Options trading is the buying or selling of an options contract. Options are used to gain exposure to specific stocks without owning the stock. This is known as speculation, and many people buy options hoping that their value will rise before they expire, at which point they can sell them for a profit.
Options are contracts between buyers and sellers that give one party or the other the right but not the duty to buy or sell an underlying asset by a certain date for a specific price. The buyer of an option believes the underlying security’s price will increase before expiration, while the seller thinks it will decrease.
The two primary options are calls and puts. A call option gives the holder the right to purchase a stock at a specified price until a specific date, so you would buy it if you thought the stock’s price would rise before then.
A put, on the other hand, is just like buying insurance. If you think that security will go down in value, then don’t hold onto it; instead, insure against it by buying put options that give you certain rights concerning that underlying asset.
Get a brokerage account
If you wish to obtain or sell options, you’ll need to open a brokerage account. Without one, you won’t be able to make any trades. Since options are derivatives of other securities, they will trade in either the cash market or the futures market.
If you’re buying call options on stocks that trade on an exchange like Hong Kong Stock Exchange (HKEX), then your broker might only allow you to place orders for those stock options in the cash market. But if it will enable them to be traded in the futures market, you would have access to both types of options contracts.
Determine whether an option is ‘in’ or ‘out-of-the-money.’
An option is out of the money (OTM) when its strike price is greater than the market value of the underlying security. For example, if you bought an OTM call option on HKEX for HKD10 while HKEX trades at HKD100 per share, that would be considered out of the money.
Every dollar that HKEX increases in price will result in a corresponding decrease in your call options’ value. However, they can still make it profitable to exercise them by selling them before expiration and closing out their position.
If you believe that a specific stock’s price will increase within a particular time frame, buying put options would give you insurance against losses. However, if you think that the value of a security will decrease in price, then buying call options would allow you to profit from its falling price without shorting it.
Selecting an option strategy
Depending on your market outlook, selecting the appropriate option strategy could limit or maximize your chances of making money when initiating a trade. The four basic strategies are vertical spreads, iron condors, credit spreads, and debit spreads.
A vertical spread requires the simultaneous procurement and sale of two options on the same underlying security with different strike prices and expiration dates. Buying a vertical spread limits potential profits and keeps risks low while selling could collect substantial premiums.
An iron condor involves buying and selling an equal number of put and call options with different strike prices, but all four must share the same expiration date. Iron condors are usually traded when investors think that a stock or index will stay within a relatively narrow range before expiration.
Credit spreads involve opening a bullish position by purchasing call options on underlying security while simultaneously opening a bearish position by writing put options on it simultaneously. This strategy is profitable because the premiums from writing put options are more significant than those paid to buy call options.
Debit spreads involve buying and selling an equal number of puts or calls but with different strike prices and expiration dates. Buying a debit spread limits potential profits, but it also keeps your risks low since you’ll only have to pay for some of the option premia.
Follow your investment decisions closely.
No matter which strategy you use, don’t ignore its movement until its expiration date. A general rule is that traders should consider closing out their positions when they’re up by 20%.