Please exercise some patience before putting your money at risk, even though you are aware of what an option is and think you understand how it functions. You are giddy with excitement and can't wait to start making money. But it's not that simple. The dangers of purchasing options before you are prepared to trade are discussed below.
Main Points
- Option details like the strike price, expiration date, and implied volatility will have an impact on a trader's potential profit (or loss).
- Beginners may be tempted to purchase numerous inexpensive out-of-the-money (OTM) options, but they would be better served by investing more money in a smaller number of options that are closer to the strike price.
- Stocks do not trade in a vacuum, so keep an eye on the broader market.
A Typical Case of Purchasing Call Options
Your favorite stock (FAVR) is currently trading at $42.50, and you are excited about its prospects. You "know" that FAVR will soon trade above $50 per share. You open a brokerage account and purchase ten FAVR call options based on your forecast. They have a 90-day expiration date and are struck at $50 (i.e., the strike price is $50). You can't wait to see the money come in. So, what happens? Typically, the expiration day arrives, and the options lose their value. The once-excited new trader in options (along with many seasoned traders who ought to have known better) loses every penny they put up. The truly sad part is that your intuition was correct. FAVR did rise, and the market price was $46 90 days after you purchased your option. The only problem is that you predicted the price increase correctly but lost money. It is bad enough to lose when your prediction is incorrect, but losing money when it is correct is a bad outcome that frequently occurs in the options world. Unfortunately, this is a common outcome, so before purchasing options, please consider the following points. The goal here is to make you aware of important information. The details can wait until you've mastered the fundamental concepts of options.Gaining Profits
The cost of an option depends on numerous variables. One cannot merely "buy calls" and anticipate making money when the stock price increases. There's a lot more at play. The issue is that inexperienced traders are ignorant of the additional elements that can influence whether a trade will result in a profit or a loss. As a result of your bullish outlook, you anticipate that the stock price will increase, but by how much? Is it reasonable to anticipate that FAVR's stock will increase by almost 18% to $50 (a rise of 90 days) based on its price history? Over time, the average daily price change (volatility) offers a good indicator of the correct response. If the average daily change in the stock price is $0.05, purchasing (OTM) call options with a $50 strike price is not a good idea. When the average daily change in stock price is $0.50, though, it is a rational move. Be conscious of how erratic the stock price has historically been.Price of Strike
Even though many traders do so, it is not necessary to purchase OTM options. They believe their prediction will be correct and want to buy the cheapest options possible, most likely because most inexperienced options traders prefer to own "a lot" of options rather than just a few. It is analogous to the thought process that leads to the purchase of lottery tickets. The odds are terrible, but the prospect of a massive payoff is too tempting to pass up. Buy options with a high probability of being in the money later based on volatility data (before the options expire). Purchases of FAVR call struck at $40, $42.5 (if such options exist), or $45 would therefore be rational. You need some trading experience to decide how much to pay for options, but there are a few things you need to be aware of. Was the price of the option reasonable or was the implied volatility of the option too high? Based on your expectation that the price would rise, did purchasing these options at this price give you a decent opportunity to profit? Was the bid-ask spread excessively broad? Trading on large markets is more challenging. Did you pay the asking price, which was a mistake? Always strive to improve yourself, right?Waiting too long to move
Option purchases should not be made with the intention of holding them until expiration. Options are a waste of resources, so your strategy should include exiting the trade as soon as it is practical to do so. A profitable options trade is simple to fall in love with and hold onto in the hopes of making a much bigger profit. Ensure that doesn't occur. You do reach your desired profit sometimes. Sometimes it involves abandoning the trade and selling the options while they still have value. Take profits and sell the option if the stock price reaches (or approaches) your target price.The Stock Market
Was it a wise move to make such a bullish play at this time? Do you think the stock market will rise? Most stocks don't trade in a vacuum, and the performance of other stocks affects both their rise and fall. In other words, is the market bullish or bearish? Did you take all of these things into account? Have you given any of them any thought? The bottom line is that if you do not pay attention to each factor, your chances of making money decrease, and the loss of your entire investment becomes the most likely outcome (especially when you purchase OTM options). Simply believing that the market will move higher or lower is insufficient. When purchasing options, the option price significantly impacts the potential profitability of the trade. It frequently matters more than a change in the underlying stock's price. As a result, you shouldn't overpay for your options based on implied volatility. It's crucial to be aware of how simple it is to lose money when purchasing options. Most traders only consider "how much money can I earn?" Please refrain from using options to gamble.Question and Answer Sheets (FAQs)
How can someone learn about and practice trading options?
Paper trading or demo accounts are special practice accounts that some brokerages offer. These accounts are financed with fictitious funds in order to execute hypothetical trades. This is a great way to test out new goods and methods to make sure you're successful before risking actual money.What exactly is binary options trading?
Binary options, such as those provided by Nadex, are essentially statements on which traders place bets. These are not the same as standard stock or ETF options. Numerous binary options pair a price with a stock index, a commodity, or a currency, but they can also be based on economic indicators like employment statistics. A binary option might be something like, "Will the price of an ounce of gold be higher than $1,800 at 1:30 p.m.?" Traders who want to answer "Yes" will purchase the binary option, and if it is successful, the traders will be paid a profit. Traders can also respond "No" by selling binary options and opening a short position.