Trading options may seem daunting to most traders, but in a real sense, it is one of the most straightforward trades to master if you understand it fully. Options trading has become popular because its price movement keeps changing fast, which can be advantageous for any trader looking to earn some profits.
Before we get into how to trade options, you first need to understand what options are. Also, know the type of options to trade and what securities you can use. That way, you will have complete knowledge about options trading before committing to any options broker and options trading platform.
What are Options?
Options are financial securities that enable traders to invest in a market’s future value. Options contracts give traders a right to buy and sell a specific amount of underlying asset at a set price before the contract expires. Note that options are just like other trading securities, and you can buy or sell them using any brokerage firm that suits your interests.
One thing about options trading is that it does not give you an obligation to trade even when you do not feel like trading. It is a good trading instrument that will help you diversify your portfolio.
Portfolio diversification is a good trading strategy for any trader since it helps you maximise your profits while minimising losses. For instance, when you trade with various options and end up losing one, the other instruments will have generated a good amount of profits to cover the losses.
Note: Even though options trading can be profitable, it carries certain risks. Therefore, while you consider trading options, make sure you are also willing to conduct extensive market research.
How Options Trading Works
Options prices are derived from other assets’ prices, making it a derivative. There are two ways to conduct options trading, including call options and put options. Let’s dive deeper into what they are so that you can have a better understanding.
1. Call Options
A call option is a type of options trading that will give you the right to buy specific assets at a set price and within a specified period. When you trade call options, you should expect to benefit or earn profits when the price of the underlying assets increases.
2. Put Options
In contrast to call options, put options does not give you the obligation but the right to sell specific assets at a particular set price within the set time frame. Therefore, when you sell put, you intend to benefit from the trade when the underlying asset prices reduce.
Options Trading Strategies
Any financial trading security has its strategy that traders need to master if they want to achieve their trading objectives – make profits. There are many strategies that you can use to your advantage when trading options online.
Note that options strategies are based explicitly on call and put options and can make you good profits if you know how to manage the risks. Below are a few of these strategies to get you off at the right foot.
This strategy is common in options trading, and it’s also referred to as “going long”. You can apply it on call options type of trade whereby you predict the rising price of the underlying asset.
The best thing about a long call strategy is that it is not capped. Therefore, the more the prices of underlying assets increase, the better for your trade. However, the amount of profits you can make will depend on the premium you pay.
Note that the long call strategy has its risks, which can make you lose your entire investment. Remember that call options have strike prices by which you can sell an underlying asset. Therefore, when this strike price remains constant or reduces, the trade expires worthless, leaving you with a loss.
One way you can avoid losses is to never apply long call options blindly without doing enough research on the options you plan to trade. The knowledge of previous price movements can give you a better idea about how the future prices will be, which is good in your options trading activity.
You will also be going long with this options trading strategy. When you buy put options, you will be expecting that the strike price will fall before the expiry date. Long put strategy is not capped. Therefore, depending on your initial investment capital, the more the price reduces, the more you benefit.
When it comes to long put risks, you need to research the market price trends in order to manage them. If the trade goes against your predictions and the underlying assets’ price increases instead of reducing, your trade becomes worthless, meaning that you lose all your investment capital.
A short call strategy is going short with call options whereby you predict the fall of an underlying asset’s market price. If the asset’s price favours your trade and keeps falling, you get to profit from the difference.
However, prices of options can sometimes rise, especially if your market analysis was not extensive. When this happens, you will lose your entire investment capital. Short call strategy is capped to your initial investment, meaning that your return is fixed at your investment even if the strike price keeps on reducing.
A short put is like the opposite of a long put strategy, but it is going short on a trade. You get to sell a put option whether the market has a bearish or bullish sentiment. In this strategy, you predict the strike price will increase hence profit from the increasing price by the time it expires.
Note that this strategy limits your returns to your initial investment capital. Moreover, if the stroke price falls below the set price, you will lose everything unless you apply a stop-loss order, which will limit the losses.
