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What Are Options and Why Are They Good Trading Instruments?

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In financial terms, ‘Options’ are contracts that let buyers trade assets or instruments at specified dates and prices, not as an obligation, but as a right. The price at which you buy or sell the asset or instrument is called the ‘Strike Price.’

The strike price varies depending upon the Spot Price or Market Price and Option type that you choose to trade. Simultaneously, the Spot Price or Market Price is fixed depending on the day, discount, or premium.

The right to buy an option is known as a ‘call,’ and the right to sell it is called a ‘put.’

Why Should You Invest in Options?

There are many advantages of trading options as compared to other assets. However, the risks are high as well. For instance, traders can protect themselves against portfolio losses by investing in options. Similarly, they can also increase their returns on existing or new positions. Options even help traders reduce the risks on all their speculative bets in any market condition.

Here are the rewards that you get by investing in options:

1. Lower Upfront Financial Commitment

The cost of trading an option is much lesser than trading, say, regular stock or a share. If you happen to win the bet, the gains are as much as you get from trading a stock or a share.

2. Limited Downsides

With Options, if you lose the trade, you lose only the contract and the trading fees. However, it is valid only if you are a buyer.

3. Better in-built Flexibility

Traders or investors have better flexibility with options. In that, they have more strategic moves. For instance, by trading in options, an investor has the following strategic moves that he or she can make:

  • Trade the option and then buy shares.
  • Trade the option, buy shares and then sell them.
  • Sell the contract to other investors.
  • Get potential returns on the money spent on the contract by selling it to other investors before running out of time.
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4. Stock Price Fixing

You can fix the stock price at the ‘Strike Price’ for specific periods by trading options. Depending on the type of options you use, it may guarantee to buy or sell the stock at the ‘Strike Price’ at any time before the expiry of the contract.

What are the Risks Involved in Trading Options?

While you have a host of benefits in trading options, all rewards come with risks. For instance, as discussed in the previous section, options have limited downsides, and you won’t lose anything extra other than the trading fees and the cost of the contract. However, it holds good only for buyers and not for sellers. So, it would help if you were wary of that. Likewise, there are other reasons why options are not suitable for investors or traders.

1. Trading Options May Lead to Unlimited Losses

Option sellers are left wide open to potential losses. Sometimes, these losses can be even more significant than the price of the contracts. A ‘put’ or ‘call’ option means that the buyer is obliged to buy or sell shares at a specified price within the timeframe given, even if it means the trading prices are unfavorable. Now, since there is no limit on how high the stock price goes, the trader will incur huge losses as he is obliged to trade at prices unfavorable to him.

2. Options are Complex

When trading options, investors look for all the short-term price movements. These movements may occur within days, weeks, or even months. Moreover, the complexities involved in trading options in itself poses a significant risk to the investor.

While there are simple strategies that you can start with, as you trade into the day, they can get more intriguing. Also, the very nature of options trading can be hard to grasp, especially for beginners. If you don’t fully know what you are getting into, you could incur potential losses.

3. Options are Liquid

While options trading has become far more common these days, there are issues with its liquidity. When it comes to trading options, you have hundreds of types and strategies that you can use. And because there are so many types, it can result in low trade volumes, making it harder to trade at suitable prices.

But it shouldn’t be a problem in most of the popular forms of options trading as long as you trade in low volumes. The problem arises when you trade non-mainstream options or in large volumes, although exchanges try to maintain as much liquidity as possible by using market makers.

4. Options are Affected by Time Decay

The effects of time decay in options trading is unavoidable. All the types of options you can trade with have fixed time limits that indicate how much longer they have until they expire. So, options slowly start to lose their value as their expiry date approaches. While not all types of options are affected by time decay, you should avoid investing in those that are, as they can adversely impact your trade.

Final Thoughts

Options are great trading instruments. However, there are as many risks involved as rewards. So, it would be best if you traded options only after thoroughly understanding how they work. If not, you can end up incurring huge losses. In particular, you should know about the effect of time decay as you could end up losing the trade over time.

If you are one of those investors looking to trade options, you can start with some simple, sure-shot strategies that have worked in the past. And once you get a hold of it, you can use other advanced techniques to make the trades.

© 2020 Tejas

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