Options Trading Explained: A Beginner’s Guide

01 Oct, 2021

8 min read

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Options may be a suitable choice for you if you want to diversify your portfolio beyond stocks, mutual funds, and bonds. Diversification comes in the form of possibilities. Understanding options trading is necessary to know about the significant risks and profits!

Introduction

By engaging in options trading, investors can increase the array of their investments to extend beyond stocks, bonds and mutual funds. Read on to have a more thorough understanding of what options trading entails.

Options Trading Explained

Options trading allows investors and traders alike to trade instruments that give them the liberty to buy or sell a specific security keeping in mind a specified date and a predetermined price.

Serving as a contract that is connected to an underlying asset which may be in the form of a stock or alternative security, options contracts are valid for a specified time frame. This time frame may amount to as little as a day to as long as a number of years.

Once you buy an option you are entitled to trade the underlying asset connected to it, however, there is no pressure for you to do so. Should you decide to trade said asset you are understood to have exercised your option.

The Varying Forms of Options

While options can exist in a number of ways, there exist two broad categories under which they may fall. These categories i.e., call and put option, have been mentioned below.

Call Option – A call option authorizes you to buy an underlying asset at a predetermined price within a certain time frame. A strike price is a term used to refer to the price paid by you. You may exercise your call option right up to the end date which is called the expiration date.

Call options can exist in the American style as well as the European style. The former entitles you to buy the underlying asset at any time leading up to the expiration date. The latter i.e., the European style option, permits you to buy the asset only on the expiration date.

Put Option – Understood to be diametrically opposed to call options, put options give you the right to sell an underlying asset at a set price strike. Put options too, have expiration dates and are governed by the same American and European style rules upon being exercised.

Understanding How to Read a Stock Option Quote

Options that are governed by equities and often referred to as “stock options” are often of interest to traders new to the realm of options. Stock options are featured on exchanges such as the National Stock Exchange and are displayed in the form of a quote. Prior to making any decisions, it is important to have a thorough understanding of the details that govern a stock option quote.

Pertinent details that make up a standard stock options quote have been mentioned below.

Stock symbol – This symbol is used to indicate and make clear the underlying asset tethered to an options contract.

Expiration date – This refers to the date on which the option will no longer be valid.

Strike price – This is the price at which you will be able to exercise your option.

Type – This refers to the kind of option involved which maybe call or put.

Premium – The cost of the option’s contract is referred to as the premium.

Determining Options Pricing

Options pricing can be garnered by using a number of models. That being said, options trading prices are ordinarily arrived at and based upon keeping in mind the intrinsic value and time value.

Intrinsic value refers to the potential profits drawn from an option, and which is derived from the difference that exists between the strike price and the security’s current price.

Time value indicates how volatility may impact an underlying security’s price right up to the expiration date.

Options pricing takes into account the stock price and strike price along with the expiration date. While the stock price and strike price impact the intrinsic value the expiration date may impact the time value.

Things to Consider Prior to Commencing Options Trading

Prior to commencing your options trading journey, it is important to keep in mind the following factors.

Options trade on a number of varying underlying assets and securities.

Although options were mentioned in reference to and tethered to stocks, they may also be tethered to other forms of securities. These can be exchange-traded funds, equities or indexes.

Calculated risk serves as the cornerstone of options trading.

Historical volatility along with implied volatility need to be focused on. The former focuses on the past and indicates the degree to which the stock price fluctuated on a daily basis keeping in mind a single year. The latter, i.e., implied volatility, focuses on what the market seeks to imply will be the volatility of the stock in the future over the course of the option contract.

Options trading makes use of the Greek alphabet.

Options traders make use of the Greek alphabet such that they can reference how options prices might change in the market. This is key to success when participating in options trading. Delta, Gamma and Theta serve as Greek alphabets most commonly referred to.

Financial goals determine options trading.

Options traders have a clear understanding of what their financial goals and the position they seek to acquire in the market. How you think about, and approach money will impact how you trade options in a direct manner.

Conclusion

In order to learn more about options trading, visit Angel One’s Smart Money portal today. Here, you can learn about the most popular options trading strategies along with the advantages and shortfalls associated with options trading.

Frequently Asked Questions

Q1. What is a strike price?
A1. Strike price refers to the price at which you can exercise your option.

Q2. What are the two types of options?
A2. Options are broadly classified into two types – call and put.

Q3. What does a stock symbol indicate?
A3. A stock symbol is used to indicate the underlying asset tethered to an options contract.

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