Three Things You Need to Know About Options Trading
As we usher in 2019, we welcome new opportunities to grow ourselves in all frontiers. And one of the areas that we are most eager to increase is our finances.
And what better way to do so that to further learn about an investment instrument that has been gaining steam for the past couple of years: options trading.
In the previous blog (internal link to “The Hows of Options Trading), we let you in on the fundamentals of Options Trading. Let’s dig a little deeper and differentiate between a call and a put.
In options trading, there are two types: the calls and puts. Call options are purchased if you want the stock to go up. Conversely, you purchase a put option if you want the stock to go down
As with everything with life, the stock market has two sides. Depending on which side you are on, you can do the opposite, in which you can sell the option as an opening trade with the intention of hopefully purchasing it back at a lower price as a closing trade.
And because almost all things that we have in life now have stock options, combined with the continuous enhancement of technology, we can easily trade options right at the comfort of our homes, in our laptops, or our palms through our smartphones.
Now, let’s look at three things that every newbie investor or whoever is interested in potentially purchasing — and selling — options.
Time to Expiration
Previously, we likened options to insurance. Buying options is like buying insurance for your stocks. And the basic principle of insurance is that you pay for it more the longer it is kept insured. It’s not just a one-time payment but is paid in increments over a period of time.
The same goes for options. You have to pay for an option with a period of 30, 60 or 90 days to expiration. But the cost for each is different because there’s a different time to expiration.
You have to remember the principle that more time to insure or hold the stock option means more money. As time passes, an options time value will decay. Naturally, this concept is called time decay.
An option’s time value decays over time. As you get closer to the date of expiration, time decay moves closer. The concept of time is not different for stock options as it is in the world. It decays or passes by 100% of the time, whether you want to or not; whether you are aware of it or accept it or not.
Majority of stocks have options that have different expirations. You can have those that have weekly, monthly, or quarterly expirations. It’s your choice depending on your preference and expertise.
Strike Price
After learning the concept of time to expiration and time decay, what you need to know next is the importance of the price of the underlying stock itself.
For each stock, there are various options available at different price increments, which are called the strike price of the option. This is the prearranged or preset price at which stock shares will be
exchanged if the option is employed.
It’s important to note that you don’t necessarily have to own shares of stock in order to trade options. However, the strike price of the option which you’re trading has a large effect on what the options price will be.
A current stock price per share for call options is determined. And this has a strike price above the current stock price, which is referred to as out of the
Money. On the other hand, the strike price that is below the stock’s price is called in the money. It’s the exact opposite for put options.
Now, if an option is out of the money at the expiration date then it is deemed of no value. It had value prior to expiration because stock prices move. Therefore, there’s a probability that the out of the money options could become in the money as long as there’s still time left before expiration.
With this in mind, we can logically deduce that the further out of the money an option is, the less valuable it becomes. This is because the probability of it being of any worth becomes less as it draws “farther” from the stock price.
This is why it’s important for you to understand first the concept of time to expiration and then stock price.
There’s also a common a misconception that you have to can’t move or trade an option until the expiration. This is untrue and you can trade or move an option anytime before the expiry date. If it goes up in value even after a day that you have purchased it, then go ahead and sell it for a profit.
Volatility
The last element that’s important in option pricing is volatility, which is the measure of the rate and magnitude of the change of prices (both up and down) of the pricing. Higher volatility results in larger price swings and higher risk. In this case, options will be more expensive.
Different stocks have different volatilities, but volatility moves around the market and the industry. It’s not the same for every stock for any period in time. A stock with low volatility now might have high volatility in the future.
In comparison, volatility is much more predictable than stock prices. Therefore, always take the correct side of volatility in order to take advantage of the market and gain profitability.
The beauty of options trading is that you are able to gain even on a presumed loss and minimize the risk of your investments, provided that you are willing to absorb some costs. It’s a good start for newbie to intermediate investors.
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