Just like equities, mutual funds, treasury bills and ETFs, options are another asset class which can be traded to make a profit. Options trading is markedly differentiated from stock trading in terms of what is being traded. In stock trading, traders buy and sell of shares of the company. This makes them part-owners of the company. In options trading, you buy the right, not the obligation to buy or sell shares (or any underlying asset being traded) within a particular time (before the contract expires). Option traders do not own shares, but contracts to buy or sell shares at a specific price (Strike Price) on a particular date (Expiration Date). The price paid for an option is called option premium. European-style contracts are those contracts that can only be exercised when they mature. On the other hand, American-style contracts are those contracts that can be exercised before their maturity.
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Institutions trade a high volume option contracts with dealers. Those who want options that come with customized provisions can do so at the over-the-counter derivatives market. Standardized option contracts are listed on many exchanges in a variety of asset classes such as individual stocks, stock indices, futures contracts, currencies, swaps, and precious metals.
The volume of options trading has been on the increase in recent years, averaging as much as 4 million contracts per day. This shows that new and beginning investors are experimenting with options trading to protect their portfolios against risk and increase their profit potential.
However, options trading is also risky and could make you lose an arm if you are not versed in its intricacies. The short-termed nature of options trading which is predicated on the near-term price movement of the underlying asset (days to months) makes it volatile because it gives the trader a short time to cover losses or take gains. Options trading is also highly speculative since you are betting on future price movement based on observed indicators, but this could swing either way. These two factors make options trading risky because you could lose a considerable amount of money within a short time frame.
The Seven Things You Need To Do Before Trading In Options
This implies that any venture into options trading needs to start with the basics. This would give the investor some clarity pertaining strategies, risk appetites and how to cut losses. Below we present the seven things you need to do before trading in options.
1. Determine your risk appetite
Determining your threshold for risk is essential in a volatile asset class such as options. You need to ask yourself how you would react if you lost some or all of your money. The broader implications of losing money and how it would affect you. Having an honest conversation with yourself would enable you to determine your risk appetite. Alternatively, you can calculate your risk appetite to get a clearer picture of what type of investment would fit your temperament. This would eventually play out in the time frame of your option trades. If you have a higher threshold for risk and can stomach losses, you can go for short-term contracts. If however, you have a lower threshold for risk and would like to be on the defensive, you can go for options that have longer expiration dates.
2. Know what options you want to trade.
Before you begin trading in options, it is only logical you know the type of option you want to trade. There are two types of options – calls and puts. Depending on your investment outlook and strategy, each one could be profitable for you. A call is a contract that gives you the right, not the obligation, to buy a stock at a future price. A put option gives you the right, not the obligation to sell shares at a pre-determined price on or before the expiration of the contract.
As a rule of thumb, call option holders exercise their contracts if the strike price is below the market price of the underlying instrument, which implies that they will be able to buy at a lower price than the market price. In the same vein, holders of put options traders will exercise their contracts if the strike price is above the market price.
There are four ways to trade options. You can buy a call, sell a call, buy a put or sell a put. Your investment strategy, risk appetite and market analysis would determine what type of option you would want to trade.
3. Know your technicals
Sound knowledge of technical analysis is required when trading options. Since options are short-termed in nature and highly speculative based on near-term price movements, you need to be able to use various technical indicators to understand and predict the stock movement and make your bets based on your analysis. Sound technical analysis makes an investor trade directionally, which gives him an edge over the market. He would be able to anticipate the movement of the market and position his trades to profit from this information.
Sound technical analysis dispels any doubts and helps you determine what type of options contract to take. If you are bullish and convinced the price of a stock would rise, you’ll buy a call option. If you are bearish and think the price of a stock will fall, you’ll buy a put option.
4. Know your fundamentals
A company’s fundamentals is another factor which could drive the price of a stock up or cause it to decline. Despite the fact that options are based on short-term projections, knowing fundamental analysis can also help you to make better decisions. Fundamental analysis allows you to dumb the noise in the marketplace and see companies for what they are worth. It’s easy to be distracted by the media and get caught in the market frenzy. However, we all know that Mr Market has a mind of his own and would always test our wits by pushing us to make wrong valuations and movements. Fundamental analysis gives investors or traders a realistic perspective of stock price. By comparing a security’s current price and its fair price, options traders can see if the stock is undervalued or overvalued and position themselves appropriately.
5. Know the range of stock movement.
Being versed in technical and fundamental analysis helps you to decipher the trading rage of a particular stock. A Trading range is the range between the lowest and highest consistent price levels of stock within an estimated time frame. By knowing the trading range, you would be able to know what type of option to trade and at what strike.
For example, after observing due diligence and you are convinced that the share price of a company currently trading for $100 would rise to $120 at a future date, you’d purchase a call option with a strike price less than $120. If the stock price goes up, rise your call option is ‘in the money’.
In the same vein, if you are convinced that the share price would fall to $80 after due diligence is done, you would buy a put option with a strike price above $80. If the stock price dips below the strike price, your put option ‘is ‘in the money’.
6. Determine the time frame
Determining the time frame of stock movement is perhaps the most challenging part of options traders, even seasoned ones. This is because the market reacts fast to news. As such, any information, positive or negative has implications for upward or downward movement of stock prices. Options with short-term expirations tend to be riskiest. This is why experienced traders take into account sudden short-term movements and try to spread their contract for an extended period as this gives the market more time to react and allow your stock movement hypothesis to play out. If you are canny enough to detect these moves, you can use options to profit by going long or short of a stock.
7. Tax consequences of trading in options
Options trading have financial consequences that go beyond profit and loss. The holding period of a contract has implications for the amount of tax you would pay. Gains made from options held for less than a one year are taxed at ordinary income rates. Gains made from options held for more than a year are taxed as long-term capital gains. As such, before trading in options, you need to determine the tax consequences that your holding period would have. This would enable you predetermine expiration dates.
Bottom Line
Options trading may seem like a great way to increase your profit and hedge against risks. However, there is also a quick way to lose money. Before you venture into options trading, make sure that you have done the seven things outlined to determine your understanding of the market and level of preparedness of the risk involved.
