Options are often seen as complex financial instruments, but they can be used to achieve various investment objectives. Whether you’re looking to hedge your portfolio or speculate on the direction of a particular security or market, options can provide the flexibility and potential opportunity that you seek.
Before trading options, it’s essential to understand the basics. This article will provide an overview of options, how they work, and some critical considerations in trading them.
What are options?
Options are contracts that entitle the holder to either buy or sell an underlying asset at a set price within a fixed timeframe. There are two types of options: call options and put options.
Options are traded on exchanges such as the Chicago Board Options Exchange (CBOE) and are available on various securities, including stocks, commodities, currencies, and indexes. To get started, it is best you work with a reputable broker such as Saxo.
How do options work?
You’re not buying or selling the underlying asset when you buy an option. Instead, you’re entering into a contract that gives you the right to buy or sell that asset at a specific price.
If you buy a call option, you can buy the underlying asset at the strike price. If the asset price rises above the strike price, you can exercise your option and buy the asset at the lower strike price. If the asset price falls below the strike price, you can let your option expire and not incur any losses.
If you buy a put option, you can sell the underlying asset at the strike price. If the asset price falls below the strike price, you can exercise your option and sell the asset at the higher strike price. If the asset price rises above the strike price, you can let your option expire and not incur any losses.
Options can be used to speculate on the future direction of a particular security or market, or they can be used to hedge your portfolio against potential losses.
Options can also be used to hedge against potential losses in other investments. For example, let’s say you own a portfolio of stocks and are worried about a potential decline in the stock market. You could buy put options on a broad-based index such as the S&P 500 to protect your portfolio from losses.
What are the risks of trading options?
While options can be used to achieve various investment objectives, they also come with certain risks. The most important risk to understand is time decay.
Time decay is the rate at which an option’s value declines as it approaches its expiration date. The value of an option is highest when it is first purchased and declines as the expiration date approaches. This is because the holder has less time to benefit from a change in the underlying asset’s price.
The amount of time decay will depend on how close the expiration date is and how much time premium is built into the option’s price. The time premium is the amount by which the option’s price exceeds its intrinsic value.
Options further from expiration will typically have a more significant time premium than options closer to expiration. This is because there is more time for the underlying asset’s price to move in your favour.
Options with a higher strike price will also typically have a more significant time premium than options with a lower strike price. This is because the higher strike price options are more likely to finish in the money.
Other factors can also affect the time premium, such as the underlying asset’s volatility and interest rates.
Another risk to consider is the possibility of losing your entire investment. This is especially true if you buy out-of-the-money options with a strike price that is not close to the underlying asset’s current price.
You can also make a loss if you sell options. As such, you must buy or sell the underlying asset at a specific price.
Options can be a versatile tool for investors, but it’s essential to understand the risks before trading. Time decay and the possibility of losing your entire investment are two of the most significant risks.
When used correctly, options can help you achieve various investment objectives. However, it’s important to remember that options are risky and should only be traded with money you can afford to lose.