Options are contracts that allow traders to exchange underlying assets or securities at a future date for a specific price. This type of contract is not binding which means the traders have the option to let it expire without using it. Hence, the name options trading.
Such contracts are based on speculations on price movements and traders can opt-out if the prices don’t move in their favor within the predetermined timeframe.
To buy an option, there is a fee called a premium. If a trader were to let the contract expire, they would lose their premium. The advantage, however, is that when price movements aren’t favorable and a trader opts out of the contract, all the trader loses is the premium. This is a lot cheaper than making losses on the actual trading position.
How Does Options Trading Work
Options are based on contracts made by traders speculating on price movements. If a trader expects the price of an underlying asset to go up, they may decide to buy an option. If the prices rise above the predetermined price within the set period, they will be able to buy the assets at a lower price. However, if the prices stay below the speculated prices the trader isn’t obligated to use the option. In such a case the traders let the option expire without any repercussions. The trader will only lose the premium used to buy the options in the first place. Premiums are usually required to open a trading position.
Essential Things To Know Before Trading Options
- Understand Options Trading Lingo
Every trader needs to under the language of the trade. Options trading is characterized by specific terms that are essential for every trader to understand. Some of these words include;
Holders and writers: A trader needs to know, who is who during a trade. Usually, an option buyer is known as the holder and the seller is referred to as the writer.
Premium: This refers to the fee paid by the holder to the writer for an option.
Strike price: This is the price at which the holder can buy or sell the underlying asset upon the expiry of the option.
Expiry date: This is the date where the options contract comes to an end i.e. the contract is terminated.
In the money: This is where exercising the option would be beneficial i.e. the trade would bring in a profit.
Out of the money: This is when exercising an option would incur losses. In such a case, letting the option expire would be the better option.
At the money: This is when the market price and strike price are the same or very close.
Break-even point: There is no difference between exercising the option and choosing to let it expire. This is because both would produce the same result i.e. the option is neither making a profit or loss.
- Understanding Factors That Affect Options Prices
To buy an option you need a premium. The cost of the option will determine whether it is a worthy investment or not i.e. it will affect the profits and losses made. Many factors affect option prices.
Speculation levels – When the strike prices are set very high or very low, then the premiums also increase. This is because these kinds of options are majorly left to expire when the speculated prices are not met within the presupposed time.
Expiry time – The length of time an option contract lasts determines its strike price. Longer-lasting contracts can ultimately increase strike prices because the market has had a good time adjusting prices movements. Similarly, if price movements move against the speculation, it also can incur some serious losses.
Volatility – Options just like most trading forms can be quite volatile. The volatility of underlying assets within the market increases their premiums.
Trading options are a unique form of trading that has unique benefits. There are some fundamental aspects about options, such as the language of the trade, that are necessary for traders, especially newbies to learn. It is also important to understand the market. Knowing the value of underlying assets, and their volatility will ultimately affect their premiums. A major benefit of options is that traders are not legally bound by the contract. They can opt-out by letting it expire.