How to Trade Options?

Learn how to Trade Options

If you wish to learn how to trade options, then it important to understand the markets and techniques which help in optimum utilization of the situation, trader’s capital, and futuristic view of markets in order to generate maximum profits and/or to minimize losses to the trader.

How-to-Trade-Options

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Source: How to Trade Options? (wallstreetmojo.com)

Top 3 Types/Ways to Trade Options

Since options are traded on exchange globally, they are regulated with standard provisions. There is hardly any scope of adulteration with outside the market arbitrage. Hence, investors can be secured from their investments.

Formula

The below table signifies In-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more (ITM), At-the-money (ATM) or Out-of-the-money (OTM) cash flows on options:

ProductITMATMOTM
CallSpot > StrikeSpot = StrikeSpot <Strike
PutSpot < StrikeSpot = StrikeSpot > Strike

The above cash flows should be net of option premium.

The premium of the option is the cost to purchase that option (long or short, call or put), driven by the intrinsic value of the underlying and time to maturity of the option.

Hence,

Premium = Time Value + Intrinsic Value

As the option approaches maturity, the time value portion of the option starts reducing, and just before maturity, the premium comes near to 0.

Examples of Options Trade

The following are examples of trade options.

Trade Option – Example #1

Call A is traded at $5. An investor with a bullish view goes long call A at the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of $105. Calculate the profit/loss at the end of maturity if the Spot at maturity is $115. Also, comment if the call was ITM/ATM/OTM to the investor.

Solution:

  • Strike Price: $105
  • Call premium: $5
  • Spot Price: $115

Total cost paid by investor: $105 + $5 = $110

As Spot in the market is $115, the investor can purchase the underlying at $105 and sell the same at $115, making a profit of $10 on the underlying.

However, net profit = Profit – premium = $10 – $5 = $5.

How to Trade Options Example 1

This call is ITM to the investor.

Trade Option – Example  #2

Put B is being traded at $5. An investor with a bearish view goes long putLong PutLong put is a strategy used in options trading by the investors while purchasing a put option with a common belief that particular security's price shall go lower than its striking price before or at the arrival of the date of expiry.read more B at the strike price of $95. Calculate the profit/loss at the end of maturity if the Spot at maturity is $105. Also, comment if the put was ITM/ATM/OTM to the investor.

Solution:

Total cost to be paid by investor: $105 + $5 = $110

However, as Spot in the market is $105, the investor would make a loss if he purchases the underlying at $105 and sells the same at $95. In this scenario, since he is “long” the option, he has a choice to either exercise the same at maturity or not.

How to Trade Options Example 2

If he exercises the option, he will make a loss of $10 (plus the premium paid @$5 to make a total of $15 loss).

However, he would not exercise the option and be restricted to a loss of only the premium amount of $5 paid to purchase the option.

This call is OTM to the investor.

 Advantages of Trading in Options

  • The benefit of limiting losses by going long on options.
  • The benefit of investing now for future expected profits. Sometimes the earnings are much more than expected earnings if the future expected event performs well beyond expectations.
  • Investment can be minimal, and risk can be taken on the much larger underlying value, which is not the case while investing in cash stocks.
  • It creates a huge leveraged network for investors in the entire market. Enhances the value of money.

Disadvantages of Trading in Options

Limitations of Trading in Options

  • A particular market view is required for prediction; however, it may be correct or not.

Conclusion

Trading into options is an important market component, and hence, this product should be studied well before making investments. With a proper understanding of market movements, one can make decent positive cash flows from the markets.

This has been a guide to how to trade options?. Here we discuss types, components of options trading along with examples, advantages, and disadvantages. You can learn more about derivatives from the following articles –

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