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Understanding Options Trading: A Comprehensive Guide For Beginners
Options trading is an increasingly popular form of investing that allows you to speculate on the direction of stocks without having to buy them outright. It’s a powerful technique for managing risk, as you can choose precisely when to exit a position. Plus, many options come with time limits — for example, contracts that expire in a few weeks — which also adds an element of excitement for traders.
But for beginners, options trading can feel overwhelming. That’s why we’ve put together this comprehensive guide. Here, you’ll find all the information you need to get started with options trading, including what options are, the different types of options, how to use them, and a little something extra to get the most out of your trades.
What Are Options?
Options are tradable financial contracts between a buyer and a seller. When you purchase an option, you have the right — but not the obligation — to buy or sell an underlying asset (the stock, index, or ETF) at a specific price. Options are derivative instruments, meaning that the option’s value is derived from the underlying asset’s value.
Types Of Options: Calls and Puts
Options are divided into two categories: calls and puts. A call gives you the right to buy the underlying asset, while a put gives you the right to sell the underlying asset. Here’s an example of how calls and puts work:
- Assume you’ve bought a call option on a stock with a strike price of $50. This means that you have the right to buy the stock at $50.
- If the stock’s price increases to $55, then you can exercise your option and buy the stock for $50, immediately profiting from the $5 difference.
- On the other hand, assume you’ve bought a put option on the same stock with a strike price of $50. This means that you have the right to sell the stock at $50.
- If the stock’s price decreases to $45, you can exercise your option and sell the stock for $50, realizing a $5 profit.
Understanding Option Strike Price
You may have noticed that calls and puts each have a strike price. This is the price at which the underlying asset can be bought (call) or sold (put). You can think of the strike price as the tipping point — if the stock’s price is above the strike price, the option is “in the money,” while if it’s below, it’s “out of the money.” This is an important concept, as we’ll discuss in more detail in the section “Choosing the Right Option Strike Price.”
Option Premiums Explained
Whenever you purchase an option, you also pay a “premium.” This is a fee that gives you the right to buy or sell the underlying asset at the strike price. It’s important to understand that the premium is nonrefundable, even if the option expires worthless. That’s why it’s important to have an idea of the direction of the underlying asset before you purchase an option.
Strategy #1: Use Options For Income & Lower Risk
One of the most popular strategies for options traders is to use them to generate income while also reducing risk. To do this, traders look for stocks that possess a steady price and sell out-of-the-money calls, collecting the premiums while capping their risk. In the event that the stock’s price moves outside of their expectation, they can simply sell their calls.
Strategy #2: Use Options To Profit On Price Movements
A second common strategy is to use options to take advantage of expected price movements. This is done by buying call options when expecting a stock’s price to increase and buying put options when expecting a stock’s price to decrease. This can be an effective way of utilizing options to maximize gains and minimize losses.
Choosing the Right Option Strike Price
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