What is options trading, and should you try it? You may have heard of this type of investing before but not completely understood how it works. Let’s take a look at everything you need to know about options strategies and whether they’re useful for beginner investors.
What are options?
Before we look at options trading, it’s worth explaining some of the basics.
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An option is a type of derivative. This just means that it is a contract based on an underlying asset. If you buy an options contract, it gives you the option to buy or sell the underlying asset at a set price, on or before a specified date.
A ‘call’ option gives you the right to buy an asset, and a ‘put’ option gives you the right to sell an asset.
Options can be bought across many asset classes, including:
Why use ‘call’ and ‘put’ options?
These two different types of options are useful for different reasons.
Buying a call option is similar to putting down a deposit. If you think the price of an asset is going to go up, you pay a deposit called a ‘premium’. Then, if the price of the asset does go up, you have the option to buy it at your pre-agreed price.
Even if it’s value doubles, you only have to pay what’s on the contract, as long as it’s within the agreed timeframe. You can also just decide to not buy the asset and forfeit your premium (deposit).
A simple way to think of put options is like insurance. You might be investing in an asset but fear that the price may go down. Buying a put option means you can limit your losses. This is because no matter how low the price goes, you can sell the contract at the pre-agreed price.
Doing this also involves a premium. However, if the market doesn’t drop during the timeframe of the contract, your only loss is the premium you paid for the contract. So this can be a good way to hedge against risk.
What is options trading?
Now that we’ve explained what options are, let’s take a look at options trading.
This involves the buying and selling of options contracts. If you buy an option, you become a ‘holder’. If you sell an option, you become a ‘writer’.
Two important points to understand are:
- If you are a holder and buy call or put options, you are not obligated to buy or sell.
- If you are a writer and sell these options contracts, you may be obligated to buy or sell.
Is options trading profitable?
Certain options strategies can be very profitable for traders. They can also be a good way to minimise your losses for other investments you have.
This way of trading can be profitable because you are potentially able to make a lot of money on a trade without having to use a lot of cash upfront.
So if you know what you’re doing, a small investment can potentially lead to big gains. However, this type of trading also comes with some significant risks.
What are the risks?
There are a number of important downsides to this kind of trading:
- The contracts are time-sensitive, usually only a few months.
- Investments are less tangible because you don’t own the asset initially.
- Trading involves something called leverage. This means that money is borrowed during the process. Although gains can be amplified, losses can be maximised.
- If you don’t know how to cover your position when selling options, your risk can be unlimited.
How do I start trading options?
If you think that options trading is something you want to try, there are a number of different share dealing accounts that allow you to trade this way.
For example, IG offers demo accounts and lots of learning resources covering options strategies.
This way of trading can be very useful to investors, but it’s vital that you completely understand what you’re doing before giving it a go.