What is options trading? Well, whether you’re drawn by tales of options traders hitting it big with a savvy bet on market movements or you’re just looking to diversify your investment portfolio this is a question you may ask yourself. However, like with anything, understanding the nuances of options trading is important before you delve in. Welcome to your beginner's guide, where we venture into this dynamic sphere and help lay down the foundations for what could be a new avenue for financial growth for you.
Before you start swimming with the sharks in the options market, you should bring yourself up to date with the lay of the land. Options trading operates on the concept of ‘options’ which are contracts giving you the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified expiration date. These can be call options, where you bank on a price increase, or put options, where you are betting on a price decrease.
Your first stop should be getting accustomed to the lingo. Terms like strike price, expiry date, and premiums will soon become your best friends as you delve deeper. In options trading, the strike price refers to the predetermined price at which the underlying asset can be bought or sold. It's essentially the foundation of your trade, setting the benchmark for the results of your investment. When you buy a call option, you are anticipating that the asset's market price will rise above the strike price before the expiry date. Conversely, buying a put option means you expect the market price to fall below the strike price before the option expires.
Premiums represent the cost you incur when engaging in options trading. It's the price paid to the seller of the option (also referred to as the option's writer) for the rights granted by the option. The premium is determined through various factors including the current price of the underlying asset, the option's strike price, the time remaining until expiration, and the volatility of the underlying asset. Understanding how to analyze these factors to calculate the right premium can be a central element in successful options trading.
Every option comes with a set expiry date, which is the date the option contract becomes void. The expiry date is critical as it dictates the time frame you have to work with, giving you a deadline to make your decision to either exercise the option or let it expire worthless. This fixed timeframe necessitates traders to not just accurately predict the market movement, but also the time frame within which these movements will occur. It's the ultimate deadline for your investment decision, determining whether you make a profit or incur a loss.
Of course, there are many other terms you are going to want to know but these three are among the most important.
Intrinsic value refers to the real value of an option, grounded in the position of the current market price of an underlying asset compared to the option's strike price. Essentially, it represents the inherent value of an option if it were to be executed immediately. Intrinsic value can be perceived as the built-in value that an option holds, indicating the financial advantage that comes with holding an option at a specific moment in time.
For call options, the intrinsic value is derived by subtracting the strike price from the current market price of the underlying asset. Conversely, for put options, it is obtained by deducting the current market price from the strike price. If the result of these calculations is negative, then the intrinsic value is considered to be zero.
Time value, on the other hand, represents the additional premium that traders are willing to pay for an option above its intrinsic value. This is mainly due to the potential for increases in the option's value over time. It is essentially the speculative value, offering the possibility for the option to gain value as it approaches its expiration date.
Time value decreases as the option gets closer to its expiry date, a phenomenon known as time decay. Therefore, options that have a longer time until expiration will typically have a higher time value compared to those nearing their expiration date because they offer a longer window for the underlying asset to potentially move in a favourable direction, hence providing a greater opportunity for profitability.
As we edge towards the conclusion of this maiden voyage into the world of options trading, let’s talk risk management. You may want to set aside a budget exclusively for options trading, a fund you are willing to risk. This way, you not only create a financial buffer but also foster disciplined trading habits.
Armed with the right knowledge, tools, and a steadfast community like EzTrades, you could well be on your way to becoming the next options trading success story. Remember, the market is a beast, constantly evolving, and so should you. Stay informed, stay agile, and most importantly, keep learning.