of compensation, and thus the assets traded have a valuation depending on the market value of underlying assets, their time period, volatility, and other market factors. The investors of options contract trade them via an over-the-counter (OTC) market or through live exchange trading with a standardised contract.
Investors trade options on the future value of the underlying asset giving traders the right of an asset by paying the premium. Thus, traders can trade with a set market price before a set date. The options come with an expiration time which traders should be aware of.
For example, a trader has an options contract that allows him to buy stocks of a company, XYZ, worth $500 for next week. So, in this situation, the trader will be able to buy the stocks of the company. If the price of the stocks goes up by $30, then the trader will get it for $500 less than the market price.
On the other hand, suppose the stock value goes down by $30 in this case, the trader does not have any legal obligation to buy the shares. The only loss that the trader will have is the premium paid by him.
Do Options Provide Leverage?
Options contracts are like the CFDs and provide their traders with the leverage. Traders can open in the market with a high market position using leverage; if the decision made by traders is correct, they enjoy double profits. However, the leverage is risky as if the investment in options comes out to be wrong; traders may lose their funds.
The options are a more attractive form of investment for market traders due to their availability with leverage.
If we want to better understand the use of leverage in options in the above discussed stock example, traders can pay $100 and use leverage to open at $500 in the market. Thus, paying the less initial amount and opening high in the market. When the price of stocks increases, traders can sell them in the market and have profits from the trade.
Hence, traders exercise the trade without having ownership of the asset and earn good profits as well. Options are an excellent trading tool if exercised properly by the investors.
How to Trade Options?
To trade options, the basic step is to understand the market that the trader is going to invest in and analyse it. Once a trader has all the information, they can easily trade and have high market profits from options. However, it is a bit of a complex process for beginners. Therefore, understanding how to trade options is necessary.
Traders can invest in the options through online brokers such as PrimeFin; they have all the facilities and services to smooth the trade with analysis and research tools. Moreover, they provide various accounts, trading platforms, order executions, etc.
Options trading is complex and requires traders to know the advanced tools and practices for benefiting from it. There are trading strategies that could be used for trading options. Here, we have discussed the steps that could be taken for smooth trade and knowing how to trade options?
The first step of the options trading is opening a trading account with a reputed and reliable online broker. The brokers provide options trading accounts for investing in the markets. However, traders should know that the trading account requires high capital investment.
The broker also verifies the investor’s past trade experience and their market potential to allow them options trading. Investors should be aware of the market risks of the trade and have capital sources for the financial investment.
The traders are required to submit the following documents for trading options:
- Investment objective refers to the capital preserved, the income of the trader, and speculation.
- Experience of the trader, thus the knowledge processed and expertise years, etc.
- Personal information relating to finance such as net worth, annual income, tax payments, employment, etc.
- Traders also need to tell brokers about their option preference, that is, the type of options to be traded.
Buy and sell of options
The second step after the broker verifies the trader is to buy and sell the options contract. A trader can choose a call option or put option depending on the style of trade and the underlying instrument. The investor buys at a strike price with a specified time period having no obligation in the call options.
On the other hand, the put options are opposite and give the trader the right to sell the underlying instrument with a specified time period and strike price.
Predicting the Strike Price
Traders have to predict the price of the options contract before the market closes; they have to know whether the price of the underlying security will increase or decrease, and based on this, they make a move. Based on this, they buy and sell the options in the market.
This is a crucial part of the trade and requires investors to predict the market change accurately. They need to analyse and research the market for this.
Options Time Frame
Another essential part of options trading is determining the expiration time of the contract. It provides the last day of the trade that traders can exercise their rights. Traders can use either the American or the European style of trading, depending on the options they exercise. Traders need to have a time frame set for the options contract for benefiting from the trade.
With all these points in mind, traders can invest in options and earn profits. They have to, however, monitor the trade regularly and keep investing in the market for a fantastic trading experience.
Styles of Trading Options
In how to trade options, we came across the time frame of the options contract, which requires investors to select their trading style. In the options market, a trader can go for two specific styles, the American and the European.
The American style requires traders to exercise their rights to trade options any time before or at the time of expiration of the contract. The style allows traders to have profit from favorable price movements of the underlying assets. Thus, traders can buy and sell the instruments at the strike price before the contract expires.
Investors have the freedom of exercising their rights anytime during the contract; the style of trading is more used than other styles of trading. However, traders may have to pay a premium or some amount for exercising their rights early.
The European style of trading is the opposite of the American style, where traders can exercise their right at the time of expiration date only. Thus, traders of the underlying asset can buy or sell it when the option matures.
Types of Options Contracts
Options contract has been divided into two types; call and put. A trader can decide upon market prediction if they want to have a call option or a put option. These are important parts of the trade, and the option contract is incomplete without the selection of its type.
The derivative contract we know uses two styles of trade which are also impacted by the type of option traded. Below we have discussed the call and put options for easy understanding of the readers.
In the call option, the investors get the right to buy the underlying instrument without any obligation of buying it at the strike price offered in the contract. The call option right is exercised when the investors believe the price of the traded instrument will increase in the near future.
The investor of the option contract gets the right to sell the underlying security without any obligation at the specified strike price. The investor sells the traded instrument in the market with the option. A trader can buy puts when the price increases and sell puts when the price falls.
Use of Options
The investors of the financial market use the options contract for three specific reasons. The risk of hedging, determining the right time to buy, and speculation. However, there are several other uses of the contract, but here, we have focused on the three main reasons for traders’ understanding of how to trade options?
The options contract initially was introduced as the hedging tool in the financial market. It was used to minimise the risks of the market and diversify the portfolio. We can understand this with an example, suppose a trader buys shares of a company and is suspicious of the fall of its price in the market.
To minimise the risk, traders use the options to sell the stocks at a price decided which is close to the current market level. When in the near future the price of the stocks falls, traders can exercise their options right and sell the stocks. This will limit the loss of the trade.
In contrast, if the price of the stocks increases, the trader does not have a huge loss and only pays the premium cost.
Determining the Buying Time
The option contract gives traders the time to decide over their investment. In the contract, if a trader has doubts about the investment, they can use options. Traders can buy the instrument with options contracts without any obligation. Moreover, they have a time period for contract maturity and the strike price.
Traders can exercise their rights after analysing the market, and if they do not want they only face the premium loss.
In how to trade options, speculation is also a great choice for investors. The options are flexible investments that make them popular for speculation in the market. The options contract has specified time and strike price to trade the right without any obligation. So, the speculators trade only to benefit from the premium price they can buy and sell it immediately when they see a profit.
Thus, speculation is a great choice in options trading. Traders can benefit from numerous ways using the options to trade and invest in the financial markets.
Trading has been fascinating for several years, but the derivative products have attracted many investors and traders. Options are one of the most invested derivatives providing traders the right to trade without obligation on specified time and price. A trader can benefit from the options using speculation and hedging as well.
However, a trader requires a good income source, capital to invest and preservations, etc., for investing in the options. A trader verifies the knowledge and trade expertise of the option traders before allowing them to trade online. Options trading is not that easy as it sounds, and traders need to have full market research and analysis for profiting from it. Also any investor would need a trusted and reputable broker to trade options with, PrimeFin is our recommended broker for the trading experience an investor can get.