Unless you are trading options with the intention to lose, your chances of success greatly improve if you start by learning the basics of options trading – whether your primary objective is preserving capital, collecting income or taking speculative positions.
That’s because an option is a derivative asset, whose value is derived from the value of the underlying asset whose price determines an option’s intrinsic value, sometimes known as its ‘intrinsic value’.
Basics
Market movement gives the possibility for traders to take advantage of by buying or selling options. When a contract is formed to allow the buyer of an option to acquire or dispose of some specified quantity of an underlying asset at a predetermined date and price, an option is issued and the trader’s profit can be earned.
Following financial products like stocks and indices are often traded in options.
Perhaps the foremost is that you can make big returns while investing far less money – options trading is a big part of that story. And that, finally, spreads are the perfect instrument to provide a risk-limiting structure to traders who like to use markets as a vehicle for forming opinions.
Though there are many benefits to options trading, it may not be suitable for everyone and will require time and resources. It is also more volatile than other forms of investing. Make sure your goals and risk tolerance matches before you start.
Contracts
An options contract is generally classified as a call or a put and, while both are capable of being put to use for generating income, hedging and speculating – ie, making bets on an asset’s future movements – their leverage amplifies premium payments substantially.
But they don’t come without added risk, up to and including total or unlimited losses, which is why you have to be fully aware of the risks before investing. Also, you need to set goals, understand investment objectives, assess your financial condition and risk tolerance, and form a plan so that you don’t commit potentially costly errors. Know the trading options terminology, such as strike prices, expiration dates and option premiums, and what is implied and expressed.
Strike prices
Options trading offers investors greater returns but, as with all forms of investing, it presents a measure of risk and requires specialised knowledge to be successful.
Ensuring that most of your trades are in-the-money when prompted to sell will limit your chance of selling an expired option, out-of-the-money. Or, put another way, an in-the-money option will retain value if stock prices subsequently fall. An out-of-the-money option will lapse as a valueless contract.
The strike prices offered for index and stock options allow traders to hone in on various tolerances for risk to reward as risk-parity strategies and take advantage of market movements while minimising exposure through a protected call or put. A strike price is the specified – and static – dollar per share amount at which options buyers will choose whether or not to buy or sell the corresponding shares of the underlying stock should the buyer choose to exercise the option.
Expiration dates
Expiration dates are a vital part of how options trade, and every trader needs to know the intricacies. An option contract can’t be traded after its expiration date; contracts are associated with a time period ranging from one day to several months or years.
An American-style option owner gets the right, but not the obligation, to exercise the option by a specified date. A strike allows the option buyer to purchase the underlying security at a specific price.
The closer you come to your deadline (that is, the closer you get to expiration day) the less your option will be worth (the lower its time value). The longer the time to expiration on an option, the more the option will cost (the more ‘time value’ it has) because it provides holders with more time in which to take advantage of a movement in the price of the underlying in their favour.
Taxes
While it may be a fruitful activity, trading options comes with certain tax rules that traders must adhere to; therefore, traders need to maintain good records of the trades pertaining to profit and loss to supply to the IRS and be aware of the different tax rules that may be applicable depending on the options traded, whether Futures (FFO), MOO, EFT or others.
If you’re a risk adverse investor, there’s just no way to dodge the complexity of highly nuanced tax rules regarding options trading – so better learn to live with that instrument. Hopefully, this article serves simply as an introduction, and you should make sure to do a lot more reading (or call a tax expert) before you engage in any actual transactions.