Straddle strategy allows a trader to buy or sell call and put options simultaneously of one underlying asset. The call and put options in this strategy must also have the same strike price and expiry date.
Here a trader can either go long or short on both the call and put options. Of course, you expect the prices to keep moving towards your predicted direction if you want to benefit from this position.
Note that this strategy allows you to diversify your trade, making you earn more profits. However, you do not want to end up on the losing side of this trade because the losses will be magnified.
Like the straddle strategy, you will hold a single position on both call and put options but at different strike prices. The underlying asset and the expiry date remains the same as when using the straddle strategy.
If you are not sure of the directions which the market price of a specific option will take, using the straddle strategy could be your best bet. However, you must be sure that the security will go through huge price movements in order to profit.
The spreads options trading strategy allows traders to buy and sell options simultaneously. The underlying assets to use with this strategy remains the same. However, the strike price and expiry dates of the options to trade should be different.
The spreads strategy can either be a call or put spreads, which means that the former is used on call options while the latter on put options. Most traders use it to reduce the net cost of entering a trade hence benefiting from the direct price movements.
Steps to Trading Options
Traders globally need an online options broker to effectively and successfully trade options. Online brokers have simplified options trading by hosting various instruments that you will require for your trade.
If you are a novice options trader, worry not because we have listed below the steps that you should follow to trade options.
Learn Options Trading
Before you start trading options, you first have to learn what you want to trade. Options trading has many trading strategies, most of which we’ve mentioned above. Learn when to apply these strategies for the benefit of your trade.
Also, begin by going through options trading courses and review every specific detail about the options trading contract. It’s good to know that missing an expiry date, trading with the wrong type of options, and not understanding the amount of risks involved in options trading can cost you a lot of money.
Choose an Options Broker
An options broker will offer you a trading platform in which you will potentially use to make real money. There are so many ways that you can use to identify the best options broker for you, which we will get into later in this guide.
Ensure the options broker has offerings or services that will match your trading interests. Whether you are just getting started or have been trading options for years, there is a suitable broker for you.
Create an Options Trading Account
It is best to learn how options trading works before resorting to opening a trading account. There are many options brokers worldwide, so whether you are a beginner, intermediary, or advanced trader, consider a broker that will align with your experience.
Once you have tested the broker using a demo account and are sure that it is the option, create a live trading account. Most brokers will only require your personal information like name, address, email, and phone number.
It is sporadic to find a legitimate options broker asking for your credit card details before your account has been verified and you want to make a deposit. Therefore, be very careful with the broker that you choose.
Select Your Preferred Option(s)
Once you have created an options trading account, you will be required to choose your preferred options to trade with. However, you cannot start trading without making the required deposit.
Options brokers have a varying initial deposit before you start trading on their platform. Some actually have zero minimum deposit requirements, which depends on their offerings. That being said, ensure that the broker you are dealing with is affordable.
You will then choose the options you want to trade with, whether stocks, commodities, ETFs, CFDs or others. Additionally, know if you’re going to trade on call or put options and be ready to open your first position.
Set Strike Price
A strike price is the fixed price that an option can be bought or sold. Once you have identified the assets to trade and the type of options to trade with, you need to set the strike price.
For example, if you want to trade call options, set the strike price you believe will keep increasing. This is because if the underlying asset’s price fluctuates below the strike price, it renders your trade worthless, making you lose your initial investment capital.
On the other hand, trading put options will let you set a strike price that will hopefully keep on reducing. This will work in your favour, and you will be able to earn from the difference of the reducing price. If the underlying assets’ price rises above the strike price, expect a worthless trade.
Note that this strike price will guide the movements of your trades. Therefore, extensive market research is needed in options trading. Also, you wouldn’t want to open a position without applying any risk management strategy that will help to minimise losses.
Determine Time Frame
Every options derivative has an expiry date. So while determining this time frame, ensure that you will not end up straining your activities in the long run. There are various expiry dates that you will choose from. It ranges from daily to weekly to even monthly and yearly.
