What is options trading? The different types, strategies, and risks
It's complex, but it doesn't have to be. Understand what options trading is, how it works, and the potential risks and rewards.
6 min read
- Options trading involves buying and selling contracts that, in turn, give the right to buy or sell assets. The contract specifies a set price and expiration date.
- There are two main types: call options (for buying) and put options (for selling). Options traders often use strategies like covered calls and protective puts.
- Although you can use tactics like leverage and risk management, options trading also involves plenty of risk. Traders have to deal with market volatility and expiration dates, and they’re under pressure to make accurate predictions.
Are you a seasoned investor looking to expand your portfolio or someone just starting out in the financial markets? Either way, understanding options trading can be a game-changer for your investment portfolio. Options trading might sound complex, but it doesn't have to be.In this article, we'll break down the fundamentals: what options trading is, the various strategies you can use, and important risks you need to be aware of while navigating this corner of the financial market. There’s a lot to explore with options trading — let’s get started.
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What is options trading?
What are the types of options trading?
- Call options: With a call option, the holder has the right to buy the underlying asset at the strike price within the given time frame. Call options are typically used when traders anticipate that the price of the underlying asset will rise.
- Put options: With a put option, the holder has the right to sell the underlying asset at the strike price within the given time frame. Put options are typically used when traders anticipate that the underlying asset's price will fall.
- Binary options: These options have either a set payout or no payout at all, depending on their status when they expire. They’re often considered simpler and more straightforward than traditional options.
- Exotic options: These options have features that make them more complex than standard options, and there are types such as barrier options, compound options, and rainbow options. They’re often customized to meet specific investment objectives or market conditions.
Strategies for options trading
- Long call: This strategy involves buying call options with the expectation that the underlying asset's price will rise significantly before the option expires.
- Long put: Similar to the long call strategy, the long put strategy involves buying put options with the anticipation that the underlying asset's price will decline significantly before the option expires.
- Covered call: In this strategy, traders who already own the underlying asset sell call options against it. They generate income from the premiums, while potentially benefiting from upside movements in the price of the underlying asset. Owning the underlying asset can mitigate the risk, hence the term “covered.”
- Protective put: This strategy involves buying put options to protect a long position that the investor has already taken in the underlying asset. Protective puts act as insurance against potential downside risk. This can help traders to limit their losses if the price of the underlying asset drops.
- Straddle: A straddle involves buying both a call option and a put option with the same strike price and expiration date. Traders use this strategy when they expect the price of the underlying asset to be volatile, but they’re unsure about the direction of the price movement.
- Strangle: Similar to a straddle, a strangle involves buying both a call option and a put option, but with different strike prices. This strategy is used when traders anticipate significant price volatility, but they’re unsure about the direction of the price movement.
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What are the risks of options trading?
- Limited time frame: Options contracts have expiration dates, and they become worthless if they aren’t exercised by the time they expire. This limited time frame can create additional pressure for traders to accurately predict the direction and timing of price movements.
- Volatility: Options prices are influenced by market volatility. High levels of volatility can increase the premiums of options contracts, making them more expensive to purchase and potentially increasing the risk of losses.
- Complexity: Options trading can be complex, especially for beginners, due to the various strategies, terminology, and price factors. It’s very risky to start options trading without thoroughly understanding how it all works.
- Potential losses: While options trading might let you reap significant returns, you also run the risk of substantial losses. If the trade doesn’t go as expected or if the market moves in another direction, options traders can end up losing the money that they paid for the option.
- Lack of liquidity: Some options contracts may have low trading volumes and wide bid-ask spreads, which impacts execution prices and liquidity. Illiquid options markets may make it challenging to enter or exit positions at your desired prices. That increases the risk of “slippage” — that is, that there will be a difference between your expected price and the actual price.
- Assignment risk: If traders sell options contracts, there’s always a risk that the option will be exercised. If that happens, it’s called “assignment,” and it means a trader may be required to fulfill their obligations under the contract, such as buying or selling the underlying asset. Assignment risk can result in unexpected positions or additional transaction costs.
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FAQ
American options can be exercised at any time before the expiration date, while European options can only be exercised on the expiration date. It’s a really important distinction for traders to understand when choosing options contracts.
Implied volatility means the market expects that the price of the underlying asset will fluctuate in the future. Higher implied volatility increases an option's premium, making it more expensive, while lower implied volatility reduces its cost.
Selling options (especially uncovered or “naked” options) often requires you to have a margin account, as it involves significant risk. Understanding margin requirements is crucial for traders to manage risk and stay ahead of any financial obligations.
The Greeks — Delta, Gamma, Theta, Vega, and Rho — measure different factors that influence an option's price. For example, Delta measures sensitivity to price changes in the underlying asset, while Theta represents time decay. These metrics help traders evaluate and manage their positions.
Yes, strategies like selling covered calls or cash-secured puts can generate income through premiums that you receive from selling options contracts. However, these are also risky strategies, so consider carefully before diving in.
Disclaimer
These statements do not constitute investment advice relating to any financial instrument. Financial instruments can be subject to high fluctuations in value. A decline in value or a complete loss of the money invested is possible at any time.
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