There are many ways to take advantage of market opportunities and protect yourself against risks. One of those ways is options trading.
In plain terms, options are contracts that give you the right to buy or sell an asset, but they are not the asset itself, and you are not obliged to exercise that right. Vanilla options are the most basic form of option trading. Brokers that provide vanilla options will provide risk management tools to enable safer trading when using options, and other than the right to buy or sell an underlying asset, they have no special features.
How option contracts work in theory
Options help you increase certainty in your trading, albeit at a price. Let us say that you, for example, bought an option to sell 100 Tesla stocks at a price of 750 USD a share within a period of one month. The share price today is 680. This means that if you currently own Tesla shares, in addition to the option contracts, you will be able to make a gross profit of $70 on each share. To calculate the net profit, you will have to deduct the cost of the options, also known as premiums.
The above example shows how options work. However, making a profit is not always guaranteed, as it is not always the case that the difference between the underlying stock price of the option and the actual stock price is in your favor.
Regardless of whether you make a profit or not, the above example describes how options can help you make maneuvers in the market. This is because those contracts give you the ability to “fix” the price of an asset in the future for a predetermined period of time.
Type of option contracts
There are mainly two types of option contracts: put options, which give you the option, but not the obligation, to sell a specific asset, and call options, which give you the option, but not the obligation, to buy a specific asset.
Key terms to understand regarding options
Options premium: The price you pay for the option is called the premium, and it varies depending on the outlook of the underlying asset. If, for example, the underlying asset is BMW stock, and investors expect the shares to increase in value (bullish expectation) then the call option will be expensive, whereas if they expect the share price to decrease (bearish expectation), then the price of the put option will increase.
Strike price (or exercise price): the strike price is the price at which you can buy or sell the underlying asset. If you bought Amazon call option contracts to buy the stock at $3000 then $3000 is the strike price. You have the option to buy Amazon stocks as long as you are within the expiration date.
Out of the money and in the money: options only have value if the difference between the strike price and the actual price of the underlying asset is in your favor (which is in the money) as opposed to when it is not in your favor (out of the money).
Trading vanilla options
In general, options trading is more suitable for those who have relatively ample experience in trading and investing. If you use a reputable vanilla options provider such as easyMarkets, you can take advantage of risk management tools like free guaranteed stop loss to help manage your trade better. Options help you capture opportunities in the market and protect yourself against some downside risks. They are also used by non-financial traders, such as farmers, who want to lock in a good price for their crops to protect themselves against price fluctuations.
Needless to say, you should assess the risks carefully and weigh the costs and the benefits before deciding to trade with options and, ensure that it can help you achieve your financial objectives.