Simple Ways to Trade in Options
An investor invests in the stock market depending upon their risk factor. Some investors invest in less risky investments such as gold, real estate, and other traditional assets, While others in riskier assets such as equity, ETFs, and bonds. Some investors are quite aware of the financial market and want to invest in riskier financial products like Derivatives.
A derivative is mainly a contract between two parties, where value is derived from an underlying asset. The underlying asset in the contract may be stocks, commodities or indices. The two parties which are involved are either buyer or seller. Both parties enter into an agreement of either purchasing and selling of the underlying asset at a predetermined price and date. But it’s not every trader’s cup of tea. It needs a lot of experience before making successful bets in these derivatives markets. Let’s look into each type of derivatives:
- Forwards: A forward is a contractual agreement between a buyer and seller to buy or sell the underlying asset at a pre-specified date and price in the future. These are non-standardized contracts and are traded over the counter.
- Future: They are quite similar to a forward contract, but in a standardized format. On the contrary, futures contracts are traded in the stock exchange.
- Swaps: It is mainly a derivative in which two counterparties exchange one’s party’s financial instrument for those of the other party’s financial instrument. Swaps cash flow is generally fixed, while the other variable is based upon index price, interest rate and floating currency exchange rate.
- Options: It is a contract that facilitates the purchase or sale of an underlying commodity like gold, silver, copper, etc for a fixed price on a future date. The best part about them is that, if one buys an options contract, then he/she is not abiding by the agreement. They are divided into two parts.
- Call options: A call option gives the buyer a right to exercise his option to buy a particular asset from the call option seller for a stipulated period. After one exercise this option, the respective counterparty has to sell the asset at the price which was agreed originally. The buyer earns profits if there is an increase in price.
- Put options: A put option is mainly a derivative contract between two parties to sell an asset at the asset price at which it was originally agreed. But it’s not an obligation. The buyer of the put expects the value of the asset to decrease so that he can purchase more quantity at a lower price. After the buyer of the put exercise his options the seller has no other choice to purchase the asset at the strike price at which it was previously agreed.
How to Trade Options?
Before taking any trade option, you need to purchase a contract to buy or sell an underlying asset. It may be stocks or commodities, usually a certain lot at a pre-negotiated price by a certain date. Before one put the trade, one needs to make certain strategic choices, such as
- First, decide which direction the following underlying asset is going to move. Bullish or bearish.
- Now analyze and predict, how high or low the stock price will move from its current price.
- Further, determine the time frame during which the stock is likely to move.
But one should aware of these key important terminologies, which will help in taking trade position:
- Premium: It is the price, which one pays for entering into the option contracts to the seller of the option. It is the percentage of underlying assets, whether stock, commodities or indices.
- Writer: The seller of the option is called a writer.
- In the money: An option is said to be in the money when the option contract makes a profit when sold at the moment.
- Out of the money: An option is said to be out of the money, if the options contract cannot make money at the time it is sold.
- Underlying Asset: It is mainly the asset on which options derive its value. It could be stocks, commodities, and indices. It plays a major role in determining the price of an option.
- Expiration date: Every option contract is of a certain period, maybe one month, two months and so forth. It is called the expiration date.
- Strike price: It is mainly the pre-determined price at which the buyer and seller of an option agreement on a contract or exercise a valid and unexpired option.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing