How To Trade Options -The Essentials Of Options Trading
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Options are derivatives. They allow traders to speculate on price movements of underlying assets with reduced risks. An option is based on an agreement between a seller and buyer. They agreed to exchange an asset for a specific price and within a specific timeframe. The advantage of options is that traders are not obligated to exercise their options i.e. they can choose not to buy or sell. When holders choose not to exercise their options, they can let the contract expire. At the point of expiry, the agreement becomes useless.
How To Trade Options
A trader can trade options on the options market.
Before trading, a trader must first set up an account through a financial services company or a brokerage firm. These firms evaluate traders’ financial position and analyze their experience before approving them.
Upon approval, there are three ways to buy options:
- Holders can hold their options until maturity. Then they can exercise the options at the strike price.
- The second way is to trade the option before the expiration date. This is where the option has bought in a profit before maturity and the trader does not think that profits may rise higher.
- The third way is to let the option expire. This is the best choice when prices never rise above the strike price (i.e. when exercising the option would lead to losses).
What Underlying Assets Can Options Be Traded On?
Options can be traded on stocks, bonds, currencies, and commodities. This provides a wide range of different types of underlying assets for traders to choose from. Let’s take a closer look at these assets.
- Stocks – This is probably the most common and known type of asset that can be traded on options. Traders have the benefit of buying options on an exchange-traded fund or index. This is essentially useful because it helps traders to benefit from overall changes within the market without having to go through the hassle of researching specific companies.
- Currency – One of the most volatile trading markets is foreign exchange. Traders can lose their investments just easily as they can make a profit. Options are useful when it comes to trading because they can be used to hedge against negative changes in the exchange rates. This will essentially protect the value of the currency in case prices move against speculated prices. For many investors that trade internationally this is an essential financial tool. If international payments are to be made in a foreign currency and the exchange rate goes up, they would incur serious losses. With an option, however, only the strike price would be required. If the price movements don’t affect the exchange rate, then traders can choose to let the option expire.
- Commodities – Prices of different products fluctuate all the time. This can either be beneficial or can harm a trader. Options can ultimately protect traders that buy or sell commodities. Speculating on price movements and paying a premium to buy an option contract can potentially save a holder from making serious losses when price movements change drastically. This also potentially lowers the risk of making losses.
- Bonds – These are majorly used options trading to protect investors against rising interest rates. Bonds have a higher value when interest rates are lower. When traders foresee and predict negative price movements, they can use options that can help protect their value. Similarly, traders can use options to make some profit if they think interest rates are going to be lower.
Advantages Of Trading Options
There are many reasons why traders may choose to trade options;
- It allows traders to speculate on price movements of securities.
- A holder may choose options as a means to protect against volatility within the underlying market.
- Investors want the opportunity to trade with as little risk as possible.
- Options trading helps protect holders against major losses.
- Because options are derivatives, traders and speculators can potentially make some huge profits with little investment.
- Options are flexible in that holders are not obligated to buy or sell before the contract expires.
Wrapping It Up
Trading options are derivatives that allow traders to speculate on price movements. There are different ways of trading options and traders need to take time to learn how this financial tool works.