Options Trading – Everything You Need To Know

January 6, 2022

You need to consider different alternatives when looking to expand your investment portfolio. Although bonds and stocks are excellent opportunities, options give you diversification. While the risks can be great, the rewards that come with options trading are higher.

Contrary to what most beginners think, options trading is not particularly complex or difficult. Any investor can make a fortune with the right know-how. Therefore, we have put together a comprehensive overview of options trading to get you started. It’s never too late to embrace versatility in the way you invest.

Options Trading – The Basics

Think of options trading as a way of trading in instruments that offer you the right to sell and buy specific securities at a distinct price and on a fixed date. Therefore, an option can be defined as a contract linked to an asset – either stock or other security. These contracts have a set period ranging from a day to a couple of years.

Having an option means you get the right to trade the specified asset. However, it does not mean you are obligated to do so. You only exercise the option if you decide to trade – at a time of your convenience.

DIY investors trading in options get to have a self-directed account. Therefore, you are always in full control of every transaction or decision. Luckily, several communities can help you make informed decisions about options trading.  These communities discuss strategies for trading and the current market outlook.

Types of Options

There are two distinct types of options in the market – puts, and calls. You need to understand these two types of options before you start options trading. Below is an in-depth look at puts and calls to get you started.

Call Option

With a call option, you get the buying rights of underlying security within a specified time and at a specific price. It is more like calling the security to come to you. Your payment is labeled as the strike price and the expiration date specifies the end date of exercising your call option.

You can either have a European-style or American-style call option. The European-style alternative allows you to only buy the underlying asset on the specified expiration date. However, the American-style option lets you buy the asset at any time before the expiration date.

Only buy call options if you anticipate the price of the asset will increase before the specified expiration date. It means you get to buy stocks at a lower price despite the increase. Therefore, you stand to increase your investment since your contract allows you to buy the underlying stock at a discount.

Put Option

Instead of giving you the right to buy an asset, a put option allows you to sell an underlying asset at a set strike price. They also include expiration dates and come in the same two styles as call options (European and American) with similar rules.

Always consider how much you are willing to invest, the time frame, and expected price movements before purchasing a put. It makes sense to buy a put option if you expect the price of the asset to go down. It means you get to sell at the original strike price despite the price drop of the underlying asset.

Extra Pointers in Options Trading

Are you ready to start investing in options trading? Well, these three pointers will get you started on the right foot:

Options are Attached to Different Types of Securities

Although this article references stocks when it comes to puts and calls, options are ideally attached to other different securities. The most common are indexes, equities, and ETFs. However, understand the difference between these options before you start trading.

Options Trading Comes Down to Calculated Risks

Individual traders in options trading need to concern themselves with two things – implied volatility and historical volatility. While implied volatility is about predicting the future, historical volatility is about considering past price fluctuations. Options trading is, therefore, simple if you have a good understanding of probability and statistics.

Know Your Financial Goals Before Engaging in Options Trading

An excellent options trader needs to have a clear understanding of what they intend to achieve financially. Therefore, it is vital to define your financial goals before you start options trading. Doing this will help you have a clear focus on what you are willing to risk and gain.

Advantages of Options Trading

One clear advantage of options trading is the flexibility it provides. Unlike other investment options, it allows you to invest with little capital. Options trading can also help you diversify your portfolio. Savvy traders understand that they can generate considerable returns.

Risks of Options Trading

For starters, trading options is much riskier than buying ETFs, stocks, and bonds. Predicting how a stock will perform in the future can be difficult. Any wrong movement and you stand to take heavy losses. Therefore, always consider your risk tolerance and goals before trading in options.

The Bottom Line

Although nothing is truly guaranteed in the investment world, you stand to make considerable returns if you do it right. It also helps to diversify your portfolio with other opportunities such as options trading and investing in blue-chip art. At Masterworks, our exclusive community can help you get started on the right foot. Start by requesting an invitation today to expand your portfolio.

Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.