Options Trading: A Step by Step Guide to Understanding and Investing in Option Trading
As an investor, there are many options you have in the investing market. As an investor, you need to start investing with the aim of building your portfolio. You can always build your portfolio using different asset classes like ETFs, Bonds, Stocks, and also mutual funds. Options trading also forms another class of assets that you can invest in. Options trading allows you to diversify your investment plan, and even though it is highly risky, the returns are also high.
What is Options Trading?
Before setting your investment in options trading, you need to understand the concept of option trading fully. As per the definition, options trading is the exchange of instruments that allows you to buy or sell specified security on a set date and set price.
We can also understand options trading as contracts that give you the right (but not the obligation) to either sell or buy some set amount of assets at a certain price or before the expiry date of the set contract.
Types of Options Trading
There are two types of options in trading. This is to set the right base towards understanding how options trading works. Here are the two types;
Call Option- a call option gives you as an investor a right to buy an underlying security at a designated price within a specified range of time. The price you pay for the called security is the strike price, while the date you call the security is the expiration date.
With the call option, you can decide to trade the options using the American Style (buying the underlying asset at any time, including the expiry date) or the European Style (only buying the assets on the expiry date).
Put Option- the call option works in an opposite manner to that of the call option. The put option only allows you to sell the underlying security at any time and at any price.
After understanding the basics of options trading, it's time now to understand how to trade with the options exactly. Here is a simple four-step process.
How to Trade Options
Opening an Option Trading Account
This is the first step that ushers you into options trading. The opening of an options account requires a lot of capital that will indicate that you really want to start trading. Because it requires deep research and studying and predicting the behavior of numerous moving parts, you need to convince the brokers that you are a potential client before you can start trading.
As you open this account, the brokerage firm has to assess your potential as a trader to screen your trading potential, your understanding of the risks involved, and your financial preparedness. After assessing you, the documented report is stored in an options trading agreement that you used to request for your prospective broker.
Before your options trading account is approved, you need to provide the following;
Your Trading Experience- before the broker agrees to work with you, he/she must know your knowledge in the options trading platform, how long you have been trading the options, how many trades you make each year, and many more experience-related parameters.
Your Investment Objectives- this includes the data of your income, capital preservation, speculation, and even growth.
The Type of Options you need- the type of options you want will help your brokerage form to set aside resources and information that will help you understand and keep a check on your investment.
Financial Information- here, your broker may wish to access your personal financial information to assess your net worth. This will help them determine whether you are prepared to invest in options trading.
After availing of the above information, the brokerage firm you choose will assign you an account level ranging from 1-5, one being the lowest risky account. Because you need to access options trading tools, information, guidance, and support, you need to do a deep search to make sure you get the right brokerage firm.
Deciding the Options, You Wish to Buy or Sell
Just as a reminder, the type of Option you choose will determine whether you will buy or sell securities. A put option lets you sell shares at a stated price before your contract expires, while a call option lets you purchase shares at a strike price within a specified time.
After carrying out your analysis and receiving the third-party idea from the research tools, you could have predicted the future of shares. This will help you decide on the type of options trading you will pick.
If you predict that the price of the stock will rise, sell the put option and buy a call option
If you predict that the price of the stock will drop, sell a call option as you buy a put option
Lastly, if you predict the stability of the price, sell one of the options depending on the demand at the moment when you want to sell the Option.
Predict the Strike Price of the Option You Have
This is the third stage leading you to invest in options trading. You need to understand that the option you buy will only remain valuable if the stock price closes your option’s expiration period. This means that the price should be above the strike price for a call option or below the strike for a put option. Make sure you buy an option that reflects the price you predict at a certain period of time.
An example is here for you; if you predict that the share of a particular company currently trading at $120 will rise up to $140, you need to buy a call option that comes with a price less than $140.
Ascertain the Option Time Frame
This is the last step towards investing in options trading. By now, you are aware that every option contract has an expiration period. As earlier stated, you can enjoy two styles of options trading; the American style and the European options trading style. If you choose to be a holder of the American option trading style, you will be free to exercise at any time within the expiry date, while if you choose to be a holder of the European options trading style, you can only exercise on the expiry date.
The expiry dates for different options trading have different expiry dates that range between weeks, months, and even years. The options that last for just a day or weeks are known to be the riskiest but maybe the best if you are a seasoned trader. If you are a long-term investor, it is advisable that you go for the options that last for years. You need to remember that the longer the expiration period, the more expensive the option will be.
FAQs About Options Trading
What is Exercising an Option?
Exercising is the buying and selling of the option at a stated price.
How is the Options Trading Risk Measured?
The risk analysis of the options trading is measured using four different parameters: Theta, Delta, Gamma, and Vega.
Are Options Taxed?
Yes. Whether you a call or a put option, they will be taxed depending on their expiration period or holding time. They will also incur capital gains, but beyond this, the specifics of the tax that is charged on the options will rely on their holding time, whether covered or naked.
If you want to invest in options trading, you need to understand their basic concepts as they are easy to grasp. Options trading can give you the best opportunity of growing your money if you can use them correctly. The options are the right channel you can use to grow your wealth.