Options are among the most powerful financial instruments available to investors, yet there is no consensus on how beginners should use options. Some traders advocate a conservative approach and argue that beginners should not buy or sell naked.
In contrast, others argue that selling covered calls can be rewarding for beginner options traders. Others argue that selling index futures using cash-secured puts also provides a low-risk way for beginners to gain exposure to equities without buying individual stocks outright.
What is Options Trading?
In finance, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller of such a contract is called a writer of the option. A call is, in essence, a bet that the stock will rise above the strike price by expiration, while a put is, in essence, a bet that it will fall below.
An American style option can be exercised any time before its expiry, while European options may only be exercised on specific predetermined dates. Because of this difference in where they can be traded and when they expire relative to each other, US options are more common than their European counterparts. As far as traders are concerned, the option is simply a stock purchase with additional features and restrictions.
Two types of options contracts: Puts and Calls
The first type, Put, is an option contract that gives the owner the right to sell a certain amount of equity at a specific price within a predetermined time frame. Calls work exactly as you might expect them to: they give the holder the right to purchase a given equity within a preset time and at an agreed-upon price.
An Options Trading Strategy
When trading options, it is possible to take advantage of both rising and falling markets and retain many of the benefits that can be obtained from buying shares or other financial instruments directly without actually having to buy them. One of the key benefits of trading options compared with owning actual stocks is rights. Still, traders can often limit their risk by carefully choosing which ‘side’ they take in buying and selling options.
This also means traders need much smaller funds than those required when forex or commodities trading, for example. Of course, there are equally as many opportunities to lose money and these benefits if approached incorrectly, mainly because options trading is a complex market to understand. For this reason, beginners should seek expert financial advice from a reputable saxo broker before beginning.
An Options Trading Example
A simple example of the benefits available when trading options would be if an investor wanted to make a one-off purchase in company XYZ but was not sure whether the share price would fall or rise before the option expired. If they bought call options giving them the right, but not obligation to buy shares at $50 by expiry then if the price went up they could simply let their option expire, losing only some small brokerage costs which can be as little as $150 depending on where it is traded.
However, if instead, they believed that XYZ was going to go down in value they could have sold put options and made a profit despite the share price falling. For example, if they sold XYZ $30 puts they would make money if XYZ’s value fell above $30 by expiry making it worthwhile to buy them back for less than this (in order to close out or “exercise” their option).
Trading options requires valuable knowledge and expertise on the market and on the specific options being traded, which are very difficult for someone new to the market to acquire. Therefore, beginners should refrain from trading options until they have significant knowledge of how the market works and what types of different options are available.