Option Trading: Meaning, How It Works, Pros And Cons
Are you familiar with option trading in online share trading? Option trading is a way to buy or sell stocks, ETFs, and more at a specific price within a certain date. Moreover, the unique feature of this trading is that buyers have the option to purchase it at a given price or date. In options trading, a "call" gives you the right to buy a security, while a "put" gives you the right to sell it.
Also, options trading might seem more complex than stock trading, but it comes with some unique advantages. In this article, we'll look at options trading in detail, understand how it works and its pros and cons.
Table of Content
What is Option Trading?
In the financial world, an option is a contract that allows (but does not obligate) an investor to purchase or trade securities, ETFs, or index funds at a predetermined rate after a certain period of time. Additionally, in options trading a "call" is a right to buy a security, whereas a "put" is a right to sell it.
However, options trading is more complex than stock trading, but if the price of the security rises, you could make relatively large profits. The reason is that an options contract does not require you to pay the full price for the security. Similarly, options trading can limit your losses if the price of the security falls, which is called hedging.
How does Options trading work?
When someone invests or trades in options, it means they have the right to use that option contract before a specific date called the expiration date. However, buying or selling an option doesn't mean they have to use it on the expiration date. Options traders can choose to use it or not.
Additionally, options are called "derivative securities" because their price is based on other things like the value of assets, securities, and other underlying instruments. In simpler words, the price of options depends on the value of other stuff rather than being a fixed amount.
How to earn profit from option trading
Here's how you can earn profit from options trading:
Call options: If the price of the asset goes above the break-even price, you can sell the call option and earn the difference between the premium you paid and the current premium. Alternatively, you can choose to exercise the option and buy the asset at the agreed-upon strike price.
Put options: If the price of the asset falls below the break-even level, you can sell the options contract and collect the difference between the premium you paid and the current premium. Alternatively, you can exercise the option and sell the asset at the agreed-upon strike price.
But if the price of the asset goes the opposite way of what you thought for a call or put option, you can simply allow the contract to expire. In this case, your losses are equal to the amount you paid for the option, including the premium and trading fees. Moreover, options trading can get more complex when advanced traders combine multiple calls or put with different strike prices or expiration dates.
Pros of option trading
Trading options has the following advantages:
- When you buy options, it's usually cheaper than buying actual stocks. You only pay a smaller amount called the premium and a trading fee.
- With options, you can lock in a specific price for a certain period. This price is called the strike price. You can trade at that price anytime before the options contract expires.
- Options offer benefits like additional income, leverage, and protection. For example, you can use options as a hedge to protect against losses in the stock market. They can also generate regular income.
- Before your options contract expires, you have different strategic choices. You can use options to buy more shares for your portfolio. You can also buy shares and sell them later for a profit. Another option is to sell your contract to someone else at a higher price before it expires.
Cons of option trading
The following are some cons of option trading:
- You might not like options trading if you like a hands-off approach to investing. It adds complexity to the investing process because you need to make decisions about direction, price, and time.
- In options trading, there is an extra step. Brokers need to approve your account for options trading after you fill out an agreement. This is done to make sure you understand the risks involved.
- To make money from options trading, you have to set price alerts and closely monitor the market. Additionally, you need to be aware of the risks and trading fees associated with different options strategies.
- Unlike trading stocks, options trading may have fees and commissions. These can vary, and you need to consider them when calculating the profitability of your options strategy.
- Options trades are usually shorter-term, which means you may trigger short-term capital gains. In India, investments held for less than a year are taxed as ordinary income, while long-term investments have a lower capital gains tax rate.
How to Start Trading Options
You can start investing in trading options once you have a decent understanding of how trading works. Then, you need to specify your investment objectives, such as capital preservation, income generation, growth, or speculation. Moreover, depending on your broker, you may have to disclose your net worth or type of options contract.
At first, options trading can be complex. However, the blinkX website is a good place to start your options trading. It's easy, just open your trading account on the blinkX website. A researcher will guide you through the process of developing a trading strategy based on your risk tolerance. After that, you can deploy capital in this strategy through a trading account.
In online share trading, option trading allows you to buy or sell stocks at specific prices within a specific timeframe. The buyer has the option to purchase or not at the specified price and date. Moreover, trading options can generate large profits if the security's price rises and protect against losses. However, it is essential to understand the workings of trading and determine your investment objectives before you begin options trading.
With option trading, you can lock in specific prices through the strike price, earn additional income, use leverage, and protect your investment. However, there are a few cons to this trading. Like, if you're looking for a hands-off investing approach, options trading may not be for you.
Frequently Asked Questions
Optional trading isn't guaranteed like stocks, bonds, or mutual funds. Also, it's possible to lose your entire investment, and sometimes more. And the premium you pay as an option holder is at risk.
Calls and puts are the types of options.
Yes, options trading is safe for beginners. However, make sure you have a margin account and an online broker to help you out.
The best time to trade options is between 9:30 and 10:30
Yes, you can sell options on the expiry day. However, you need to know how to execute them and between which range markets will expire.
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