Options offer traders leverage and an ability to hedge and limit their losses, but their reputation as risky investments often scare away new traders. That shouldn’t be the case.
An option is a versatile security. It’s a contract that allows the buyer the right to buy or sell an asset within a specific time period. If the asset underperforms, the trader is under no obligation to honor the option contract and can simply let the option expire. When this happens the trader loses the amount of the initial investment, but avoids the losses they would have been saddled with had they purchased the asset outright.
There are two types of options: calls and puts. A call gives a trader the right to purchase an asset within a specific time period. If a trader buys a call, he’s hoping the asset’s value increases before the option expires. A put gives a trader the right to sell an asset; the trader’s hoping that the value declines before the option expires. Buyers of options are referred to as holders, while sellers of options are known as writers. The price that a holder or writer can buy or sell the underlying stock is called the strike price.
There are several advantages to buying options, but most traders will start day trading options for two reasons:
- To Speculate. When day traders are buying options to speculate, they are betting on the price movement of an asset. The versatility of options allows traders to make money on speculation when the market goes up or down, or even sideways. Profiting from options isn’t easy; a trader has to correctly identify the asset that will move, whether it will increase or decrease, how much movement it will have, and over what time frame this movement will take place. Day traders use options in spite of this risk because it’s an effective way to use leverage. The ability to control a hundred shares with one option contract makes it easy for day traders to generate profits when they correctly identify a price movement.
- To Hedge. Many day traders look at options as an insurance policy. Options are a means to insure their investments against losses. By using an option, traders can limit the downside without compromising the full potential of their investment. Since traders aren’t under any obligation to pick up an option, it’s a cost-effective way to manage risk.
To learn more about day trading options, check back with our blog as we address options strategies in greater detail in our next entries. If you can’t wait to jumpstart your education and want to start trading, contact www.101investing.com today and start your trading journey right now!