TRADING
WHAT IS OPTIONS TRADING
Options trading is an investment strategy based on purchasing and selling options contracts. These contracts grant the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset, such as stocks, currencies, commodities, or indices, at a predetermined price and on a future date. The primary goal of options trading is to leverage price fluctuations in financial markets to generate profits.
This article will delve into what you need to know about Options Trading.
Best Options Trading Apps
Key Features
Versatility: Options traders have the flexibility to take bullish, bearish, or neutral positions in the market, as well as to use options to complement other positions (e.g., buying stocks).
Limited Losses: Unlike other strategies, an options trader can limit their losses to the cost of the option contract.
Leverage: Options trading allows for significant leverage, meaning one can control many underlying assets with a relatively small investment.
Variety of Strategies: Numerous options, such as covered calls, protective puts, spreads, and straddles, that suit different market scenarios.
Duration Flexibility: Options contracts can have different expiration dates, ranging from days to several months, allowing traders to adapt to their price movement expectations.
Structure of Financial Options
Options are financial contracts that grant their holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a specific price, known as the "strike price," on a predetermined date, known as the "expiration date." Options are traded in financial markets and have a specific structure that includes the following key components:
Underlying Asset: This is the financial asset to which the option refers. It can be a stock (e.g., an option on Apple stock), an index (e.g., an option on the S&P500 index), a currency (e.g., an option on the EURUSD forex pair), or another financial instrument. The underlying asset is the asset on which the option's price and other components are based.
2 Types of Options:
Call Option: Grants the holder the right to buy the underlying asset at the strike price before or on the expiration date.
Put Option: Grants the holder the right to sell the underlying asset at the strike price before or on the expiration date.
Strike Price: This is the price at which the option holder has the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. The strike price is set when the option is created and does not change.
Expiration Date: It is the date on which the option contract expires. After the expiration date, the option generally no longer holds value and ceases to exist. Some options, such as European-style, can only be exercised on expiration dates. In contrast, others, like American-style options, can be exercised anytime before or on the expiration date.
Option Premium: The premium is the price paid by the option buyer (holder) to the option seller (writer) for acquiring the option right. The premium can vary and is determined by factors such as the volatility of the underlying asset, time until expiration, and the difference between the strike price and the underlying asset's current price.
Operation
Options trading involves several stages, including:
Market Analysis: The trader assesses market conditions and selects an underlying asset based on their price expectations.
Strategy Selection: They choose an appropriate options strategy, such as a call option if they are bullish or a put option if they are bearish.
Contract Purchase: They acquire the options contract by paying a premium, which is the contract's cost.
Position Management: During the contract's validity period, the trader may decide to exercise the option, sell it in the secondary market, or let it expire worthless.
Pros and Cons
Pros:
Potential for Unlimited Profits: Leverage can lead to significant profits if the market moves in the expected direction.
Loss Limitation: Risk is limited to the cost of the option contract.
Strategy Flexibility: A wide range of strategies can be tailored to different market scenarios.
Hedging Tool: Options are also used as a hedging tool to protect investment portfolios against market downturns.
Cons:
Premium Loss: If the market does not move in the expected direction, the cost of the option contract is lost in its entirety.
Complexity: Options strategies can be complex and require a good market understanding.
Dangerous Leverage: Leverage can lead to significant losses if the market moves against the trader.
Choosing the right trading strategy is a crucial decision for any investor. There is no universally superior strategy, as what works for one person may not be suitable for another. Your choice should be based on your financial goals, risk tolerance, and lifestyle.
Examples of Options Trading
Example 1: Call Option on Stocks
Opening a Position: Suppose a trader observes that XYZ Company's stocks are trading at $50 per share and believes the price will rise in the next month. The trader buys a call option on XYZ with a strike price of $55 and an expiration date of one month for $2 per contract.
How to Open the Position: Buy 1 contract of XYZ call option with a strike price of $55 for $2 per contract.
Closing a Position: XYZ stocks have risen to $60 per share after one month. The trader decides to close their call option position to take profits. They sell the call option contract for $5 per contract.
How to Close the Position: Sell 1 contract of XYZ call option with a strike price of $55 for $5 per contract.
Example 2: Put Option on Market Index
Opening a Position: Let's assume an investor believes the overall market will decline significantly in the next three months. They buy a put option on the S&P 500 market index with a strike price of 4,000 points and an expiration date of three months for $50 per contract.
How to Open the Position: Buy 1 contract of S&P 500 put option with a strike price of 4,000 points for $50 per contract.
Closing a Position: After three months, the market has experienced a decline, and the S&P 500 market index has fallen below 4,000 points. The investor decides to close their put option position to take profits. They sell the put option contract for $100 per contract.
How to Close the Position: Sell 1 contract of S&P 500 put option with a strike price of 4,000 points for $100 per contract.
Example 3: Call Option on Forex
Opening a Position: Suppose a trader monitors the EUR/USD currency pair and believes that the euro will appreciate against the dollar in the next two weeks. They buy a call option on the EUR/USD currency pair with a strike price of 1.2000 and an expiration date of two weeks for $100 per contract.
How to Open the Position: Buy 1 contract of EUR/USD call option with a strike price of 1.2000 for $100 per contract.
Closing a Position: After two weeks, the euro appreciates against the dollar, and the trader decides to close their call option position to take profits. They sell the call option contract for $150 per contract.
How to Close the Position: Sell 1 contract of EUR/USD call option with a strike price of 1.2000 for $150 per contract.
