Options trading is a popular form of financial investing that can help traders to take advantage of price changes and market movements. Options are a type of derivative, which means they derive their value from another asset – usually an equity, index or commodity. With options trading, the buyer has the entitlement but not the responsibility to purchase or sell an underlying asset at a specified price by the expiration date set in their contract.
It makes them a flexible and cost-efficient way for traders to speculate on potential market outcomes without putting up too much capital upfront. This article will discuss how traders can maximise their chances of doing well through options trading in addition to capitalising on opportunities offered by derivatives markets.
Covered call writing is a popular strategy that allows traders to generate passive income by writing short-term calls against an underlying asset they already hold. When writing calls, the trader agrees to sell their stock at a predetermined price on or before the expiration date. If the market rallies and the option is exercised, they can potentially make additional gains from the premium received in exchange for giving up stock ownership. This strategy best suits bullish traders on specific security who don’t want to commit too much capital upfront.
Bull spreads give traders leverage when taking a bullish position in an underlying asset without having to buy it outright. It involves purchasing options with lower strike prices and selling options with higher strike prices within the same expiration period. Traders can take advantage of option positions if the underlying asset reaches a higher strike price by expiration. This strategy is suitable for short-term investors looking to bet on potential positive market developments without taking too much risk.
Bear spreads allow traders to take a bearish position in an underlying asset without selling it outright. The spread involves selling options with lower strike prices and buying options with higher strike prices within the same expiration period. If the market moves down, traders can collect more returns from their option positions than they would have if they had sold the underlying security. This strategy works best when used as a hedge against long stock positions to protect funds in the event of a downturn.
Straddling is a strategy in which traders buy call and put options with the same strike prices and expiration dates to benefit from positive or negative price movements. It allows them to take advantage of upside and downside opportunities in an underlying asset without owning it. Traders will be able to find opportunities if the market moves up or down beyond the breakeven points set by their option positions. This strategy best suits traders who are unsure about the direction of market prices but still want to benefit from changes in price levels.
Combination trades allow traders to combine different strategies into one position, such as buying or selling calls and puts. It allows them to take advantage of bullish, bearish, neutral, and volatile market conditions. Combination trades are suitable for traders who want to use multiple strategies with the same underlying asset rather than having different positions on different securities. Moreover, traders can hedge these trades against existing positions to limit losses in an adverse market.
While trading options have several benefits, traders must also know about the risks. The awareness of the risks will help traders to manage their investments better and benefit from opportunities without incurring heavy losses.
As options approach their expiration date, the value of the contracts will start to diminish. It is known as time decay and can significantly reduce the potential value of an option position. Traders must ensure adequate funds to manage time decay risk and maximise their returns when options trading.
Unexpected big moves in the market may result in significant losses for traders who are not prepared for volatility. Traders must be able to predict volatility levels and adjust their positions accordingly to protect their funds.
If an option’s underlying asset does not trade actively or lacks liquidity, it could lead to sudden price movements that can wipe out options positions. Traders must know the liquidity risks and ensure they can exit their positions if needed.