An option is a contract that, when agreed upon by all parties involved, means that you can buy or sell an agreed-upon item at an agreed-upon price for a fixed amount of time, hence why they are known as “derivatives”.
If someone wants to trade in options, they will often use leverage, which means using borrowed money to make more profit than would otherwise be possible. Of course, though this type of trading does carry its risks, the stock market could crash overnight due to any number of events (such as Brexit ), and you could stand to lose more than double what your initial investment was.
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Types of traders
There are two types of options traders;
Speculators
Speculators create considerable swings in the market by simply buying and selling options as a way of turning a profit.
Options traders
Options traders are more interested in contracts that protect against loss than those that aim for quick cash. It takes longer for an options trader to turn a profit, but they can also limit their losses using more intelligent option strategies.
What are derivatives?
There are options available on all sorts of things, including stocks, indices, currencies, and commodities. These are known as derivatives because their value is derived from something else; for example, if the price of oil goes up, an oil option would increase in value.
Although there are undoubtedly many risks involved when you trade in derivatives, there is also an awful lot of potential for returns. Make sure that if you do plan on investing, you are aware of just how much your potential profits could be before making any decisions, though because otherwise, it might turn out to be a very costly mistake.
An example of options trading
The simplest way to explain options trading is with a straightforward example. Suppose you bought a few shares of Apple stock at £700/$950, and the price has since shot up to $1,000. You’re worried that people will stop buying it and start selling it because it’s too expensive, so you set up an options trade which means that someone else guarantees that they’ll buy your choice of Apple stock from you if, for whatever reason, the share price drops below $900 within the next six months. You just let the contract expire and enjoy your profits if it doesn’t.
What is straddling?
Options traders also use a tactic called “straddling”. This is when you create an equal number of calls and put options at the same strike price – e.g., 100 calls @ £55 and 100 puts @ £55 – because then your profit or loss will be the same whichever way the market goes, leaving you with no risk of losing more than 100 units.
What are Butterflies?
Butterflies are a very low-risk, low-reward type of options contract that involve setting up two different agreements with the same expiration date but at two different strike prices, e.g., £41/$51 and £42/$52; if the market price stays between these two prices (the short strike price and the long strike price) then you make £1 per each butterfly you set up (£2 total).
If it falls below or above this range, then your profits can be huge but still capped by how many butterflies you’ve created. The more butterflies, the better, but keep in mind that it takes much longer than other types of options trading for this to work.
Conclusion
One mistake traders new to options sometimes make is thinking that they’re safer than they are because, unlike stocks, every opportunity has a limited life span and value. Before trading options, new traders are advised to contact a reputable online broker from Saxo Bank. Try out their demo account and practice different trading strategies before investing your own money. Start your investment journey today and sign up for a free trial here.
