An option is one way you can trade on the market without the risk of buying or selling stocks. Because options trade at a considerably lower price compared to the underlying share price, investing in options is a cheaper way to have a larger position in a stock without the need to take ownership of its shares. Options trading can help you reduce risk while maintaining the potential for higher percentage returns, at huge cost savings.
What Is an Option?
An option is a financial contract between buyers and sellers relating to a particular stock. The buyer of the option is given the right to do whatever the contract specifies, but is not obliged to do so. Thus, the buyer will only exercise the option when it’s smart to do so.
Traders use options either to speculate or to hedge risk. Rational traders realize there’s no “sure thing,” as every investment comes with at least some risk. The risk is what investors are paid for when they purchase an asset.
Hedging is like purchasing insurance. It protects you against unforeseen circumstances, but you hope you never have to use it. If the price of the stock falls, holding an option will help limit your losses.
How to Trade Options
In order to get started with options trading, you will need to follow these steps:
- Learn what determines options prices: An option’s price varies depending on several different factors. The three biggest factors include the level of the underlying market compared to the stock price, the underlying volatility of the market, and the time left until the option expires.
- Understand the risks involved: Learning what moves options prices is a great first step towards profitable trading, but if you really want to master this market, you will need to understand the risks associated with trading options. By understanding each risk, you can take steps to reduce it.
- Choose a strategy: There are many options strategies you can use in your trading. Some of the most common strategies include the long calls and puts, short calls and puts, straddles and strangles, and spreads.
- Decide how you would like to trade options: You can trade options either with a broker or with Contract for Difference (CFDs). When you trade with an options broker, you will deal on their platform, and they will process your order on the actual exchange. The broker takes a commission on each trade. When you trade options with CFD, instead of getting the right to buy or sell the underlying market, you’re getting the right to buy or sell CFDs on it. The price of CFDs will always be the same as the underlying market. This means that your profit or loss would be the same as when trading with an options broker.
Options trading is a great way to invest without risking large amounts of money upfront. Keep in mind, however, that options trading is ideal for sophisticated investors. If you’re new to trading, don’t trade in options unless you have talked with an expert and are comfortable with the basics.