It’s important for investors to know how to trade options.
Setting aside a portion of your portfolio for options trades is essential.
Options provide you with excellent opportunities for leveraged plays and they can help you earn larger profits—all with a smaller cash outlay.
When you learn option trading strategies, you can hedge your portfolio and limit risk. However, any new investors worry about options.
They think trade options are too complicated.
But once you understand this type of investing, and understand the pros and cons, it can become a very powerful strategy.
To begin with, what are options?
Options are simply conditional derivative contracts that allow the option holders, those that buy the contracts, the opportunity (or option) to buy or sell a security at a preset price.
When they buy at this price, they’re charged an amount called a “premium”. This premium is paid for the opportunity to buy at that price.
If market prices are unfavorable for the option holder, then the option expires, which ensures the losses are never higher than the premium.
Options are divided into two types: call and put. With a call option, the buyer of the contract purchases the right to buy at a predetermined price.
This price is sometimes called the strike price or the exercise price.
With a put option, the buyer also gets the right to sell the asset in the future at the preset price.
There are five strategies when it comes to options trading:
- The Long Call: For the long call, you buy a call option; you “go long.” This is one of the most straightforward strategies. You are simply betting wager that the underlying stock will rise above the strike price by expiration. It’s simple and most new investors choose this strategy for that reason.
- The Long Put: With the long put, you’re wagering on a stock’s decline rather than its rise—like you do with the long call. In this scenario, you will buy a put option, believing that the stock will fall below the strike price by expiration.
- The Short Put: The short put is the opposite of the long put. In the short put, you sell a put, or you “go short”. With this strategy, you bet on the idea that the stock will stay flat or rise until the expiration. The put would then expire worthless and you’ll walk away with the entire premium. Just like with the long call, you can wager on a stock rising, but there are major differences.
- The Covered Call: This strategy has two parts, so it’s a bit more complicated than those above. First, you must own the underlying stock and then sell a call on that stock. In exchange for a premium payment, the investor will have to give away all appreciation above the strike price. This strategy hinges upon the fact that the stock will stay flat or go down until expiration. This allows the call seller to keep the premium and the stock. If the stock sits below the strike price at expiration, the call seller keeps the stock and can write a new covered call. However, if the stock rises above the strike, the investor must give the shares to the call buyer, selling them at the strike price.
- The Married Put: This is another more complicated strategy. With the married put, you combine the long put with owning the underlying stock. This “marries” the two together. For every 100 shares of stock, the investor buys a single put. This allows an investor to continue owning the stock for potential appreciation while still hedging his position if the stock falls. It works a lot like buying insurance; you pay a premium to protect your assets against decline.
While these strategies have been simplified here, you can see that options allow traders to risk smaller amounts than they would otherwise.
In most cases, your potential loss is limited to the premium you’ve paid, but your potential profits are unlimited. Options offer investors a variety of different ways to profit from trading underlying securities.
These trading strategies involve different combinations of options, underlying assets, and other derivatives.
However, for new investors, basic strategies for include buying calls, buying puts, selling covered calls and buying protective puts.
There are more advantages to trading options, like downside protection and leveraged returns. However, there are disadvantages.
For example, upfront premium payments are required, and some new investors are not comfortable with this.
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