For example, more extended expiry time frames give your open position time to move and play out. You could end up earning good profits if the prices of the underlying instrument continue to rise or fall.
One thing to note though about longer expiry periods is that, the longer a position remains open, the more money you get to invest. This only means that you should confirm your trading capital and invest with funds that you are willing to lose.
After you checked all the above steps for options trading, you are now free to start trading. Do not forget to analyse the underlying assets’ price trends and use the necessary risk management tools to increase your profit potential.
Choosing an Options Trading Broker
There are many brokers in the financial markets, and finding a suitable one is not easy. However, there are many recommended options brokers to choose from. On this website, we also refer you to the best options brokers, and we can advise you to take a look at choose from our list.
Below, we will guide you on the factors you will have to check to identify a broker that will match your needs. We hope you will leave here fully prepared to place your first trade and succeed.
Trading options is different from trading ordinary assets, and you may find yourself spending a lot of money, especially if you open a position with longer expiry time frames. For this reason, you should take your time to look for a legitimate broker.
A legitimate broker should have a brokerage license and be regulated by one of the most respected financial global authorities, such as the Financial Conduct Authority (FCA) in the UK. The authorities that regulate such brokers set regulations that favour you as a trader. As a result, your trading capital will be safe, and you are sure of getting the best services while trading.
An options broker should host the kind of options you want to trade. Do not assume that all brokers offer all options in the financial market, or you might end up being disappointed. For example, consider a broker with vast stock offerings if you want to trade stock options.
As a beginner, you want to improve your skills and strategies as you continue trading. Most of the best options traders will offer you free learning materials for this purpose.
Start by signing up for a demo account, which of course, is also free. Explore the platform and identify where your strengths lie. You will also access other learning resources such as webinars, articles, recorded videos, and more using the demo accounts.
Additionally, both newbies and experts will require research resources. Depending on your experience, consider a broker that will make your analysis as simplified as it could be.
When choosing a broker, you should test its customer service centre. While using the demo accounts, you can check their availability. Can they be accessed 24/7 or on weekdays only. Also, identify the mode of communication that you prefer. Do they offer live chat, phone calls or email support?
The best thing to do is to reach out to them and see how responsive they are. Ask as many questions as you would like, which will make you decide if their replies are satisfactory or not.
An options broker’s platform will either make you enjoy your trading activity or be frustrated by it. Complex platforms will not encourage you to keep going, and you do not want to give up on an activity that could potentially be making you good money.
Ensure you are accessing every trading tool on a broker’s platform. The design should also be eye catchy to keep you glued.
Most importantly, the options trading platform needs to be supported on mobile devices so that whenever you cannot access a desktop, you can still open a position and benefit from the trade.
Options brokers have varying trading costs because they want to attract all kinds of traders. Since you will have a budget for your trade, check if the broker you are using will be within that budget.
The things to confirm are the minimum deposit amount, trading fees, inactivity charges, and holding charges.
Our advice for newbies is to go for an options broker with low charges. You need to start with small investments as you continue to grow.
Pros and Cons of Options Trading
Trading options is risky but can be profitable at the same time. Let’s take a look at the pros and cons of options trading.
- High-profit potential
- Low risks since options can also be used to hedge positions
- More trading strategies
- It is flexible for all traders
- Enables traders to fix a strike price
- Options have expiry dates.
- Commissions charged trading options can be a bit higher.
Options trading is one of the best trading methods that carry a high potential for good profits. Remember that there are risks of losing money with this form of trade. Therefore, make use of risk management tools such as take profit and stop-loss orders.
At this point, we believe that you are prepared enough to start your journey at trading options. Many traders enjoy the flexibility that comes with this trading activity, such as determining strike price and the time to see how a trade plays out.
That being said, traders willing to trade options should be ready to always keep an eye on their activities, and observe market trends to make informed decisions.