Trading and investing in various assets is becoming more and more popular around the world, and thanks to the internet — it is also incredibly easy to start. However, with the trading industry becoming so advanced and developed, it can be difficult to understand every aspect of it, which is why we will explain options trading today, and tell you everything you need to know about this solution.
What are Options?
Options trading doesn't tell you much from the name itself, which is why the best way to start might as well be to explain what options are.
Simply put, options are contracts that allow investors to buy or sell some underlying instrument, including ETFs, securities, or even indexes. Traders can purchase them or sell them at a previously established price over a certain period.
However, it is worth noting that, when it comes to trading options, you do not really get in contact with the underlying asset. Instead, you bet on its future price, depending on whether you expect it to go up or down.
Options are traded on the options market, similarly how stocks are traded on the stock market. If you buy an option that lets you buy a share at some later date, that is known as 'call option.' On the other hand, buying an option that allows you to sell shares, later on, is known as the 'put option.'
Call and Put Options
As mentioned, there are two types of options — call options and put options. While they give you the right and the ability to purchase securities, you are under no obligation actually to do it.
While we have briefly explained what these two types of options are, let's take a deeper look into what each of them includes and requires.
1) Call options
Once again, call options are contracts that allow investors the right to buy some amount of shares of some commodity or security, and over a certain amount of time. It is completely optional, and investors are not obligated to do so.
Buying a call option indicates that the investor expects the price of underlying assets to go up. That way, they could make a profit off of their contract.
Buying call options also comes at a fee, which is known as the premium. In other words, the premium might be viewed as a down-payment. Meanwhile, purchasing a call option means that the buyer agrees with the seller regarding the strike price (the price at which you buy the underlying security).
When the contract expires, the buyer can purchase the underlying asset at a predetermined price, regardless of the asset's price in the open market.
2) Put options
On the other hand, put options allow investors the right to sell shares of an underlying asset at a specific price, and after a certain period of time. The entire process functions pretty much the same way as the call options, except this time, you are selling instead of buying.
The price at which you are selling is once again called the strike price, while the fee you pay for the options is called the premium.
Obviously, the biggest difference is that put options are used by those who expect the price of an underlying asset to go down, instead of up.
Options: Long and Short
When you buy futures contracts, going long means that you expect the price to rise, while going short means that you expect it to drop.
When trading options, however, the situation is a bit different. Typically, options trading is always a 'long,' whether you buy a call or a put option.
You can still go short too, of course, and shorting an option means that you are selling that option. However, the risk is extremely high, and the profits you can make of that sale are rather limited, and they depend on the option's premium. The premium usually goes up as more time is left on the contract, which is something that you should keep in mind.
Benefits of trading options
You might be wondering what exactly are the benefits of options trading? After all, people would not risk their money without a good reason to do so. This is entirely correct, and there are plenty of advantages to trading options in NZ, such as:
1. Increased cost-efficiency
Options have significant leveraging power, meaning that you can get an option position just like you would do with stock positions, only at huge cost savings. Of course, to do it right, you need to know which calls and puts to buy, and that requires knowledge, information, and experience. However, when you compare options to stocks, you can save up a lot more simply by purchasing puts and calls.
2. They can reduce risk
We mentioned earlier that there is quite a bit of risk involved, and that is still entirely true. However, there are situations when options can reduce risk. As always, it all depends on how you use them.
Options can reduce risk because they do not need as much financial commitment as equities. As such, they are relatively impervious to major impacts of gap openings, which means that you get a certain level of protection that you do not have with many other assets.
3. Returns have the potential to be higher
Trading options allows investors to make the same profit as they would by trading a different asset, even though they had invested a lower amount of money. In other words, potential returns during options trading can be significantly higher, provided that the investor made the right decision.
4. More investment alternatives
Options also have another major advantage, which is the fact that they offer additional investment alternatives. This is due to the fact that they are rather flexible, and you can use them to recreate other positions, which are called synthetics.
Synthetics present investors with several different ways of reaching their goal, which is, obviously, quite useful. However, synthetics are something that is typically considered advanced options trading, and it is best to leave it to professional traders, at least until you get the hang of how options trading works.
Risks of options trading
Of course, where there are benefits, there are also some risks to keep in mind. Options trading comes with a few that are not deal-breakers for a lot of people, but you should definitely be aware of them in order to make a profit, rather than lose your investment.
1) Exposure to amplified or unlimited losses
The first and the largest danger when it comes to options trading is the fact that you can experience significant losses when you sell options. In fact, the losses could actually be much greater than the price of the contract itself.
When you buy or sell shares, within the time frame of the contract, you have to buy them or sell them at a specific price. If that price is unfavourable for you, you can't really do much about it. And, since there is no limit or clear rule to price movements, this can lead to a less than favourable outcome.
2) Limited time
When it comes to trading stocks, investors have no deadline. If they are patient enough, they can wait for years, or even decades before their investment pays out. This is not the case with options trading. Options trading is short-term trading, meaning that you have to capitalize on short-term price movements.
That means that you need to encounter a price movement that suits you within days, or weeks, at best. In other words, you need to pick the right time to buy the contract and to assess properly when the time might be right to sell or walk away.
3) There are requirements that traders must meet
Finally, there are also certain requirements that are required for some trading strategies. One such requirement is having a margin account, which is a line of credit that can be used as collateral if the trade moves against you. This is something that you need to have if you wish to sell call options on assets that you do not own already.
The minimum amount of opening a margin account varies from one broker to another, although you should keep in mind that the amount and interest rates will depend on the number of securities and cash that are in the account.
In the end, trading options in NZ can be very beneficial if you do your research and make your trading moves carefully. Remember that making a wrong decision is all too easy and that it can be pretty expensive. Always remember only to invest what you can afford to lose, and you should be fine. Practice and experience will help you become good, but until then, small amounts, research, and keeping track of the market’s behaviour are the key.
Author: Ali Raza - A journalist, with experience in web journalism and marketing. Ali holds a masters degree in finance and writes extensively about the financial markets and fin-tech industries.