How Exactly Options Trading Work

If you want to try something else other than cryptocurrency, Forex, futures, or stock investments in your portfolio, options trading can be a good option to grow your income, limit your risk, and hedge against market changes.

Options are the most versatile instrument ever invented. Since options trading costs less than stocks, they provide a high leverage approach to trading that can significantly limit the overall risk to a trader or provide additional income. Options trading is being recognized by both experienced and new investors, contributing to its phenomenal rise.

Options trading can be used to maximize your stock portfolio. When investors combine the two, they have more options than if they simply traded equities.

Options trading can function in a similar way to an insurance policy. If the value of a stock you own falls, for example, buying certain types of options can help you offset any possible losses on your stock.


Definition of Options | How do they work?

An option is the right, but not the obligation to buy or sell the underlying asset at a specific price, on or before a specific date.

There are no margin requirements if you want to purchase an option because your risk is limited to the price of the option. In contrast, option sellers receive a credit in their account for selling an option and get to keep this amount if the option expires worthless.

However, option sellers also have an obligation to buy or sell the underlying asset if an assigned option holder exercises their option.

Therefore, selling an option requires a healthy margin.

options

3 Parts of a Standard Options Quote

1. Strike Price

The price at which an underlying asset can be purchased or sold if the option is exercised is called the strike price. Options trading is available at several strike prices above or below the current price of the underlying asset.

2. Expiration Date

The date the option expires is referred to as the expiration date. A stock option expires by close of business on the 3rd Friday of the expiration month. All listed options have options available for the current month and the next month as well as specific future months.

Each stock has a corresponding cycle of months that they offer options. There are three fixed expiration cycles available. Each cycle has a four-month interval:

  • January, April, July, October
  • February, May, August, November
  • March, June, September, December

3. Premium

The price of an option is called the premium. An option’s premium is determined by a number of factors including the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.

  • Buying an option creates a debit in the amount of the premium to the buyer’s trading account.
  • Selling an option creates a credit in the amount of the premium to the seller’s trading account.

Once you own an option, there are three methods that can be used to make a profit or avoid loss:

  1. Exercise it – by exercising an option you have purchased, you are choosing to take delivery of (call) or to sell (put) the underlying asset at the option’s strike price. Only option buyers have the choice to exercise an option.

    Option sellers, on the other hand, may experience having an option assigned to an option holder and subsequently exercised.
  2. Offset it with another option offsetting – is a method of reversing the original transaction to exit the trade. If you do not offset your position, then you have not officially exited the trade.
  3. Let it expire worthless if an option has not been offset or exercised by expiration, the option expires worthless. If you originally sold an option, then you want it to expire worthless, because then you get to keep the credit you received from the option premium.

    Since an option seller wants an option to expire worthlessly, the passage of time is an option seller’s friend and an option’s buyer enemy.

2 Different Types of Options

Start by learning about the many types of options you can trade to build your understanding of options trading.

1. CALL OPTIONS

Call options give the buyer the right, but not the obligation, to purchase an underlying asset. They are available at various strike prices depending on the current market price of the underlying asset. Depending on the mood of the market, you may choose to buy or sell a call option.

Buying a Call Option

If you choose to buy (or go long) a call option, you are purchasing the right to buy the underlying asset at whatever strike price you choose until the expiration date. The premium of a long call option shows up as a debit in your trading account.

The premium amount represents the maximum risk a long call strategy can incur. Profit is made on a long call when the price of the underlying asset rises above the strike price of the call.

The call’s premium will increase in value depending on how high the underlying asset rises in price beyond the strike price of the call. As the price of the underlying asset rises, the long call becomes more valuable. That is why you want to go long a call option in a rising or bull market.

Selling a Call Option

If you choose to sell (or go short) a call option, you are selling the right to buy the underlying asset at a particular strike price to an option holder. Selling a call option prompts the deposit of credit in your trading account in the amount of the call’s premium – a limited profit. You get to keep this credit if the option expires worthless.

Thus, to make money on a short call, the price of the underlying asset must stay below the call’s strike price. If the price of the underlying asset rises above the short call’s strike price, it will be assigned to an option holder who may choose to exercise it.

The maximum loss is unlimited to the upside, which is why selling unprotected call options come with such a high risk. Short-call options are used in stable or bear markets.

Types of Call Options

  • In-The-Money – if the current market price is more than the strike price
  • Out-Of The Money – if the current market price is less than the strike price
  • At-The-Money – if the current market price is the same (or close to) the strike price

2. PUT OPTIONS

Put options give the buyer the right, but not the obligation, to sell an underlying asset at the strike price. Put options come at various strike prices depending on the current market price of the underlying asset with a variety of expiration dates.

Unlike call options, you might consider buying a put option if you expect market prices to fall. In contrast, if you are expecting the market to rise, you might consider selling a put option.

Buying a Put Option

If you choose to buy (or go long) a put option, you are purchasing the right to sell the underlying asset at the strike price you choose until the expiration date. The premium of the long put option will show up as a debit in your trading account.

The cost of the premium is the maximum loss you risk by purchasing a put option. The maximum profit is limited to the downside as the underlying asset falls to zero. If the price of the underlying asset falls, the corresponding put premium increases and then is sold at a profit.

