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Millions of traders enter the financial markets and make trades without ever owning a single one of the assets that are being traded. Options are financial instruments that allow market participants to buy or sell the right to buy or sell an underlying asset at a predetermined price and time. This allows them to execute trades and make a profit without needing to actually own the underlying asset, which can be very convenient for traders that are primarily concerned with very short-term gains and are less inclined to hold assets in their accounts for years on end.

In options trading, The right to buy is called a "call" option, and the right to sell is called a "put" option.

Options trading is not subject to the same degree of taxation as stock or Forex trading, as it is not concerned with the underlying asset itself, rather, it considers the performance of the asset and represents a “bet” from traders regarding the outcome.

It must be noted that options trading is a highly advanced approach to financial asset trading and may include complex strategies with multiple variables at play. This is necessary, as an unsuccessful options trade loses the entire amount of capital spent on acquiring options contracts.

If you are a beginner trader and would like to know more about how options trading works - this investfox guide is for you.

As already mentioned above, options trading does not involve buying and selling the underlying asset. Options contracts give traders the right to buy or sell the underlying asset at a predetermined price and date.

When a trader buys an options contract, they pay a premium for the right to buy or sell the underlying asset at a set price (the "strike price") on or before a specific date (the "expiration date"). The price of an options contract depends on multiple factors, including the price of the underlying asset, the time of expiration, and the level of market volatility.

If the trader decides to exercise the option, they can either buy or sell the underlying asset at the agreed price or sell the option to another trader for a profit. If they do not exercise the option before the expiration date, the option expires and the trader loses the premium paid for the option, which represents the primary risk of options trading.

The key purpose of options trade is to hedge against price fluctuations of existing positions or to generate additional income through selling options contracts.

A key concept in options trading is the expiration of the contract in relation to the strike price. For this purpose, there are two key ways an option contract can expire - in the money, or out of the money:

- “In the money” (ITM) refers to an option contract that sees the current price of the underlying asset above (for call options) or below (for put options) the strike price of the option contract
- “Out of the money” (OTM) refers to an option contract that sees the current price of the underlying asset below (for call options) or above (for put options) the strike price of the option contract

In general, ITM options are more expensive than OTM options because they have intrinsic value, which means that they are more likely to result in a profit if exercised. On the other hand, because of the fact that OTM options have no intrinsic value, they are cheaper to buy and solely focused on the underlying asset moving in a favorable direction.

Call and put options are the two main types of options contracts on the market that allow traders to “bet” on the price of the underlying asset increasing or decreasing:

- A call option is a contract that gives the holder the right, but not the obligation, to buy the underlying asset at a predetermined price on or before the expiration date. The buyer of a call option expects the price of the underlying asset to rise above the strike price before the option contract reaches the expiration date. If the price of the underlying asset does rise above the strike price, the buyer can exercise the option and buy the asset at the lower strike price and sell it in the market at a higher price, generating a profit. If the price of the underlying asset does not rise above the strike price before the expiration date, the buyer loses the premium paid for the option
- A put option is a contract that gives the holder the right, but not the obligation, to sell a specific underlying asset at a predetermined price on or before the expiration date. The buyer of a put option expects the price of the underlying asset to fall below the strike price before the expiration date. If the price of the underlying asset does fall below the strike price, the buyer can exercise the option and sell the asset at the higher strike price and buy it back in the market at a lower price, generating a profit. If the price of the underlying asset does not fall below the strike price before the expiration date, the option expires worthless and the buyer loses the premium paid for it.

While put and call options are the two main types of options contracts traders can buy and sell, there are also other types, such as binary and exotic options.

Binary and exotic options are variations of standard options, which can provide traders with some advantages that they would not have using traditional options contracts:

- Binary options are types of options that have a fixed payout if the option is in the money at expiration, as well as a fixed loss if it is out of the money. Binary options have a simple payout structure, with the payout depending on whether the underlying asset price is above or below the strike price at expiration. If the asset price is above the strike price at expiration, the option is "in the money" and the buyer receives a fixed payout. If the asset price is below the strike price at expiration, the option is "out of the money" and the buyer loses the premium paid for the option
- Exotic options tend to have more complex payoffs that are not solely based on the price of the underlying asset. Time, volatility, and interest rates are all factors that can be included in an exotic option contract. Some examples of exotic options contracts include:
- Lookback options - the payoff of these options depends on the highest or lowest price of the underlying asset over the lifespan of the option contract
- Barrier options - these options have a barrier price that, if crossed, can either activate or deactivate the option
- Asian options - These options are based on the average price of the underlying asset over a specified period of time
- Compound options - these options give the right to buy or sell another option at a specified price

Binary and exotic options are advanced financial instruments that require a deep knowledge of technical analysis and are generally not advisable for beginner traders.

