How to Trade Options

What is Option Trading?

An option is a contract which grants you the right, but not the obligation to buy or sell an underlying asset at a set price on or before an expiration date. Options are a type of derivative security. It allows you to buy or sell stocks, ETFs, etc at a specific price within a specific date. There are two types of options. One is the Call option and the other is a Put option. A call option gives you the right to buy a stock and a put option gives you the right to sell a stock.

Options Trading Terminology

Following are the main options trading terminology.

Holders and Writers.

Premium.

Strike price.

Expiration Date

In the Money

Out of the Money

At the Money

Break-event Point

Option Trading Strategies

The Long Call

The long call is the simplest option trading strategy, where you buy a call option or go long. The holder of the option expects the underlying market to increase in value. As the market price rises the option premium also rises and the buyer would be able to earn profit by selling his option before expiry.

If the buyer holds his option until expiry and the price of the underlying asset is above the strike price, then the buyer will be able to exercise his right to buy at the strike price and earn profit in that way.

So, buying a call option is a simple and popular strategy because the holder of the option cannot lose more than the premium he pays to open the contract.


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The Long Put

Another simple options trading strategy is to buy a long put option. It is similar to the long call except for the buyer of the option expects the underlying market to decrease in value.

As the market price decrease, the option premium also rises and the buyer would be able to earn profit by selling his option before expiry. Or, if the buyer holds his option until expiry and the price of the underlying asset is below the strike price, then the buyer will be able to exercise his right to sell at the strike price and earn profit in that way.

So, buying a put option is also a simple and popular strategy because the holder of the option cannot lose more than the premium he pays to open the contract.

Risk-Free Options Trading

Covered calls are generally considered one of the safest investment strategies because it has two parts. According to this strategy, an investor must first own the underlying stock and then sell a call on the stock.

According to this strategy, the written Call option is in the money. And the current market price of the stock to be above the strike price of the call options at the time of entry.

The next main point is to Buy the same contract out of the money Put options at the same strike price with the same expiration time of your call options.

One of the important parts is that you need to ensure that the difference between the strike price of call and put options and the current market price of the underlying stock.

The out-of-money put options will be cheaper than the in-the-money call options. Now we assume there is no implied volatility. As a result, the difference between call option premium and put option premium will be your risk free profit.


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Why Should You Use Options?


  1. Speculation

Speculation is a bet on the direction of future prices. Based on fundamental or technical analysis, a speculator may believe that the price of a stock will rise. A speculator may purchase the stock or a call option on it. Some traders prefer to speculate with a call option rather than buying the stock outright since options provide leverage. When opposed to the entire price of a $100 stock, an out-of-the-money call option may only cost a few pennies or even cents.

  1. Hedging

Options were created specifically for the purpose of hedging. Options hedging is intended to reduce risk at a reasonable cost. We can consider employing options such as an insurance policy in this case.

Assume you wish to invest in technology stocks. You do, however, want to keep your losses to a minimum. Put options allow you to limit your negative risk while still enjoying all of the gain in a cost-effective manner. Short sellers can use call options to limit their losses if the underlying price swings against their transaction, particularly during a short squeeze.