What Is Options Trading?
The trading of instruments that offer you the right to purchase or sell a particular investment on a specified date at a specific price is known as options trading. Options are derivative financial products dependent on the value of underlying securities like stocks. An options contract gives the buyer a choice to purchase or sell the underlying asset, depending on the contract type. Unlike futures, an option holder shall not be obligated to buy or sell the asset if they do not choose to do so.
Options are traded in the OTC (Over The Counter) and the exchange markets. When the right is sold to a person, the seller retains the obligation. And he has to oblige when the holder exercises his right. The holder of the right will exercise the right only if it is beneficial. When a right is exercised, it is advantageous to the holder and not beneficial to the seller.
The holder of each option contract will have a set deadline by which they must exercise their option. The striking value of an option is the stated price of the option. Call and put options provide the foundation for various option strategies for hedging, income, and speculation. A trader can retain a leveraged position by speculating on options positions in an asset for less money than buying the asset’s shares. Option trading adds revenue and even protection to a trader’s investing portfolio. Options are commonly used as a hedge against a falling stock market to reduce one’s downside losses.
Call Options: An option that gives the buyer the right, but not the duty, to purchase a stock, bond, commodity, or other asset or instrument at a defined price within a specific time frame. The underlying asset is a stock, bond, or commodity. When the price of the underlying asset rises, the call buyer profits. There are two types of call options in options trading: a long call and a short call. The buyer anticipates the price to rise in a long call, while the seller expects the price to fall in a short call.
Put Options: An option grants the owner the right, but not the obligation, to sell an underlying asset at a striking price within a specific time frame. Striking price is the predetermined price at which a buyer of a put option can sell. There are two types of options in options trading put options: long put and short put. A long put buyer expects the price to decrease, whereas a short put seller expects the price to increase.
Options Trading Strategies
Trading options are fundamentally flexible. Traders can make a variety of intelligent actions by using strategies before their options contract expires. The two strategies that follow are:-
Vertical Spread Trading Strategy
A vertical spread is an options strategy. You purchase one call and concurrently sell another call with a different strike price but the same expiry date. Vertical spreadsrestrict risk as well as possible profit. When traders foresee a moderate move in the underlying asset price, they will utilize a vertical spread.
If you’re confident that the objective will function as resistance, vertical spreads are an excellent strategy to trade. The vertical spread is divided into two types of strategy: net debit and net credit. The former includes purchasing options beforehand, making the transaction a net debit trade, while the latter requires selling options upfront, making the approach a net credit trade.
The vertical spread family includes a variety of techniques, with Bull Call Spreads and Bear Put Spreads being the most common.
a) Bull Call Spread:- A bull call spread is a strategy in which a Call option is purchased, and a higher strike call option is sold. The net premium outflow is reduced to the degree that the premium on traded options is diminished, but the risk is reduced since you have less to lose as traders may use this approach to limit their losses or minimize their gains.
b) Bear Put spreads:- A bear put spread is an options strategy in which an investor or trader anticipates a moderate-to-large drop in the price of a security or asset and seeks to lower the cost of holding the option contract. A bear put spread’s primary approach is to buy a higher strike price put and then sell a lower strike price put; the aim is to watch the stock drop and close at any point equal to or above the lower strike price at expiry.
Short Strangle Options Strategy
One short call with a higher strike price and one short put with a lower strike price is used in this strategy price to make up a short strangle. The underlying stock and expiration date are the same for both options, but their strike prices are different. A short strangle is formed for a net credit (or net receipt) and profits if the underlying stock trades in a small range between the break-even points. The amount of profit made will restrict the total premiums received minus commissions. It is a profit-limited strategy with a neutral attitude.
A strangle resembles a straddle. But instead of using a call and put at the same strike price, it employs options with different strike values. This strategy is preferred when the trader believes the underlying stock will have low volatility in the foreseeable future.
In conclusion, for the above two strategies, when traders foresee a moderate move in the underlying asset price, they will utilize a vertical spread. Vertical spreads are mostly directional trades that could be customized to reflect the trader’s perspective on the underlying asset, whether bearish or bullish. While the short strangle is a neutral strategy, it is employed when the trader anticipates the underlying stock to have relatively low volatility in the short future. The vertical spread strategy has low risk, and a high pay off whereas the short strangle option is a strategy with restricted profit potential and unlimited risk potential.