62.58 billion. This is the total number of futures and options contracts traded worldwide in 2021, according to data released by the FIA (Futures Industry Association). This is 33.7% more than in 2020. Last year was the fourth year that “the global derivatives exchange markets set a year-over-year record in terms of overall trading activity.”
These types of stocks have shown rapid growth in recent years. Experts expect the numbers to rise in 2022 due to interest in options trading.
In recent years, option trading has become one of the most preferred investment vehicles. For beginners, this can be a daunting task. There is too much information on the market that often needs to be clarified. Getting lost in a sea of options is easy without proper guidance and knowledge.
Before embarking on your trading journey, you must first understand what options are. We have written this guide for beginners who want to enter the world of options but need more knowledge and want to improve.
What are option contracts?
Trading options involve buying and selling the underlying asset at a predetermined price at a specific date in the future. Option contracts are derivative contracts that give buyers the absolute right (but not the obligation) to buy or sell the underlying asset at a predetermined price and date in the future. The underlying assets can range from stocks and bonds to market indices or derivative contracts. To qualify, buyers must pay sellers a premium, known as the option premium.
These derivatives are divided into call or put contracts. The buyer of the option acquires the unconditional right to purchase the underlying asset in the future at a predetermined price, known as the strike price, or strike price in the case of a call option. On the other hand, those who hold a put option have the unconditional right to sell the underlying asset on the expiration date at a predetermined strike price.
Buyers exercise their rights only if the market moves in a direction that increases the value of that right. If market prices are unfavorable for holders, they do not exercise their rights and the options become void.
Important conditions for option trading
It is very important to understand these few terms about options trading:
- Execution price: A predetermined price agreed upon when purchasing an option contract.
- Training date: The date until which the holder of the option has the right to exercise it at the strike price. After this date, opportunities tend to become useless.
- Intrinsic value: The intrinsic value of an option contract is the difference between the strike price of the option contract and the price at which the underlying asset is currently trading.
- External value: The extrinsic value usually takes into account factors other than those taken into account when calculating the intrinsic value that affect the premium. This may include items such as the duration of the option.
- In-the-money and out-of-the-money options: This is necessary in order to determine whether the option is profitable or not. The price is determined by the underlying security and the time remaining until the options expire.
- American options: Investors can exercise these options at any time before expiration.
- European options: These options can only be exercised on the expiration date.
Steps to follow when trading options
If you are about to start your options trading journey, follow all the steps below:
1. Open an options trading account
If you want to trade options, you must have an options trading account. Compared to a simple stock brokerage account, an options account usually requires a higher capital investment. Also, due to the higher complexity, brokers require more information about the trader (his income, liquid equity, capital preservation or speculation, investment knowledge, etc.). Thus, an options trading account consists of several more steps than an exchange one. trading account.
The broker will assign an initial trading level based on risk levels, which will be the trader’s key to placing certain types of options trades. If you want to trade both stocks and options, you can choose broker which offers both services.
2. Choose an option contract
After successfully opening an options trading account, you must select the type of option contract you want to enter into. If you expect the market to grow, buy call option or sell a put option. If the market goes down, sell a call option or buy a put option. However, you can sell a call or a put if the market is stable.
3. Predict the strike price
An option contract is only valuable if the price of the underlying stock closes the option’s expiration period in-the-money, i.e. above or below the strike price. (Above for calls and below for puts.) Thus, predicting the correct strike price is extremely important. Note: You cannot select any exercise price. Options quotes, also called option chains or matrices, consist of a range of available strike prices based on the stock price and their increments are standardized across industries. In addition, the premium paid is also classified into intrinsic and time value.
4. Predict option time frames
All option contracts have an expiration date that varies from a few days to months and years. This period, too, cannot be invented from scratch. Daily options usually carry a higher risk. If you are a long-term investor, those with longer expiration periods are more suitable for you.
Basic options trading strategies for beginners
Choosing the right options trading strategies is very important as these strategies can decide if you can make a profit and how much. There are several market strategies, most of which are quite complex. Beginners can start with the strategies below.
- Long calls: Traders who believe that the price of the underlying asset will rise can purchase a call option on that asset with less capital than the asset itself. This strategy is relatively safe because even if the value of an asset falls, the loss is limited to its premium. However, the profit is unlimited. Only use this strategy if you have confidence in a particular stock, ETF, or index fund and want to limit your risk.
- Long ties: Traders who believe the underlying price will fall can buy put option on this asset. Since a put option works in exactly the opposite way compared to a call, a trader will benefit from this strategy when the price of a stock, ETF, or index falls. The risk associated with short selling is also reduced. Traders should keep in mind that there is no limit to the risk with a short position as there is no limit to how high the price can go and if it does, the contract will be worthless.
- Covered calls: A covered call strategy involves buying and selling a call of the same underlying asset. Traders usually resort to this strategy when the price of the underlying asset remains almost unchanged or only slightly increases. The strategy helps investors earn a premium.
- Protective fetters: A defensive put strategy involves buying a lower put option to cover an existing position in the underlying asset. It is placed on the bottom floor so that traders do not lose a lot of money, although a premium must be paid. It is ideal for traders who own the underlying asset and want to protect themselves from it.
Benefits of options trading
Options trading provides several benefits. Some of them are listed here:
- Great flexibility: Traders can choose a specific strike price and expiration date at their discretion. In unfavorable cases, they are not required to make a deal.
- Hedging portfolio: Options are a hedging tool. If you own shares in the company, you can buy put options to mitigate potential losses.
- Cost effective: Options provide an economical way to place a speculative bet while offering less risk.
Is option trading appropriate in the current economic climate?
The current year has been bad for the financial market as a whole. Concerns such as decades of high inflation, Russia’s invasion of Ukraine, or rising oil prices have driven most growth stocks down. Stock trading can seem risky in volatile market conditions, but option contracts usually thrive.
This is because, in general, option contracts are speculative and are commonly used by investors to protect against the risk of loss. It’s easier to make money using options when the market is down. Following the credible Optional Alerts the service can be useful for learning and getting trading ideas from more experienced traders.
About 943.7 million options contracts were traded in March 2022, according to the Options Clearing Corporation, and this time those numbers are 4.4% higher than last year. According to the records, March 2022 was also second largest trading month.
This article originally appeared on Geek Wealth.