Ever thought of entering into the stock market using options trading? If yes, does this thought bring worries in your mind about how risky it is and what might be its benefits. If the answer is yes again, scroll down to know about the benefits and risks involved with options trading.
Stock market is a place where you buy and sell stocks/ shares. Stock markets can either be over-the-counter, wherein most of the trading is done online or it can be face-to-face, where people actually gather on the trading floor to buy and sell stocks. New York Stock Exchange (NYSE) is an example of face-to-face trading market. The NASDAQ is an over-the-counter stock market.
About Options Trading
There are several ways of trading in the stock market. One such method is the options trading. An option gives you the right, without an obligation, to buy or sell a particular underlying asset at a specific price on or before the expiry date of the contract. Let’s look at the different types of option contracts –
- Simple Plain Vanilla Options: These are simplest of all the types. Such options include the call and put option. They are easy to understand and can be bought by first-time options traders.
- Long-Term Options: These are good for investors looking for long-term investment. Such options can be kept in holding for may be one, two or three years depending on the expiry of the contract.
- Non Standard Options: Also known as exotic options. They have different contractual terms from regular options. They are mostly traded in over-the-counter exchanges and their terms are decided by the traders themselves.
Another categorization of options is based on the time when they can be bought or sold –
- European Option Contracts: These contracts can be bought or sold only on the date of its expiry.
- American Option Contracts: These contracts can be brought or sold either on or before the date of expiry.
To understand option trading pertaining to simple vanilla options, it can be said that a “call option” is the one whose price increases when the market has a positive movement and decreases when the market has a negative movement. On the contrary, a “put option” is the one whose price decreases when the market has a positive movement and increases when the market has a negative movement. Option trading might appear an interesting trading tool as the amount of money that one can make is huge. But, investment in option trading also involves a lot of risk.
Risks of Option Trading
- There is a risk of losing the whole invested amount in a short time period. If the market does not move in the direction in which one has anticipated, it is quite possible that the whole invested amount turns zero.
- It is important to keep in mind the expiry date of an option. Failure of exercising the option before or on the expiration date renders the option valueless.
- The terms at which an option can be exercised may pose certain risks to the contract holder in a way that one should monitor whether the required action is being taken on time.
- The value of the option goes on decreasing as it comes near to its expiry.
- The complexity of multiple transactions should be well understood prior to investment. Improper understanding may also be a risk to investors.
- It is risky to trade in foreign exchanges when U.S. markets are closed.
- Investors buying and selling options through a broking firm may get affected if the firm goes bankrupt. It is therefore, important to take the help of a renowned broking firm if one has to invest through them.
Benefits of Option Trading
- The first benefit of trading in options is that one has the option of trading no matter in which direction the market moves. One can always choose a “call option” or a “put option” depending on the market movement, be it positive or negative.
- Second benefit of option trading is that one can trade with a small investment capital.
- A small capital investment can fetch high returns in option trading.
- The effect of market fluctuations can be avoided as option trading allows traders to protect their position from fluctuations.
An investor who is trying his hands on option trading for the first time should have the knowledge about the benefits and risks involved with it. One should try starting investment with a small capital so as to avoid heavy losses, if at all they occur. Investors should also start option trading with the simplest option contracts like the simple plain vanilla options, in order to get hands on experience in option trading.
Strategies involved are varied and depend on the time period of investment, the capital invested and the risk appetite of the investor. It is hence, important to keep these things in mind before investing so as to maximize the profits and minimize the losses. Now you must have understood how risky is option trading, but you can gain profits if you are careful enough and know your business well. Happy trading!