If you have experience with trading in forex, stocks, or commodities already, you will find getting used to the differences in options much easier. In case you are new to trading in general, you will need a little more time to catch up on the basics. Either way, the following five are each key facts to know before you start trading options.
1. Options are Derivative Contracts
When an asset draws or derives its value from the values of other assets, it’s called a derivative. A financial contract that is both tradeable and a derivative is called an options contract, or just options. There are two primary types of derivative contracts that define options, namely, call and put contracts.
2. What Call and Put Contracts Mean
A call contract is an option where you are allowed to buy an agreed upon number of shares of the underlying security at a prefixed strike price, before the contract expires. The allowance is a right and not an obligation, so you are supposed to manage the contract in the best way that benefits you.
If an options contract gives you the right to sell a specified percentage of the underlying asset at a predetermined strike price before the contract expires, it’s called a put contract. Just like call contracts, the terms in a put contract are allowances and not obligations.
It takes time to gather the knowledge, experience, and understanding of the market patterns to benefit from buying and selling options. Read James Cordier’s complete guide to option selling and get yourself properly acquainted and equipped with the various strategies that you will need as an options trader.
3. Buy Call Contracts When You are Confident about Positive Market Growth
Buy call contracts, aka calls, when you are confident that the price of the underlying securities is going to rise before the contract’s deadline passes. In other words, investors buy call options when they are expecting to make profits by leveraging their position in a soon to be bullish market.
4. Buy Put Contracts When You are Confident about Negative Trends
The biggest difference between regular stocks and options is the fact that you can profit even when you are expecting the market to be negative for the underlying assets. If someone is buying a put contract, that means they are investing in their estimate that the underlying asset will go down in price before the contract expires.
5. Only Covered Shorts are Legal in Most Cases and Places
Naked short strategies are seldom legal and never recommended, as they can be ruinous for the seller on failing. Covered shorts are legal and can be employed as a sound strategy in the trade for those with the experience to do so. Despite the borrowing fee you will need to pay the investment bank, it’s a safer option if you are confident about applying a short strategy.
Note that you will often come across terms such as long and short while trading in options, which can be confusing. To avoid confusion, always remember that long refers to buying an options contract, while short refers to selling one. This will remain applicable irrespective of the options type.
Trading Options article and permission to publish here provided by Sara Edwards. Originally written for Supply Chain Game Changer and published on August 2, 2023.
Cover image by Sergei Tokmakov, Esq. https://Terms.Law from Pixabay