Options trading allows investors to speculate on the future price of an underlying asset, including commodities, currencies, and stocks. Options contracts provide investors with the right to buy or sell the underlying asset and a predetermined date, but they’re not obliged to follow through with the sale. Options trading can be highly rewarding, but there’s also a high level of risk. Throughout this article, we’ll equip you with a solid foundation to begin exploring options trading.
Getting Started with Options Trading
Before you can trade options, you need to choose a broker and open an options trading account. Most brokers offer options trading, but some of them will have entry requirements including minimum balance and experience.
When narrowing down trading brokers, consider the fees and commissions, platform and features, and the quality of customer support. You will find plenty of customer reviews online, and you can also network with other investors to find out which ones work for other people.
Like any other means of lucrative investment, options come with a high level of risk, which you must fully understand before you get started. For example, you risk the entire amount of the premium, which means you may lose more than your principal investment.
Devising a trading plan will help you remain disciplined while making logical trading decisions. Your plan should take into account your investment goals, risk tolerance, and trading strategy.
Options Trading Strategies
There are many different trading strategies that will help fulfill any goals. Even though there are general strategies, you may need to make adjustments to suit your particular style of goals. However, the most common options trading strategies include:
- Covered calls. This strategy involves selling a call option against a stock you already own, which helps to protect against falling stock prices or to generate income.
- Buying puts. If you believe the price of an asset will fall before a certain date, then buying puts is a good idea.
- Buying calls. Buying a call gives you the right to buy an underlying asset at a specified price on a certain date. This is a popular choice if you believe an asset will rise.
- Spreads. A spread strategy involves buying and selling options contracts with different expiration dates and/or strike prices. Spreads help to lower risk and generate income.
- Protective puts. This strategy involves buying a put against a stock, and it’s typically used to protect against stock market declines.
These are just a few of the options trading strategies to choose from, but you should make sure whichever strategy you pick fits in with your risk tolerance and investment goals.
Here are a few tips for making your choice:
- Consider risk tolerance: How much money are you comfortable risking? Decide on a percentage of your balance per trade and then stick to it when choosing options.
- Know your investment goals: Are you attempting to generate income, speculate on market direction, or hedge your portfolio?
- Understand risk vs. reward for each strategy: Fully understand the risks and rewards before following a strategy.
To help make informed decisions, spend plenty of time reading educational material including blogs, podcasts, YouTube channels, and books by professional options traders like James Cordier’s complete guide to option selling.
How to Read Options Chains
An options chain is a table that shows you all available contracts for a specific underlying asset. These tables are typically shown on broker websites or trading platforms.
They are often listed in terms of strike price, call/put options, and expiration date. The strike price is how much the underlying asset will be sold or bought for if the options are executed. The expiration date is the last date to excise the contract. Put options give you the opportunity to sell an underlying asset at the strike price. On the other hand, call options allow you to buy an asset at the strike price before a set date.
You will also find other information on the options chart, including:
- Volume: Number of options contracts traded in the current day.
- Ask: The lowest price a seller is willing to sell an option contract for.
- Bid: The highest price a buyer is willing to pay for a contract.
- Last: The last price an options contract was traded at.
- Open interest: The total number of outstanding option contracts.
When reading the chains, find the expiration date, strike price, and call/put you’re interested in, and then weigh up the bid, ask, last, volume, and open interest information.
How to Manage Risk
Risk management is an essential part of any investment strategy, and options trading is no different. To increase your chances of success while reducing losses, here are a few tips:
- Use technical analysis: Technical analysis helps to identify trading opportunities.
- Develop a trading plan: Helps to keep you grounded while investing.
- Implement stop-loss orders: If an option falls below a certain price, this order will automatically sell an option.
- Monitor trades closely: Keep taps on trading charts and withdraw when necessary.
- Diversify your portfolio: Don’t rely on one investment. Invest in a range of different options contracts.
How to Use Technical Analysis
Technical analysis involves studying historical trading volume and price charts to identify trends and patterns, which can be used to predict future market movements. Technical analysis is beneficial to options traders because it lets them manage risk much more effectively. Common technical indicators include relative strength index (RSI), moving averages, MACD (moving average convergence/divergence), and Bollinger Bands.
How to Use Options for Hedging
Hedging is a method of reducing risk by taking an opposite position in a related market. Options can be used to hedge anything from currencies to commodities. One of the common ways to hedge using options is to buy a put against a long stock position.
Options can yield high profits but they’re also pretty complex and risky. However, now that you are equipped with the information outlined above, you’re in a great position to continue learning about options and then make your first trade.