I apologize about the horrible pun in the title, but what’s the deal with trading options? Yes, I did it again. Now that I’ve gotten that out my system, let’s jump into trading options. For the uninitiated beginning or only slightly experienced trader, options might be completely alien to you. We will look at what they are, how to trade them and the pros and cons of trading options. Here we go.
What the &*+%$ are Options?
Trading options are said to be the way professional traders go to market (insert little piggy reference here). There are two sides of this “transaction” the person that “buys” the option and the person that “sells” the option. No matter which side of the transaction the trader chooses to be on they are not obligated to own the underlying asset.
Usually options have a target price (that the “buyer” expects the underlying asset to reach) and a timeframe. So, if you were on the buying end of an option, you would speculate that a certain stock, currency or commodity would reach a price within a week. There are two types of options – a call option which assumes the underlying asset will go up, and a put option which speculates an asset’s price will drop.
Option Trading: In the money or Out of the money
If the instruments price is over the strike price by the time it expires (or under if it’s a put option) then the option is called “in the money” if it’s not it’s “out of the money”. All options start out of the money at the beginning of the contract. Being “in the money” is better than “out of the money” if you didn’t pick that up from their respective names.
You might also see the terms “option writer” used for the seller and “option holder” used for the buyer. The option holder must “pay” a premium depending on the underlying asset price, the market volatility and the duration of the option. The option writer on the other hand is paid the premium.
Just to make everything a little more complicated there are two different types of options – European and American options – luckily their distinction is simple, American options can be exercised before the timeframe of the option expires a European option can only be exercised upon expiration.
Should I trade Options?
You are probably still wondering if options are worth it, they seem complex and speculative. The thing is that especially on a call options, your risk is limited to the amount of your premium. You can’t lose more than that. Now on the put side, your risk is technically unlimited, but you can easily fix that by setting up stop loss. Oh, jeez you don’t know what that is either?! Look…stop loss is when you set a price level that will cause your trade to close when its reached. That way your losses won’t ever surpass what you intend on risking.
The cons of options? Well, like I said above, options can be complex, need a lot of data gathering and a lot of knowledge regarding what is going on in the world. They can be challenging, but like I said your risk and exposure to the market is known, you only risk as much as you are comfortable with.