Want to trade options? Good for you! It can get pretty complicated though so you’ve got to make sure you’re doing it right. Luckily, you’ve found us! We’ve got all the answers.
Ready to find out about how to trade options like a pro?
Let’s get into the details.
How to Trade Options: What Are They?
Put simply, options are contracts that give you (i.e. the trader or bearer) the right to buy or sell at a pre-set price before or when the contract runs out.
There is zero obligation to sell or buy, you are simply handed the right to do so.
You can purchase these options like any other asset — using an investment brokerage account.
It’s fairly simple, but to be worthwhile, you must understand what you’re doing.
They are a great way to enhance your trading portfolio.
Not just because the contracts tend to be much shorter but also because they add protection, leverage, and income.
How to Trade Options: How Do They Work?
Essentially, all you are doing here is figuring out the probability of future price changes.
That’s the basic premise.
The buying price changes depending on how likely something is to happen. In short, the more likely, the more you’ll pay.
Alongside the likelihood is time.
If an option is due to end relatively soon, it will have far less value.
Why? Because the closer a contract is to the end, the less chance it has to move.
For example, a three-month option contract is more valuable than a one-month value because there is more chance for the price to move in your favor.
As you can probably imagine, volatility plays a role here too.
If there is a lot of uncertainty surrounding the odds, bigger movements can occur, which increases the chances of huge changes.
How to Trade Options: The Basic Step-By-Step Guide
Step One: Know The Account Requirements
In this aspect, opening a stock trading account is easier.
When you’re opening an options account, you have to prove you know what you’re doing and produce more capital.
Why? Because predicting lots of different things takes a great deal of skill and knowledge that you must display before brokers will hand you permission.
Step Two: Choose The Direction
We’re going to keep this simple.
- If you believe that the price of an option will rise, you buy a call.
- If you believe that price will drop, you buy a put.
There is a lot of market and trend analysis that you have to put in to make a well-educated guess here.
Step Three: Predict The Degree
Let’s give you an example:
If you think the current price for a $50 stock is going to increase to $75 at a certain point in time, you need to buy a call option with a current price of less than $75.
Equally, if you think it’s going to decrease from $50 to $20, you need to buy a put option with a price above that $20 mark.
Here is a clever technique on how to go about choosing a strike price for your options.
Step Four: Consider The Timeframe
All contracts in options trading have an expiration date.
This is the final time you can utilize the option.
Unfortunately, you can’t just magic up a date.
Instead, you have to look at the ones that are given to you in the chain for your specific contract.
They can range from years to months (even days to weeks!).
But be careful with the short ones; they are usually best left alone unless you’re a very experienced trader.
How to Trade Options: The Risk
Stock and forex markets bring a load of slippage and price gaps along with them.
But you won’t have that problem here.
In options trading, the risk is capped.
You cannot lose more than the cost of the option you’ve purchased.
Plus, you can (sometimes) get an even better ROI than you first thought.
How? Because you simply don’t know what you’re going to get.
It’s said to be a 4:1 risk-reward ratio which you just can’t find on any other market type.
How to Trade Options: The Bottom Line
Trading options isn’t scary if you know how.
But remember, we have only covered the basics here.
To be in with a good chance of success, you must make sure you know exactly how to read options tables and analyze trends.
Only then will options trading be a well-made decision.