Introduction to Options Trading: What You Need to Know Before Getting Started
Options trading can be an intimidating topic for beginner investors, but it doesn’t have to be. With some basic knowledge about what options are, how they work, and the strategies involved, anyone can get started in options trading. Here is a beginner’s guide to the world of options.
What Are Options?
An option is a type of contract that gives you the right, but not the obligation, to sell or buy an underlying asset for a specific price on or before a certain date. This could be a bond, stock, commodity, currency, index, or anything else that has a market value.
The two main types are:
• Call options give the holder the right to buy the underlying asset at a specified price within a specific period. Call buyers hope the price of the underlying will go up before the option expires.
• Put options give the holder the right to sell the underlying asset at a specified price within a specific period. Put buyers hope the price of the underlying asset will go down before the option expires.
Every options contract has an expiration date by which the option must be exercised. Standard expiration cycles are monthly, quarterly and yearly. The more time until expiration, the more time the underlying asset has to reach the target price and the more expensive the option.
Options come with significant risk and reward potential. The main advantage of options is that you can gain exposure to stocks and markets while investing much less money than buying the asset outright. However, if the option expires out of the money, you lose 100% of your investment. Calculator tools can be used to calculate profits and help understand options risk.
Why Trade Options?
There are a few key reasons investors trade options:
• Leverage – Options enable leverage because you can control a large position with a relatively small amount of money. This allows for strong profits if the trade works out.
• Hedging – Options can be used to hedge an existing position in your portfolio to reduce risk. For example, if you own a stock, you can buy a put option on that stock to protect against downturns.
• Speculation – Options allow you to speculate on the price movement of assets, enabling higher returns than simply buying and holding the asset.
• Diversification – Options give you more ways to generate returns and diversify your strategies beyond just buying and selling stocks.
• Income – Options strategies like covered calls generate income from your holdings in the form of premiums.
Options Trading Strategies
There are numerous options trading strategies suited for beginners. Here are a few of the main ones:
• Long calls
• Long puts
• Covered calls income
• Cash secured puts
• Vertical spreads
No matter your strategy, it’s essential to use stop losses and maintain good risk management. Never risk more than you can afford to lose.
How to Get Started
If you want to get your feet wet trading options, here’s what you need to know:
First, choose a brokerage account and apply for options trading approval. Brokers require you to apply separately for options trading once your account is open. Approval depends on your investing experience.
Develop your investing strategy. Study up on options and pick a prudent strategy based on your capital, risk tolerance and goals. Long calls or puts are good starting points. When you are ready, make your first trade. Start small to get the hang of ordering options trades and managing risk. As you gain experience, you can slowly increase position sizes.
Manage your positions. Track your profit/loss daily and adjust or close positions before expiration to take profits or limit losses.
The keys are to start small, learn continuously, develop disciplined trading habits, and keep emotions out of decisions. With the right guidance and smart strategies, options can be an effective trading tool for many investors.