Options trading can be an invaluable way of mitigating risk and diversifying an investor’s portfolio. While it may initially seem complex or intimidating for novice investors, some basic strategies can help protect downside risks while mitigating market risk.
Options are leveraged instruments that enable traders to place directional bets with limited downside exposure. This article will review some basic concepts of options trading, such as calls and puts, as well as combinations.
Basic Concepts
Options are financial contracts that give buyers the right (but not obligation) to buy or sell underlying assets at a predetermined strike price over a specific timeframe, known as an option’s strike price. They act as leverage and can increase an investor’s purchasing power or capital value. Options are widely available across asset classes including stocks and exchange-traded funds (ETFs), commodities, debt securities (such as bonds) and foreign currencies.
Investors use options as a speculative bet on future price movements or as a hedge against market risk in existing positions. When trading options, traders pay a fractional premium of total asset costs per contract – making options an affordable way to speculate on asset classes such as stocks. An options’ premium depends on both intrinsic and extrinsic values of their underlying asset – the higher its probability is, the more costly will be its option premium when profiting from it.
Expiration Dates
Options trading has become a popular investment choice among investors with various goals in mind, such as income generation, asset protection from market fluctuations and speculation. Before engaging in options trading, it is important to clearly establish your objectives, assess risk tolerance and evaluate time and money commitment levels; additionally it is wise to familiarise yourself with your financial status while using simulators for testing strategies prior to allocating any real capital.
Option contracts allow you to exercise the right, but not the obligation, of buying or selling an asset at a set price for a short period of time, such as days. When purchasing or selling options you typically pay an upfront premium that can range anywhere from several dollars up to several hundreds dollars.
Buy call options only at your own risk if the premium paid exceeds any potential profit that might result from stock movement in your favor; but options expire, increasing their risk as their expiry date approaches.
Strike Prices
Strike prices provide a powerful tool for creating risk/reward profiles tailored to your trading goals. An option gives the holder of that option the right (but not obligation) to buy or sell an underlying asset at a predefined price within an agreed timeframe, ultimately reaching their final expiration date where either they retain value or become worthless.
The relationship between strike price and asset price is of great significance in determining whether an option will be in-the-money, at-the-money or out-of-the-money; additionally it’s one of the primary inputs used to establish the premium (market price of an option), implied volatility and market price of an option contract.
When selecting their strike price, traders must consider both intrinsic and time value when making their selection. Intrinsic value refers to the immediate profit potential if an option were exercised immediately while time value represents future potential profitability; these elements combined are what make options so appealing for traders; yet it must be remembered that having an established trading strategy and risk appetite are also necessary elements in using strike prices effectively.
Options Combinations
Investors employ combinations of call and put strategies when trading options to meet various investment objectives. A long combo (also referred to as synthetic futures trade) involves simultaneously buying one call option and selling another call option on the same underlying asset with different expiration dates and strike prices, thus providing exposure to possible price increases while offering defined risks and rewards at reduced costs than purchasing it directly.
Combination strategies enable traders to customize risk and reward profiles by taking advantage of specific options characteristics, like time decay and volatility. While collars use just two options, more advanced strategies involving four options of two different types, like iron condor spreads, offer even greater precision when it comes to profiting from precise changes in an asset’s price such as low-volatility range-bound moves.
