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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

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?

Options trading is a form of investing where traders buy or sell contracts, called options, that have some predetermined parameters. A holder of an option has the right to buy or sell a particular underlying asset at a set price (called the strike price) within a set time frame. These contracts derive their value from the performance of the underlying asset, which could be stocks, commodities, currencies, or even indices.

Options trading offers traders a way to profit from changes in the underlying asset's price without actually owning it. This can provide opportunities for leveraging investments, hedging against potential losses, and generating income through various trading strategies, but it can also come with substantial risks.

One more thing to note: an option is just as the name suggests — optional. Holders of options aren’t obligated to exercise them and can choose to let them expire instead.

What are the types of options trading? 

There are two main 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.

In addition to these basic types, there are also more specialized forms of options trading, such as:

  • 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.

Understanding the different types of options trading allows traders to choose the most suitable strategies based on their risk tolerance, market outlook, and investment goals.

Strategies for options trading

Options trading offers many strategies that traders can employ to capitalize on various market conditions, manage risk, and (hopefully!) achieve their investment objectives. Here are some common options trading strategies:

  • 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. 

These are just a few of the options trading strategies available to traders. Each strategy has a unique risk-reward profile, and various factors like market outlook, risk tolerance, and investment objectives can influence the choice of strategy. Before implementing any strategy, traders should thoroughly understand the mechanics of it and how it could affect their trading activities.

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What are the risks of options trading?

Options trading offers several benefits and opportunities, including leverage, risk management, flexibility, and diversification. But it also has inherent risks, such as: 

  • 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.

Overall, while options trading has plenty of benefits, traders need to carefully consider and manage the risks that come along with it — just like with all types of investments. Your best bet if you’re interested in options trading? Develop a solid understanding of options strategies, risk management techniques, and market dynamics — this kind of knowledge can help you successfully navigate the complexities of options trading.

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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.

By N26

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