Understanding Option Trading – Why it is The Best and Safest Derivative
Understanding option trading and its fundamentals should be “required knowledge” if you want to be a successful trader. Options are one of a number of things called “derivatives” and are called this because their price is “derived” from the price movements in an underlying asset such as a share, commodity future or currency. But of all derivatives, option trading is considered to be the safest alternative. The main reason is, because unless you sell “naked” positions, which is never recommended, your maximum risk will always only ever be the amount you invested.
Other derivatives such as futures, spot price forex trading and CFDs do not carry this safety net … although some CFD brokers such as IG Markets will offer traders a ‘guaranteed stop loss’ these days. But from my experience, I have found that the leverage in these types of financial instruments works against you just as much as it does for you. Unlimited profit potential can also quickly become unlimited loss potential, so you are more nervous about position size and moves against you. Consequently you can often be stopped out before your position recovers and goes in the direction you believed it would.
So understanding option trading is certainly a worthwhile exercise. The only downside is that, unlike futures and CFDs, option pricing is much more complex. But their very complexity is what makes them so versatile and flexible.
Understanding Option Trading Strategies
You can construct combinations of buy (long) and sell (write/short) positions with the same, or different, expiration dates and exercise prices – these are called “option spreads”.
Or you can as it were, take a bet both ways, by purchasing both call and put options simultaneously, in anticipation of a large price move within a reasonable time frame after the positions are taken. Due to this marvellous little thing called “leverage” the profitable option will do so well that it will not only cover the cost of the losing option but make you a nice profit as well. Variations of this strategy are called “straddles” and “strangles”.
Or if you already own shares, or wish to purchase them, you can also write call options at exercise (strike) prices above your share purchase price and make extra income selling “covered calls“.
Educating yourself in options trading should also include knowing how to hedge your investment positions. Hedging is a process whereby you spend a small amount of money to create a position that will make sufficient profit or loss, to offset the effect of price movements in your asset portfolio, which cost you a much larger sum. The leverage available in derivatives is what gives you this power.
Another critical feature of understanding option trading, is the absolute rule that all options eventually expire. Consequently, one component of their pricing is known by the Greek letter “theta” which stands for “time decay”. The closer an option position gets to its expiration date, if it has no instrinsic value, its value declines at an exponential rate. But did you know that there are strategies you can employ which actually take advantage of this and provide a very effective way to profit. The very popular Trading Pro System series of educational videos explores this concept in detail.
Understanding option trading means becoming acquainted with the all the option trading basics and advanced option trading strategies. So have a look around this site for a while. Follow the links on this page to begin your exciting journey of discovery and self education. Empower yourself to become financially self sufficient.