With online trading platforms getting popular among netizens, options are one of the most sought-after trading instruments.
Although the concepts sound very alluring, they are heavy to understand for many. Even many people want to enter the world of trading but are not sure what options are and if it is profitable to indulge in options trading.
Since the concept is becoming popular, it is essential to have a complete guide on everything you need to know about options trading and if it is profitable to start trading with options.
Therefore, we have come up with a comprehensive article covering everything you need to know about options.
We will discuss everything in this article, whether it is about the profitability of options, types of options, or popular strategies. So let’s get into it.
What Are Options?
The term options are used for a type of financial instrument. However, the essence is similar to that of the literal meanings of an option. We can define the options as,
“Options are financial instruments that do not have an intrinsic value but derive their value from the underlying securities like stocks, foreign exchange, etc. Options are also called financial derivatives and traded in future markets.”
We can explain options as the contracts that allow the buyers of options to buy or sell the underlying asset(stocks, forex, etc.) according to the terms and type of contract(option).
For instance, if a person has a call option, he has to write to buy the underlying asset at a specified price within a specified time period.
Options are useful when the prices of certain assets or commodities are volatile. The traders can cover the expected losses that might occur if the price of a certain commodity or asset might go up or down against expectations.
History Of Options Trading
If we go back to the origin of options, the first future market for commodities was established in Japan, where a Japanese samurai expected to corner the rice markets. However, if we try to locate stock options history, Greek was the first to speculate on the olive harvest.
The formal practice of options trading became popular in the 1920s when a famous American, Jesse Livermore, speculated stock price movements.
He did not possess the securities he was speculating on and only predicted future prices. He worked as an option bookie who would take the opposite side of what would be popular about certain security in the market.
For instance, if someone would come up to him and speculate that the stock of XYZ company is going up, he would take the other side of the trade. In the beginning, the market of options was compromised by illegal activities and bookies.
Even some cases were highlighted that resulted in strict scrutiny from agencies like SEC and FBI in America.
Later on, Commodity Exchange Act also covered the options and futures markets to prevent the illegal trading of these contracts. The act also outlined the standard procedures for any industry via Commodity Futures Trading Commission.
Nowadays, there are many online brokers and trading platforms where any person can speculate and invest in different options, futures contracts, and other derivative securities.
Major Terms In Options Trading
Understanding options trading is not difficult if you are familiar with the major terms used in options trading. Therefore, we will define the important terms before diving into how options work.
Here are the essential terms you must understand:
As already mentioned, options are contracts that give the right buyer of the contract to either sell or buy certain underlying assets at a specified price. However, the term options contract specifically represents 100 shares of the underlying security for any option.
Derivative securities derive their value from the underlying assets, such as stocks, commodities, forex, etc. An underlying asset can be defined as the asset having its real value and characteristics.
The price of an option is called premium, irrespective of whether it is a call or put option.
The strike price represents the price at which the option contract buyer can buy or sell the underlying stock.
There can be different options with different strike prices. The strike price can be better explained as the exercise price, as the option buyer has the right to execute the call or put the option at this price.
The expiration of the option contract is also an important term to know. It represents the expiration date of an option contract, after which the option buyer can not execute the trade whether the strike price hits or not. The option no longer remains valid after expiration.
When an options trader buys and sells multiple options(call or put) against the same underlying asset, it is called an options spread.
It is a trading strategy in which each option has a different strike price, expiration, or both for each option. There can be horizontal or vertical spread strategies.
How Do Options Work
The working of options trading differs depending on the type of option. Therefore, you must know the types of options.
There are two types of options which are as follows:
A call option is a contract in which the option buyer has the right to buy underlying assets at the strike price before the expiration of the option contract. If the underlying asset price increases, the call option’s value increases. The call options are bought when stock prices are speculated to be increased in the future.
A put option is a contract in which the contract buyer can sell the underlying stock at the strike price until the contract’s expiration.
When the underlying security price falls, the owner of the security can minimize the losses by selling their shares at a fixed strike price. Therefore, the value of a put option increases when the underlying security’s price falls.
Risk And Reward In Options Trading
When we have to decide if options trading is profitable or not, it can’t be done without comparing the risk and rewards involved in this type of trading. Therefore, we will start with the risks you are exposed to as an options trader.
- When you step into options trading, you must be on the right side of theory to capitalize on your investment. It implies that the whole science of options trading depends on how well you pick the movement of a security and time it correctly. Therefore, beginner traders have a high risk of losing money by the wrong speculation.
- When you buy options, but the price moves unfavorably in the short term, the option will become worthless due to an unrecoverable price fall of the option’s premium.
- Options and futures contracts are usually sold for highly volatile underlying stocks or assets. Therefore, you should expect the prices to vary from day to day when trading options.
- Options have a certain expiration date, after which they are not exercisable. It is different from stocks that have an indefinite life.
- The government does not guarantee options, and you won’t be able to recover your money if lost.
- If you are trading in the stock, the trading cost will be lower than that of options. Besides, stock brokers usually charge a 0% commission when trading on online platforms.
There are certain benefits of doing options trading.
- You can earn high returns over a short period as the volatile prices of stocks make the options exercisable from day to day.
- You are not as exposed to price volatility as you would face when directly trading the stocks. It works like a loss minimization strategy in business. And as a trader, you can capitalize on the options prices changing with stock prices.
- If the stock price increases for any uncontrollable reason, the options owners will get an advantage on options.
- The options investors have the choice of strategies like the covered call to minimize the risk of losing money.
- You can also make a profit by holding the options for a year or longer as long-term capital.
Is Options Trading Profitable?
If we have to decide if options are profitable, risk and reward comparison is the best way to give the verdict. After comparing, we can safely say that options are indeed a lucrative investment and trading option to increase the gains.
However, it is a profitable business for only those with knowledge and expertise in stocks, options, and future contracts.
If you know what you are doing and what you must do, you can turn options trading into a profitable business. Besides, you can also go through the risks and rewards on your own to decide whether you want to invest your capital in options trading. However, in general, a lot of people make money by options trading.