Whether you are in your early 20s or late 50s, starting an investment portfolio is something that everyone should consider. Putting down an investment has become an essential part of life since everyone needs to accentuate their income and get a steady sum to count on in their future. However, the investing pool can be impossible to navigate, especially if you do not have a guiding hand.
Once you decide to put down investment in your cards, you will hear of so many things that you can put your money in. Some will tell you to buy stock, while others believe forex trading is the way to go. Additionally, some will preach the gospel of options trading.
However, the essential thing that you should always have at the back of your mind is that it is better to learn about all the investment options given and decide where you fit best. Therefore, this article will highlight everything you need to know about options to equip you well to determine where to put your money.
What are Options?
Although options have become very popular in the few years, as indicated by its record high trading of 7.47 billion contracts in 2020, most people still do not understand what they are. Some people often confuse stocks with options, while other times, the people who ask this question do not even know what they entail.
Therefore, to clear this up, an option is a form of a derivative contract that will offer you as an investor the right (option) but not a burden to sell or buy an EFT or a stock at a given price, known as the strike price, for a set time either years or months. At the end of the specified period, the option expires, and therefore its value no longer exists, and neither does the option.
The definition of an option also outlines its main difference from stock. Unlike stocks, an option represents the possibility of ownership and not ownership in the company in question. Since it is a contract until exercised, an option shows potential only.
The initial charge of the option buyer is an amount often referred to as a premium for the privilege of having the right over that option. Therefore, the option holder retains the ownership, and if the market prices do not favor them, they let the option expire, which only draws a loss of the premium. However, if the market prices get to a place where the option is valuable, the option holder uses it.
Types of Options
Before getting deeper into options, it is vital to understand the language used, which involves knowing the option types. There are two types of options:
- Call Options
- Put options
In this option, the contract holder has the right to buy the option in question on a future date at a preset price, the strike price. Therefore, in this contract, the option holder is only extended the right to buy the option by a particular day at the set price. This means they cannot sell or utilize the contract after the date has passed.
The option in question is, on most occasions, referred to as the underlying asset. It is important to note that the option holder profits when the price of the underlying asset increases.
There are two types of call options:
- Long Call Option –This is the same as a call option where the option buyer has the right but not the obligation to buy an underlying asset at a set strike price on a future date. However, the main advantage of a long call option is that it allows the buyer to plan to buy the underlying asset at a lower price. For instance, the buyer might purchase a long call with the expectation that the company in question will experience a newsworthy event that will raise the costs of the assets. However, if this does not happen, the maximum losses experienced are limited to the premium paid.
- Short Call Options – In a short call option, the seller of the underlying asset promises to sell at a fixed price in the future. Therefore the buyer does not have much of a bearing on the future price of the underlying assets. The buyer is only left to accept the price offered and hope that the underlying asset will get to the promised price.
Whereas in a call option, the buyer of the option has the right to buy the underlying assets, in a put option, the buyer is selling the underlying option at the strike price. Unlike call options, you can find put options on various underlying assets such as currencies, commodities, stocks, bonds, indexes, and futures.
Another striking difference between the call and put options is that the option loses its value as the underlying asset increases in price in input options. Additionally, in put options, although as a contract holder, you will not carry the burden of selling a given number of the underlying assets, you will have the right to sell at the set price within the given timeline.
Having tackled the types of options available in the market, you should note that although an option can last for a very long period, eventually, all options expire. As the expiration day nears, the options generally lose their value and are worthless. Therefore, as you consider options trading, this is important to keep this in mind.
What is Options Trading?
Once you have understood what options are, the second most asked question is what options trading is. You buy or sell EFTs, stocks, indexes, or futures at the set strike price within the specified duration when you trade options. The most beneficial aspect of trading options is that it gives you, the buyer, the flexibility of not buying the underlying assets at the given time, which will lead to losses.
Additionally, options help the buyers make considerably larger profits when the prices of the underlying assets go up. Apart from helping you restrict your losses and giving relatively high profits, in options trading, you also do not have to pay the total amount for the underlying asset when signing the contract. Therefore, it avails you with an aspect of flexibility and security.
Some of the terms used with options trading include:
- Hedging: This is the art of protecting yourself from price fluctuations of the underlying assets and giving you the option of buying or selling at a predetermined price in a specified period.
- Leverage: This term refers to the art of options trading, helping you profit from underlying asset prices without paying the total cost. Therefore, you have control over the assets without paying for them first.
Options trading is quite lucrative, but it is necessary to mention that it is more complex and involves so much more compared to trading regular shares. Therefore, it is vital to grasp as much knowledge in monitoring market fluctuation, investment practices, and ways to trade before diving into the deep end.