Selling a Put Option

If you choose to sell (or go short) a put option, you are selling the right to sell the underlying asset at a particular strike price to an option holder. The premium of the short put will show up as a credit in your trading account.

In most cases, you are anticipating that the short put option will simply expire worthless on the expiration date so that you keep the premium received. The premium amount is the maximum profit you can receive by selling a put option. Selling put options are used in a stable or bull market.

Types of Put Options

  • In-The-Money – when the strike price is higher than the market price
  • Out of-The-Money – when the strike price is lower than the market price
  • At-The-Money – when the strike price is equal (or close) to the market price

What Affects Options Trading Prices?

Option pricing is based on a variety of factors. There are seven main components that affect the premium of an option.

  1. The current price of the underlying asset
  2. The strike price of the option in comparison to the current market price (intrinsic value)
  3. The type of option (call or put)
  4. The amount of time remaining until expiration (time value)
  5. The volatility of the underlying asset
  6. The current risk-free interest rate
  7. The dividend rate, if any, of the underlying financial asset (only stocks)

Primary Determinants of an Option’s Price

Intrinsic value and time value are two of the primary determinants of an option’s price. Intrinsic value can be defined as the amount by which the strike price of an option is in the money. It is actually the portion of an option’s price that is not lost due to the passage of time.

factors affecting options

At-the-money and out-of-the-money options do not have intrinsic value, because they do not have any real value. You are simply buying time value, which decreases as an option approaches expiration. The intrinsic value of an option is not dependent on the time left until expiration.

Time value is the amount by which the price of an option exceeds its intrinsic value. Also referred to as extrinsic value, time value decays over time.

In other words, the time value of an option is directly related to how much time an option has until expiration.

Volatility

Volatility is one of the most important factors in an option’s price. It measures the amount by which an underlying asset is expected to fluctuate in a given period of time. It significantly impacts the price of an option’s premium and heavily contributes to an option’s time value. Volatility can be viewed as the speed of change in the market.

Volatility measures the speed of change in the price of the underlying asset or the option. The higher the volatility, the more chance an option has of becoming profitable by expiration. That is why volatility is the primary determinant in the valuation of options premiums.

Liquidity

Liquidity is the ease with which a market can be traded. A plentiful number of buyers and sellers boost the volume of trading producing a liquid market. Liquidity allows traders to get their orders filled easily as well as to quickly exit a position.

You can determine the liquidity of a market by reviewing the market’s volume to see how many shares have been bought and sold in one day. As a rule of thumb, you s should choose markets that trade at least 1 million shares a day. It is also important to ascertain whether or not the trading volume is increasing or decreasing.

This kind of volume movement is studied to indicate turning points in the market price action.

Leaps

Long-term Equity Anticipation Products (LEAPS) are options that do not expire for at least 9 months and can have an expiration, of 2 or 3 years out. Once an option’s expiration gets closer than 9 months, they become plain options again with an entirely new ticker symbol.

The expiration is a long way off and that makes them prime candidates for long-term plays and secure bets for shorter-term trades.


How To Use Options?

Options can be used in a variety of ways to profit from a rise or fall in the underlying market. The most basic strategies employ put and call options as low capital means of garnering a profit on market movement.

Options can also be used as insurance policies in a wide variety of trading scenarios. Options increase your leverage by enabling you to control a specific asset without tying up a large amount of capital in your trading account.

The amazing versatility that an option offers in today’s highly volatile markets is relief from the uncertainties of traditional investing practices. Options can be used to offer protection from a decline in the market price of a long underlying asset or an increase in the market price of a short underlying asset.

You can also use options strategies to profit from a move in the price of the underlying asset regardless of market direction.

There are two general market directions:

  • Market up
  • Market down

It is important to assess potential market movement when you are placing a trade. If the market is going up, you can buy calls, sell puts or buy the underlying asset. But you can combine long and short options and underlying assets in a wide variety of strategies. These strategies limit your risk while taking advantage of market movement.


Limited Risk Option Strategies

Until you fully understand the various option strategies, it is important that you concentrate initially on the limited risk strategies.

Bullish Strategies:

  1. Buy Call
  2. Bull Call Spread
  3. Bull Put Spread
  4. Buy Call/ Bull Put Spread
  5. Buy 2 Calls / Buy 1 Put

Sideways Strategies:

  1. Straddle
  2. Bull Call Spread / Bear Put Spread
  3. Bull Put Spread / Bear Call Spread

Bearish Strategies:

  1. Buy Put
  2. Bear Put Spread
  3. Bear Call Spread
  4. Buy Put / Bear Call Spread
  5. Buy 2 Puts / Buy 1 Call

Defensive Strategies:

  1. Covered Calls
  2. Covered Puts
  3. Covered Call/ Buy Put
  4. Covered Put/ Buy Call

Since I primarily day trade crypto, I know that I am not into this options trading very much. So, if you’re curious to know more, just click the button, and I’ll take you through day trading:

As always, if you have any questions about this topic, feel free to comment down below and I’ll get back to you soon!

-Martina

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