There’s no doubt, that option trading is certainly a slightly less well-known area of the trading market. There is no definitive reason as to why this is the case. Some think it might be due to the fact that there’s not as much information available on them, others think that it might be because they can be more difficult to understand than the trading of more regular and better-known securities can be. Click here for a guide to options trading.
Whatever the reason is, hopefully after reading this guide you will feel not only more informed on options and what they are including what they have to offer, but that you might even consider taking on some options trading yourself.
Before we get into the depths of options and what they have to offer the trader, it’s a good idea to get a reasonably broad understanding of firstly, what they are and why they exist. Options are, simply put, another type of security that can serve as a safety measure to another security that you have in place.
Options – A Type of Derivative
Options are part of an area of securities that are called derivatives. What is a derivative? In financial trading terms, a derivative is a type of security that relies on another security above it for the determination of its price. For example, in real-life terms, rubber is a derivate of a tree. The tree must exist in order for the rubber to exist, simple as that. To enter back into financial terms, another security must exist for a derivative of it to exist.
As we have already established, another security of some sort must exist in order for a derivative to do so. A derivative relies on something known as an underlying asset – that underlying asset being what the derivative’s price is determined by.
How are derivatives traded? Derivatives are traded via either over the counter methods or on larger stock exchanges too. As you may or may not know, over the counter trading is most commonly used for trading penny stocks/shares. It does, therefore, come with somewhat more risk than purchasing derivatives from an exchange.
A derivative can be any type of financial security whose value is either dependant on or stems from another set of assets. This other financial asset could refer to any financial security, including stock, bonds, currency, etc.
What Does An Option Offer?
An option offers to the investor the right to buy or sell a particular amount of a security at a pre-determined price, up until a certain date. That certain date is agreed upon when the option is made and purchased.
Why Do Investors Use Options?
Because they have a prediction on the future of a security – If an investor thinks that the price of a stock that they’re looking at is likely to go up in the next term but they don’t want to purchase it in full right at that moment, they may take out a call option.
A call option will allow that investor to agree at the current time that they have a certain amount of time to purchase that the stock at that price. However, a call option does in no way obligate the person that takes one out to purchase that stock before the expiration of the option. All it does is allow the investor to purchase the stock at the agreed price, regardless of the stock price on buying day, at any time up until the contract expires.
Why might a buyer want to do this (take out a call option)? There are many reasons to why a call option could be great for an investor’s situation. If they don’t want to part with all of their funds at that point in time even though that they think the stock is at a good purchase price, they are able to secure the stock to buy at that price for a designated time frame. All the investor will need to do is spend a much smaller amount of their investment fund to secure this option, as opposed to a large amount. It also eliminates the risk of losing a large amount of money to a security that ends up failing or a stock that doesn’t perform as you were expecting. It’s a great way of reducing risk.
Hedging – What Is It & How Does It Relate To Options?
The purpose of hedging is to minimize the risk in a trading situation. Some investors like a certain degree of risk and some do not. It really all depends on how much money you have to lose, and whether you’re willing to place a large sum of money up-front that could be very quickly lost.
Whilst some investors will have a large enough amount of money not to worry overly about risks, the majority of investors aim to keep their risks as low as they possibly can at all times.
An easy way to think of hedging is like a deposit. By hedging, you are placing a much smaller amount of money down at first in order to secure a certain asset, such as an investment rate in terms of trading, or in real life perhaps a large product or service. The only difference between these two examples is what you’re going to get in the end. In real life, if you place a deposit on a product, you know that you’re going to get that product. Placing a deposit on a security does not guarantee that the security is going to go the way that you want it to in terms of value, but it does guarantee that you aren’t going to lose any more money than that deposit.
If you are in doubt of which way the value of a stock or share will go, hedging is never a bad idea. Your initial risk is low, and you can still choose to increase it should the stock start going your way. Hedging is an essential part of options trading.