Options Trading - How does it work? - Explained by EaglesInvestors

The way we see it, options trading is an instrument for individuals who do not like investing heavily in stocks. It is an agreement two people make to sell or buy the right to an underlying stock. For example, the person who buys an option pays a premium to the seller hoping and speculating that the stock price will go up before the agreement expires or vice versa. With options trading, you have the chance to practice a variety of strategies with limited or unlimited risk or profit potential, develop hedging trading opportunities for yourself.

What is options trading and how does it work?

options trading

In the early 1970s, options were developed as a way to mitigate risks. Traders were experiencing high volatility, and they were using options to help hedge their positions. Now you may have heard that options are inherently dangerous, but that’s not necessarily true.

Of course options like any other trade or investment are going to have Associated risks, but they don’t have to be extremely dangerous. Let’s look at something you might be familiar with; a credit card are credit cards dangerous? Of course not, but if you don’t know what you’re doing with them or if you’re not disciplined you can get yourself into a lot of trouble, and the same is accurate with options.

Options are not inherently dangerous but if you don’t take the time to study the risks and rewards associated with options you can get yourself into trouble.

Options trading – how to do it properly

Example 1

Let us take a scenario where you want to buy a stock. First of all, we want to put our money in the direction of the money flow, so we have to look for a stock that is in an upward trend. Let’s assume we are going to buy a thousand shares, and we are going to pay $ 50 a share for that stock. It will cost us $ 50 000 to make the purchase, and we can hold on to it for as long as we want. There is no expiration on this; you decide when you want to sell that position. If you get a stock that pays dividends, then that will be one way to profit from this trade.

Assuming the stock stays right at that purchase price, you will get that dividend as a return on investment. If you buy that stock at 50 dollars and it goes higher than 50 dollars, then you are going to make a profit. On the other hand, if it goes lower than $50 it’s going to be a loss to your account.

Let’s take a look at how options are used in the following trade

Referring to the first example: so we bought the stock, what can we do a little bit differently using options trading. Introducing the first option;

1. THE CALL OPTION

The call option is going to give YOU as the buyer, the right to purchase the stock for a certain price, and you get to specify that price. The amount at which you get to buy your chosen stock is called the strike price.

Let’s use a more familiar example:

Example 2

Say you are buying real estate, the buyer and the seller agree on a couple of things: the closing date and the price. Now for call options, the amount that is agreed upon beforehand is called the strike price, and the closing date will be the expiration date for that option. Of course, you are going to have to pay a fee for the right to buy the stock for the strike price. That fee is called premium, in options trading terms.

2. THE PREMIUM

It is very much like the down payment in real estate transactions, it’s not the full amount, but it’s a smaller amount that locks you into that contract.

So with a call option, you’ll pay a premium to receive the right to buy that stock at a specified price.

What may affect the value of the premium?

– Strike price

As the strike price is lower, there is more built-in value in that call option. The amount is called the intrinsic value, as intrinsic value goes higher, you are going to pay more “premium” for the call option.
However, some other things will affect the call premium as well, such as:

– Time value

The longer the time left before the expiration, the more premium you will have to pay for that call.

– The cost of the option will be influenced by the volatility of the stock

Increases or decreases in the stock price volatility tend to be reflected in premium increases or decreases.
You must understand that there is no one-to-one relationship between the options trading and the stock in fact :

1 option contract = 100 shares
10 options contracts = 1000 shares

options trading

Example 3

We’re going to buy ten option contracts which represent 1000 shares of the stock, and we’re picking a strike price of $50. Another factor to consider is the time frame. We’re buying an option that has two months left until expiration while the stock is trading at $50 a share. So we can only use this contract for two months after that it is completely worthless to us.

A couple of things can happen from this point. Typically when the stock price increases the call premium increases. When the call premium increases we could sell the call for a profit. But there’s also a risk here, and that is if the call premium decreases which typically happens when the stock price drops. In that instance, we would sell the calls for a loss.

How can we manage risk in options trading?

If we buy the stock how can we protect that position against falling prices?

Please watch this video tutorial where you will learn how to risk manage your options trading.

3. THE PUT OPTION

While the call option gives you the right to buy, the put option gives you the right to sell your stock. So you own the stock, and by purchasing the put option, you have the right to sell that stock. You also get to choose the price at which you would like to sell the stock. That specified price is also called the strike price. When you pay a premium in return, you are getting value, this value is the ability to sell that particular stock at a predetermined amount. The put option will be valid for a specified term and then expires at the end of the term, that date is the option expiration

What affects the premium of a put option?

Just like with a call there’s going to be a built-in or intrinsic value to this. For example, with the “put options” the higher the strike price, the more expensive it’s going to be, because we have more inherent value.

The time remaining until expiration will affect the cost of the premium. More time means a higher premium.
Finally, as the underlying stock price has higher volatility that volatility will be reflected in the higher premium for the put options.

Key point: you will have more protection owning the put contract than you would have without it.

Options Trading VS, CFD Trading

CFDs and options trading carry some similarities, but also many key distinctions, and both are suited to their appropriate objects. Unlike share, options tradeing are also derivative instruments that are leveraged by nature. That said, there are several essential differences around leverage and the actual pricing of the instruments. At first glance, both seem similar, but there are some essential principles for comparison.

CFDs are agreements who close out a contract for the profit/loss in the difference between opening and closing price of an instrument.

Options are rights to purchase shares or commodities later at a set price. Options are obtained at a fraction of the underlying asset price and give the trader the right to acquire the asset later if he so chooses. Usually, it happens when it proves to be profitable. The profit part for the trader is calculated merely as Profit = Selling Price – (Buying Price + Options Price).

Concerning functional diversities, firstly the transparency of instrument pricing differs significantly among CFDs and options. CFDs proved to be more accurate trackers of underlying markets than options for some reasons.

Options Trading and CFD Trading Similarities

Options suffer the same as futures. If a decline or a price spike or expiry tops, and it’s logical that this is the case. The value of the right to buy shares is less valuable with less time to exercise it in your favour. Before it grows void, very often it proved to be hard in getting accurate measures of whether an option reflects the real underlying asset value.

CFDs are mainly marketed by direct access brokers that track the underlying market tick for tick. As brokers are required to meet similar CFD positions with live positions, many brokers hedge to balance the risk and at the same time adding value for the traders.

options trading

Conclusion

I am pretty sure by now you have a detailed idea of what options trading is and how it works. If not make sure to practice using the terms and you will be a master in no time.

Another critical advantage of CFD trading is that they are available on a considerably more comprehensive as opposed to options. Options trading is considered to be much harder to handle because it cannot be traded in association with an index or rate.

Depending on your trading approach this might not be a problem but for beginners not as flexible.

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