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How Options Trading Works

Posted by on July 21, 2020 in Business, Investing and Insurance with 0 Comments

Options are powerful financial instruments that allow but do not require the bearer to buy or sell an underlying security or asset at a predetermined price before the expiration of the contract. They can be bought or sold on the options market through retail or online brokers like most other classes of assets with investment accounts. When as an investor you purchase shares at a later time usually at a stated price but within a specific period, it is referred to as “call option” while those that allow an investor to sell at a stated price but within a specific period are “put option”.

In buying or selling options, every contract has a specific expiration date in which the trader or investor can exercise their option, but it is not mandatory to do so at this point. As a result of this, they are considered derivative securities, meaning that its price is derived from other things such as the underlying instruments and this makes them less risky than stocks when they are used correctly. Some examples of these derivatives are calls, puts, swaps, futures, forwards, and so on. You can read more on this here.

The price stated on an option is referred to as strike price and it is a percentage of an underlying asset. They are not the same as stocks as they do not mean that a person owns a part of a company. You can always walk away from a contract whenever you like.

These kinds of financial instruments can add to an investor’s portfolio protection, added income, and a form of leverage. They are used in generating recurring income and for speculations when wagering on the directions that stocks will go.

Types

There are two major types which are the American and the European. This is not based on any geographical location but the time in which it can be exercised. The American can be exercised at any time between purchase and expiry while the European are exercised at expiration. There are also other types including Asian, Bermudian, exotic, and binary options.

How it Works

The value of an option is about speculating and determining the chances of future price events. This means that the higher the probability of something occurring, the more expensive the option that profits from the event will be. Also, the more the period before its expiry, the less the value will be since the chances of a price move reduces as the expiry draws close. Time is an important component when it comes to options. The more time available, the more the chances of a price move in an investor’s favor while the less the time, the less the chances of a favorable price move.

Asides time, another factor that affects its value is volatility. This is because the odds become greater when there is uncertainty. Large swings in prices will increase the possibilities of substantial moves and the greater the price, the greater the probability of an event occurring. This means that the greater the volatility, the more the value of the option. You can see the different reviews at http://daytrademethods.com/ to get a better understanding.

How to Trade

Trading options involves certain risks that you must be aware of as an investor. You will always see brokers give a disclaimer as a result of this stating that it is speculative and that there the risk of loss.

Due to its complex nature of this investment instrument and the amount of funds involved, before you start trading, you need to clear a few hurdles. Brokerage firms will usually screen potential investors to try to know more about them, their experiences when it comes to trading and how much they understand the risks before awarding a permission slip to begin trading. Some of the things you will need to provide include:

  • What your investment objectives are
  • Your trading experience; the length of time you have been involved in trading stocks, how knowledgeable you are when it comes to investing, how many trades per year you make and also the size of these trades.
  • Your personal information; net worth, employment, and annual income.
  • The kind of options that you desire.

Based on your responses to the above, the broker will give you a trading level which can be anything between 1 and 4. This serves as your pass to trading certain options types.

As an investor, it is your duty to choose a broker to trade with. Find one with experience, knowledge, tools, and a willingness to offer guidance and support especially if you are new to this kind of trading.

The Elements Involved in Trading Options

Taking out an option means buying a contract to sell or buying a stock which is usually 100 shares per contract at an already negotiated price and date. To do this, you need to

  • Speculate on the direction the stock will move. This will determine which of the types of options contract you get; whether a call or a put.
  • Predict the price move.
  • Determine the time frame the stock will likely move

When you have been able to determine these, you can then go ahead and either buy or sell.

Conclusion

Whether you are a new comer to investment or not, trading options can be very interesting and serve as a means of income or leverage for you. Ensure you do a proper research and get all the information needed before delving into it. Also, you should choose a broker or brokerage firm that is not only knowledge or experienced but also ready to offer guidance and support when you need it.

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