Some Examples of Options Trading Structures
Buying a Call Option
Strategy: This strategy involves buying a call option on an underlying asset when you expect the asset's price to increase.
Example: If you believe that XYZ Company's stocks, currently trading at $50, will increase, you can buy a call option on XYZ with a strike price of $55 and an expiration date of three months for $2 per contract.
Buying a Put Option
Strategy: Buying a put option on an underlying asset when you expect the asset's price to decrease.
Example: If you believe that the market overall will face a decline, you can buy a put option on the S&P 500 index with a strike price of 4,000 points and an expiration date in one month for $50 per contract.
Selling a Covered Call Option
Strategy: Selling a call option on stocks you already own. If the price rises, you will sell your stocks at the strike price.
Example: If you own 100 shares of ABC Company, currently trading at $60 per share, you can sell a call option on ABC with a strike price of $65 and an expiration date of $3 per contract in one month. If the stock price rises above $65, you are willing to sell them at the agreed price.
Bear Put Spread Strategy
Strategy: This strategy involves buying a put option with a low strike price and simultaneously selling a put option with a higher strike price on the same underlying asset.
Example: If you believe that XYZ Company's stock, currently at $50, will drop in price, you can buy a put option on XYZ with a strike price of $45 and, at the same time, sell a put option on XYZ with a strike price of $40. This limits your risk and profit potential.
Selling Naked Put Option
Strategy: Selling a put option on an underlying asset you do not own, hoping the price will not fall below the strike price.
Example: If you believe that DEF Company's stocks will not fall below $30, you can sell a put option on DEF with a strike price of $30 and an expiration date of $2 per contract in one month. If the price remains above $30, you keep the premium.
These are just a few of the many options trading strategies available. Each one has its specific purpose and associated risks.
A Trader's Hourly Review of This Strategy
Options trading is an activity that requires careful planning and monitoring throughout the day. Here is a review of a trader's typical activities in this strategy throughout the day:
9:00 AM: Start of the Day
The trader begins the day by reviewing economic news and market events that can affect the underlying assets of their options. This includes earnings reports, macroeconomic news, and geopolitical events.9:30 AM: Market Analysis
Technical and fundamental analysis assesses market trends and potential price movements. Opportunities to enter new trades or adjust existing positions are identified.10:30 AM: Position Management
The trader reviews open positions and makes adjustments as necessary. They may decide to close a position if a certain level of profit or loss is reached or extend the expiration date of an option if the strategy requires it.Noon: Lunch and Break
The trader takes a break for lunch and disconnects from the market for a while. Maintaining a balance between work and rest is important to stay focused.2:00 PM: News Monitoring
Additional news reviews are conducted to stay updated on significant developments that could impact trading decisions. Breaking news can have an immediate impact on prices.3:30 PM: Last Hour of Trading
The trader prepares for the market's closing and makes final decisions about open trades. This may include the decision to hold positions overnight or close them before the market closes.4:00 PM: Market Close
With the market closing, the trader records the day's trades, calculates profits and losses, and plans their strategy for the next day.
Most Used Indicators in Options Trading
Options traders use a variety of indicators and metrics to make informed decisions. Here are some of the most commonly used indicators and tools in options trading strategy:
Implied Volatility: Implied volatility is a key indicator in options trading. It represents the market's expectation of future volatility in the underlying asset. Options traders look for assets with high implied volatility for strategies like covered call writing.
Delta: Delta measures an option's price sensitivity to underlying asset price changes. A delta of 0.5 means the option will move approximately half a point for every point in the underlying asset.
Theta: Theta represents the time decay of an option as it approaches expiration. Traders often sell options with high theta values to profit from time decay.
Vega: Vega measures how an option's price changes concerning changes in implied volatility. Traders can use vega to assess the impact of volatility changes on their positions.
Gamma: Gamma measures the rate of change of delta. Options traders use gamma to evaluate how an option's delta will change as the underlying asset's price moves.
Put-Call Ratio (PCR): PCR compares the number of call options to put options on an underlying asset. A high PCR can indicate a bearish sentiment, while a low PCR can indicate a bullish sentiment.
Open Interest refers to the total number of outstanding options contracts on an underlying asset. Changes in open interest can provide insights into market sentiment.
Profit and Loss (P&L) Charts: Traders often use P&L charts to visualise the potential performance of their options strategies at different underlying asset prices.
Technical Analysis: Options traders also employ technical analysis, including candlestick patterns, support and resistance levels, and oscillators, to decide entry and exit points.
Combined Greeks: Experienced options traders analyse the Greeks (delta, theta, vega, gamma) of their trades altogether to understand the risk and profit potential of their strategies.
Hedging Strategies: Besides traditional indicators, options traders use hedging strategies such as spreads, straddles, and strangles to manage risk and improve their chances of success.
Risk Management
Risk management is crucial in options trading. Traders must be aware of the associated risks and take steps to protect their capital. Some risk management practices include:
Setting Limits: Traders should set profit and loss limits for each trade and adhere to them rigorously.
Diversification: Avoid putting all eggs in one basket by diversifying trades across underlying assets and strategies.
Use of Stop Loss: Utilise stop-loss orders to limit losses in case of adverse market moves.
Appropriate Position Sizing: Do not risk a disproportionate portion of capital on a single trade.
Continuous Education: Stay informed and learn about new strategies and risk management techniques.
Conclusions
Options trading is a versatile strategy that offers opportunities to profit from market movements. However, it also comes with significant risks and requires a disciplined approach and careful risk management. Successful traders in this strategy are those who thoroughly understand how options work, follow a consistent strategy, and stay informed about market news and events.