Learning how to trade options
Options trading is a distinctive and unique way to trade as it involves the buying and selling of what is called ‘options contracts’. These contracts give the holder a right, but not an obligation, to buy or sell an underlying asset at a specific price on a predetermined date.
Options trading is slightly more complex than trading stocks, mutual funds of bonds, and certainly comes with much higher risks. However, it also comes with a much higher reward if done correctly and investors are typically drawn to the practice to diversify their portfolio and increase their capital.
Although options trading is seen to be reserved for the most advanced investors, in reality almost anyone can participate in options trading. You just need to have the right skills, knowledge and experience.
What is options trading?
To put it as simply as possible, options trading is the trading of a financial instrument, security or asset that gives the investor or trader the right to buy or sell a contract at a pre-determined price by a pre-determined deadline. It is one way to lock in a set price over a certain timeframe, like a year or a month, so as not to fall victim to price fluctuations where the value of the asset may rise, or fall, in this time.
Options are also financial derivatives. This means that they acquire their worth from the underlying security. There is always a buyer and a seller at play in options, and where someone wins, another must lose.
The key to remember is that the trader has the right, but not the obligation, to trade the contract. This is referred to as ‘exercising the option’ and there are two basic methods to do so (‘calls’ and ‘puts’).
However, options trading often sounds more convoluted than it really is.
Puts and calls options
Puts and calls options are the two main types of options trading. Before you engage in the options market, it is vital that you understand the difference and apply the best approach which suits your style of trading.
For instance, a call option is when you have the right to buy a stock at a specific price – referred to as the ‘strike price’ – at any given time before the contract of that option expires. Meanwhile, a pull option is where a trader or investor has the right to sell a stock at its strike price before the contract terminates.
However, these are not the only ways to participate in options trading. Indeed, there are many different styles and variants within the options niche. Consider for instance that there is an American-style option and a European-style option, both of which have different rules and apply to different stocks. You must commit to learning the different styles and regulations if you wish to successfully trade in options.
How does it differ from regular trading?
Options trading is in stark contrast from regular stock trading. The key difference between the two is that while stocks represent a stake or share of ownership in a company, options are contracts involving other investors where you ‘bet’ on which way a stock price is going.
Options have many different characteristics, regulations and rules in place which regular traders do not have to contend with. To be successful, investors need to expand their knowledge by learning new terminology, concepts and trading methods.
In addition, options trading involves the trading of different and more complex underlying securities, such as equities and indexes. It can be an entirely new market for some traders who are not familiar with these types of trades.
Options trading also comes with a higher degree of risk. Investors need to operate with a strict entry and exit strategy and adhere to their own calculated risk which involves studying historical volatility.
Advantages and risks of trading options
The risk of options trading can be huge. One wrong turn, no matter how seemingly small the mistake is, can be extremely costly and put you at a serious setback. It is much riskier investing in options than it is to buy stocks or bonds.
However, with greater risk comes greater reward. A key advantage of trading options is that it offers much more liquidity and therefore scope for a higher capital. Options are also much more flexible, allowing you to invest with smaller sums while reaping bigger rewards.
How to learn to trade options
Evidently, trading options is not for the faint-hearted. You’re up against other experienced investors and you have to adhere to an unrivalled strategy that puts you on top.
The best way to learn how to trade options is through an accredited financial course. Despite the mass amounts of resources online, options trading is one venture where you’re going to need a diploma or similar qualification to truly understand the practice. You’re also going to need to learn how to safeguard yourself from the prevailing dangers, which you cannot learn alone.
Alongside your studying, you should also set up a practice account. This is the next best thing to the real deal as you’ll be able to oversee how successful, or unsuccessful, your options trading plan works.
But don’t stop there: seek a mentor, consume as much financial content as possible and read books and articles in your spare time. Whatever you can do to expand your knowledge on options trading is vital – and may make all the difference between winning and losing in options.
Do I need qualifications to become an options trader?
A degree or higher education in a finance or related field is always ideal if you’re looking to break into a career in trading. However, it is not essential and there are plenty of resources online to learn from. Fast-track financial courses and diplomas that are taught online can also assist you in your goal of becoming an options trader.
Is options trading for me?
Whether or not options trading is for you entirely depends on your commitment to learn and your personality. However, if you already have a keen eye for stocks, there’s no reason why options trading can’t be another way for you to diversify your portfolio and protect your overall capital.