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How to Trade Options » EXPLAIN OPTION TRADING » Understanding Option Trading

Understanding Option Trading

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, options trading is considered to be the safest alternative. The main reason is that 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 options 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 marvelous 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 intrinsic 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 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.

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DISCLAIMER: All stock options trading and technical analysis information on this website is for educational purposes only. While it is believed to be accurate, it should not be considered solely reliable for use in making actual investment decisions. This is neither a solicitation nor an offer to Buy/Sell futures or options. Futures and options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in this video or on this website. Please read "Characteristics and Risks of Standardized Options" before investing in options. CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVERCOMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.