Ten fundamentals you need to know on Options Trading
Posted on 3rd May 2017
The term options trading as the name suggests gives you more alternatives or options to enhance your portfolio. Besides enjoying more flexibility in your trades you can also manage your risk in a better manner with options. However, before including them in your repertoire of trading strategies it's important to know and form a clear understanding on certain basic facts about options.
- Calls and Puts : There are two kinds of options: Call and Put. Whenever the price is expected to soar higher than the current rate within a specified time, a trader can select a call option. On the reverse if the price is surmised to sink lower than the current level within a specified time frame, a trader can go for a put contract.
- Strike price vs current rate : The Strike price is the value at which an investor buys the CALL/PUT option whereas the current rate is its real-time rate. On expiry, your strike price and current rate can be compared to assess whether you set up a successful trade or not.
- Set risk and reward : In an option trade you are aware of how much you are likely to win or lose right from the beginning. There is no leverage cost to be incurred and you don't have to pay a penny more than the amount you risked on the trade. Option trading is unlike forex. It does not matter how high or low an asset's price goes as long as it closes in the money for you.
- In the money and Out of the money : While exercising an option if your forecast matches the actual outcome and you register gains then you are in the money. If you make a faulty prognosis and the outcome is something else which results in your loss then you are out of the money.
- Options have an expiry date: Options come with an expiry date after which an option holder forfeits the right to buy or sell the underlying instrument at the specified rate. This pre-set period is called expiration. Depending upon the option there are different expiration dates like weekly, monthly, quarterly and even longer durations.
- Right to buy or sell : Options confer you the right to buy or sell an underlying asset at a specific price. Nowadays, options are available across a range of securities like futures, indices, commodities, forex, bonds etc.
- Option Premium : Each option is purchased at a premium which must be paid regardless of whether the contract is exercised or not. Simply put, premium is the price you pay to trade in options in the derivatives market. The payable premium is its inherent value plus its time value. Market fluctuations and how close the strike rate is to the-then current rate also influence the premium. Savvy investors at times sell one option (also known as writing an option) and utilise the premium received for buying another option. Investing in multiple options either intensifies or reduces your risk.
- Options come with caveats : Options also have their own pitfalls. Options have an expiry date so one should only invest up to a level they can afford to because they can end up losing their entire capital too. Selling options without hedging one's position through other options can lead to substantial and even unlimited losses. Also, prices move very fast in options trading. Thus one should aim for trades with bigger scope for profits so that even if one's selling isn't very accurate one can register gains.
- Choosing the right broker : Most of the leading brokerage firms nowadays are well-versed in options trading. Several brokerages even offer specific tools to assist traders in options. However, it is to be borne in mind that mostly firms with lower commissions can mean poor customer support. Again, rates vary among brokers so make sure you talk to them about their specific margin rates and policies.
- Concluding remarks : An ideal method to trade in options is to paper trade before risking your real money. When you enter your options trades with realistic expectations, you'll be better at managing your trades and your risks. It's always a good idea to start small. That way even if the trade goes against your favour, you can easily bounce back.
Compare Forex brokers in South Africa with ForexBrokersAZ.com
