Exchange-traded options, or just “options” for short, are contracts that allow the buyer to buy or sell a security at a specific price on or before a certain date if they so choose. They’re traded like stocks and other securities, which means you can buy and sell them throughout the trading day.
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Hedging risks with options
Options are often used to hedge risk since they protect against potential losses in security without having to sell the security outright.
You could buy a put option on that stock, which would give you the right to sell it at the current price anytime before your option expires. It would allow you to wait out any dips in the stock price while still keeping the upside potential of the security.
Using options to speculate the value
Many traders also use options to speculate on whether or not underlying security will go up or down in value. When using options for speculative purposes, time is your best friend.
Since you’re only obligated to hold an option until expiration (if it’s not exercised), you can keep options for days, weeks, months or even years before they expire and take your profits off the table.
Of course, there’s no such thing as a free lunch in securities trading. While selling put options allows you to keep your costs low if things turn out well for you (because you get to keep the option premium), you can lose a lot of money if the underlying security moves against you. So, like everything else in securities trading, you should use options in conjunction with a solid trading plan and risk management strategy.
How to trade exchange-traded options
Now that you have a basic understanding of what options are, let’s look at how to trade them.
Find an options broker
The first step is finding an options broker who offers trading in the specific options contract you’re interested in (see it here). Once you’ve opened an account with a broker, you’ll need to fund it with enough cash to cover your margin requirement.
Cover your margin requirement
The margin requirement for options contracts is generally lower than for stocks or other securities, but it varies depending on the contract and the broker.
With most brokers, you can find the margin requirement by multiplying your option’s contract value by an appropriate percentage. For example, let’s say you bought one put option worth 50 shares of a company’s stock. If the contract value of that option is around $700, your margin requirement might be 1%. In this case, it would be $7000, which you would need to have in your account before opening a position.
Choose an options contract
There are many options contracts with different expiration times and strike prices.
- Long-term options typically have higher premiums than their shorter-dated counterparts, which means that they’re best suited for either hedging purposes or for those traders who don’t mind tying up their cash in investment for an extended period.
- On the other hand, short-term options are perfect for traders looking to take advantage of quick price movements in the underlying security.
Consider your risk tolerance
When deciding which option to buy or sell, it’s essential to consider the current market conditions and your risk tolerance. For example, if you think that a stock will go up in value, you might want to buy a call option rather than buying the stock itself. This way, you’re not risking as much money on the trade, and you still have the potential to make a profit if the stock goes up.
Conversely, if you think that a stock will go down in price, you might want to sell a put option rather than shorting the stock itself. This way, you’re not risking as much money on the trade, and you still have the potential to make a profit if the stock goes down.
As with all securities trading, it’s important to remember that options involve risk. So, before you start trading options, be sure to read through your broker’s terms and conditions and understand the risks involved in each type of trade.
Now that you understand what options are and how to trade them, it’s time to get started!