Options are contracts that give you the privilege of buying or selling shares of a company at a determined price over a set period of time. There are two types of options contracts. A call option is a contract that gives you the right (not the obligation) to buy the shares at the strike price (the agreed-upon price), whereas put options give you the right (not the obligation) to sell the shares at the strike price. Either way, you will have to pay a premium to buy such a contract.
Opening an Options Trading Account
If you want to open an options trading account, you will need to provide the prospective broker the following details.
- Your investment objectives (income, growth, speculation, etc.)
- Your trading experience and knowledge of trading.
- Your personal financial information like your annual income, and employment information.
Based on these details, the broker would assign you a trading level, and accordingly, you could trade the most suitable options.
How to Trade Options
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Let’s take a look at an example to understand the basics of options trading. XYZ company is trading at $50 per share. You buy a call option contract at a strike price of $50 per share with a premium of $2 per share. Typically an option contract consists of 100 shares, so you would pay $200 for this call option contract.
If the price of the share rises to $70, however, you could buy 100 shares at the strike price of $5,000 and sell it at the new price of $7,000. You would make a profit of $1,800 after deducting the price that you paid for the contract.
Conversely, a put option could be profitable if the share price goes down, and you could sell the price at the strike price.
Advantages of Options Trading
There are many advantages to options trading.
Possible Higher Return
Let’s take a look at another example. A company is trading at $20 per share. The call option contract for 100 shares would cost you $200 at a premium of $2 per share. If the share price rises to $30, an increase of $10, the value of the contract also rises to $1,000.
In this scenario, if you buy 100 shares at $2,000 and sell it for $3,000, you make a profit of $800 after deducting the price of the contract. In thise case, you would receive a 140 percent return. If you sell your contract at its new value of $1,000, on the other hand, you would make a profit of $800, a 400 percent return on your $200 investment.
These types of contracts offer limited risk. You would never lose anything more than the cost of the contract irrespective of how bad the company’s shares are performing in the market.
American options contracts provide a lot of flexibility for investors. You could enforce the contract anytime during the tenure of the contract.
Risks Involved with Options Trading
Prices may Move Very Fast
As options are highly profitable investments, their prices often fluctuate. You cannot watch the options pricing in real-time throughout the day, so you should invest wisely so you can make a considerable profit.
All option contracts expire. As the expiration date gets closer, the deterioration of the premium accelerates, and the contract can become valueless. As an options investor, you should only invest an amount you can afford to lose.