What exactly is Options Trading? How does it differ from other forms of investing?

In today's post I will be discussing all you need to know on Options Trading as a beginner. Options provide another option for investors to receive a return on their financial assets. I will  cover what options trading is, why you might want to trade options and where you should look to get start.

I am not a financial advisor or registered investment adviser. The information contained in this blog post is provided for general educational purposes only. Any advice you take here is at your own risk and when investing, you are taking the full responsibility yourself. You must do your own research before making any decisions.

What is options trading?

Options trading is a type of derivative contract where investors agree to pay a premium (or receive a discount) for the right to purchase or sell a financial instrument at a certain price within a specified time period.

The option buyer has the right to exercise their option at any point during the life of the contract. This means they can decide whether or not to take delivery of the underlying asset. If they don't want to exercise their option, then they simply let the option expire without taking possession of the underlying asset. In contrast, the option seller agrees to deliver the underlying asset at expiration date.

When buying options, traders are essentially betting on the future direction of the underlying asset. For example, if you believe that the stock market will go down over the next year, you might choose to invest in put options that give you the right to sell shares at a lower price in the future. Conversely, if you expect the stock market to rise, you would buy call options that allow you to buy shares at a higher price in the future.

If you think the market will rise, you might want to invest in calls. For instance, if you think the S&P 500 will go up 20% over the next month and you want to lock in profits, you could buy a call option that lets you buy shares at $700 per share.

Why trade options?

Options trading is one of the easiest ways to make money online. You don't have to put up much capital upfront and there are no commissions involved. All you do is buy and sell options contracts. If you want to learn how to trade options, read our step-by-step guide here.

On the other hand, the risk can be high. When you're trading options, you're essentially leveraging your money which means if you win, you could win big but if you lose you could lose big. You know the saying, high risk high reward.

What are call options?

Call options give investors the right, but not the obligation, to purchase a specific number of shares at a set price within a specified period of time. They allow traders to make bets on whether a stock will rise or fall.

Options are leveraged products similar in nature to CFDs and spread betting. In both cases, the investor makes a bet on the future value of a financial instrument. But unlike CFDs, where the trader takes out a loan against the underlying asset, options require no collateral. Instead, they work like insurance policies – the buyer pays a premium upfront and receives a payout if the contract expires in his favor.

The difference between a call option and a put option is that the former requires the buyer to pay up front while the latter requires the seller to do it.

What are put options?

Put options give you the right, but not obligation, to sell shares at a specified price on or before a given date. You pay a premium to buy the option, and if the price drops to the level you set, you receive the difference. If it goes up, you lose the amount paid plus interest.

Buying puts gives you the chance to make money if the stock price falls. Sellers of puts must satisfy margin calls if the stock price rises above the strike price you choose.

Covered Calls

A covered call strategy involves purchasing stocks, and then immediately selling calls against those positions. You are essentially betting that the underlying stock will rise over the life of the contract. If it does, you profit from the difference between the purchase price and the sale price. However, if the stock falls, you lose nothing because you sold the call at a lower cost than what you paid for the position.

There are several types of covered calls, including buying puts, selling straddles, and selling calls. Each type of covered call offers unique benefits and risks. For example, buying puts gives you exposure to rising prices without having to pay the premium associated with owning the stock outright. Selling calls allows you to lock in gains while avoiding potential losses. Writing straddle contracts provides both upside and downside protection.

The following video explains how a covered call works and why it might make sense for investors to use one.

How Can I Start Trading Options?

Options trading involves placing limit orders, or buy/sell orders, or market orders. This means you place an order to purchase or sell at a specific price. If the stock moves up or down during the option expiration period, you could lose money because you didn't know what the stock was doing. You might want to consider opening a margin account to increase your risk tolerance.

In order to trade options you must find a broker giving the options to trade... well options. Some brokers that allow you to trade options on include : Interactive Brokers LLC (www.interactivebrokers.com), Thinkorswim® (thinkorswim.com) and TradeStation® (tradestation.com).

How to trade options in the UK

Options trading is popular in the United Kingdom because it offers high leverage and low commissions. In addition, there are no taxes on profits earned from option trades. However, there are some differences in how options trading works in the UK compared to the US.

In the US, options trading is regulated by the Securities Exchange Commission (SEC). This agency requires brokers to register with the SEC and obtain licenses. Brokers must also comply with certain requirements regarding customer protection and reporting.

The UK does not regulate options trading. Instead, the Financial Conduct Authority (FCA) regulates financial firms, including brokerages and banks. These firms must follow certain rules to protect consumers.

Similarly to the US, to trade options in the U.K., you need to open an account with a firm that has the ability to trade options. 

There are several types of options contracts. A European style option gives the buyer the right to purchase shares at a fixed price within a specified period of time. An American style option allows the buyer to exercise the option anytime during the life of the contract. There are also exotic options such as covered calls and straddles.

Covered calls allow investors to profit from stock market declines while protecting against losses. They work like this: You buy a call option at a premium. If the underlying security rises above the strike price, you will collect the premium paid for the option. If the underlying security falls below the strike price, you lose nothing.

Straddles involve buying both a call and a put option. If the underlying stock moves up, you make money; if it drops, you lose money.

Options Trading Strategies to Know

There are many different ways to approach options trading. Traders can choose to buy or sell options based on fundamental factors such as earnings reports, economic data, interest rates, stock prices, etc. Others might focus on technical indicators like moving averages, MACDs, Bollinger Bands, RSI, ADX, etc. Still others might use chart patterns, volume spikes, support/resistance levels, etc.

Some traders prefer to use technical tools to help them identify trends. For example, some traders might look for bullish or bearish engulfing candlesticks, while others might look for trendlines, channels, flags, etc.

Finally, there are those who take a longer view and wait for opportunities to develop over several weeks or months. These types of traders are known as “long term investors.” They might use options to hedge against risk, protect profits, or generate income.

#1 - Long Term Investors

Long term investors tend to be patient and willing to hold positions for extended periods of time. They might use options to protect gains, reduce volatility, or generate additional income.

#2 - Swing Traders

Swing traders try to profit from short-term price movements. This type of trader tends to make quick trades and move quickly from one position to another. He might use options to hedge his portfolio during times of high volatility.

#3 - Day Traders

Day traders attempt to profit from small price changes usually within the same trading day even down to a few minutes per trade. They might use options as part of their overall strategy. They might also use options to hedge their portfolios.

Summary

The UK does not have any specific laws governing options trading. However, the Financial Conduct Authority regulates all financial firms, including broker-dealers and banks. Broker-dealers must follow certain rules to ensure they do not mislead their clients.

To trade options in the UK, you need to open an accounts with a brokerage firm that offers these services. Once you have opened your account, you can begin trading options.

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Thanks for Reading

FAQ

How Do Experienced Investors Use Options?

As mentioned earlier, traders use options to speculate and hedge. To maximize their returns, traders track options prices and employ sophisticated strategies, such as a strangle or an iron condor. Here is a quick introduction to some of the strategies that are fairly simple but effective in making money. You can find out more about options strategies here.

Source: investopedia.com

What are call options?

Buying a call option gives you the right, but not the obligation, to buy an underlying market at a set price – called the ‘strike' – on or before a set date. The more the market value increases, the more profit you can make.

Source: ig.com

What are put options?

Buying a put option gives you the right, but not the obligation, to sell a market at the strike price on or before a set date. The more the market value decreases, the more profit you make.

Source: ig.com

Where Do Options Trade?

Listed options trade on specialized exchanges such as the Chicago Board Options Exchange (CBOE), the Boston Options Exchange (BOX), or the International Securities Exchange (ISE), among others. These exchanges are largely electronic nowadays, and orders you send through your broker will be routed to one of these exchanges for best execution.

Source: investopedia.com

What happens after an option is assigned?

An investor who is assigned on a short option position is required to meet the terms of the written option contract upon receiving notification of the assignment. In the case of a short equity call, the seller of the option must deliver stock at the strike price and in return receives cash. An investor who doesn't already own the shares will need to acquire and deliver shares in return for cash in the amount of the strike price, multiplied by 100, since each contract represents 100 shares. In the case of a short equity put, the seller of the option is required to purchase the stock at the strike price.

Source: finra.org