Generally, pricing options is a complex process that involves mathematical models to determine the fair value of an option. The key variables that are used to determine the price of an option contract include:

- Underlying asset price - the price of the underlying asset is the most important factor in determining the price of the option contract. The higher the price of the underlying asset, the more valuable the option contract becomes
- Time to expiration - the longer the time to expiration, the higher the price of the option. This is due to the fact that there is more time before expiration, which increases the probability of the option expiring in the money
- Strike price - if the strike price is closer to the current market price of the underlying asset, the option will be more expensive
- Volatility - higher volatility increases the price of options as it increases the potential for larger price movements in the underlying asset
- Interest rates - higher interest rates increase the cost of carrying the underlying asset, which in turn increases the price of the option

A commonly used model of options pricing is the Black-Scholes model, which takes into account all of the aforementioned factors.

Similarly to the trading of any other financial instrument, options trading is done using a mix of fundamental and technical analysis. Understanding the fundamental factors affecting the underlying asset is crucial in determining the potential success of an option contract, as well as the risks and opportunities associated with buying them.

Fundamental analysis involves analyzing the intrinsic value of an asset to determine its viability as an investment, as well as the underlying fundamental risks the asset is exposed to.

For example, a particular asset, such as a stock or currency pair, may be exposed to macroeconomic risks and these risks can differ in terms of scope and their effect on the performance of the underlying asset.

Suppose a trader would like to purchase call options for stock XYZ. Let’s assume that the underlying XYZ is the stock issued by a gold mining company. The trader would naturally do research regarding the price of gold, the effects of economic cycles on the price of gold, as well as the current challenges and opportunities facing the industry.

After overviewing the macroeconomic factors, the trader can then scrutinize the actual performance of the XYZ company, such as its operations, financial performance, management, etc.

All of these factors can play into the performance of the underlying asset, which then determines the price of the options contracts.

By understanding the intrinsic value of the underlying asset, the trader can then determine whether the asset is overvalued or undervalued and buy put/call options accordingly.

In conjunction with fundamental analysis, technical factors, such as volatility, momentum, and chart patterns are key in analyzing options contracts. Understanding the technical characteristics of the underlying assets can help traders choose when to buy call or put options and when to sell or exercise them.

Traders often use technical indicators, such as the Relative Strength Index (RSI), to confirm trends and identify potential reversals and continuations on a chart.

This is especially important when trading options that are close to their expiration date, as confirming favorable trends can show the probability of whether the options could expire in the money or out of the money.

Furthermore, technical analysis can serve as the basis of options trade decisions. For instance, if technical analysis suggests that the underlying asset is likely to break through a resistance level, traders can buy call options, as they expect the price of the underlying to rise. Conversely, if technical analysis suggests that the underlying asset is likely to break through a support level, traders can buy put options.

The process of options trading is a multi-step process that is easy to follow. First of all, you will need a brokerage account that allows you to trade options. Typically, a brokerage will ask you if you’ve had any prior experience with options trading and depending on your answer, might place some constraints on how much capital you deploy in options trading.

The general options trading process goes as follows:

- You choose the underlying asset you would like to trade options for. This can be anything from a stock, ETF, currency pair, index, commodity, cryptocurrency, etc
- You determine the strategy you wish to use, depending on the asset and the type of options contracts you would like to trade, as well as when to exit the trade, or whether to exercise your options or sell them
- Select an options contract you would like to buy. The market will list many contracts of different strike prices and expiration dates and you can choose which one to buy and how many contracts to trade, depending on your expectations regarding the price direction of the underlying asset
- Place your order through your broker’s trading platform. Review details carefully before placing your order to avoid any unintended errors
- Monitor your position regularly to check how the underlying asset is performing to decide whether to sell the options contract or exercise it
- Once your initial objective has been reached, close the position by selling or exercising the options contract

It is important to consider that options trading as a beginner may be intimidating, but having a solid trading strategy in place can help mitigate some of the risks associated with options trading. Furthermore, it is crucial to understand that options trading is a “zero-sum game”, meaning that for every winning option contract, there is a losing one.

As a financial derivative, options are often compared to futures contracts, and while there are some similarities between the two, they are also vastly different in some regards.

Some key differences between options and futures contracts include:

- Options contracts give the buyer the option, but not the obligation, to buy or sell the underlying asset at a specified date and price, while futures contracts require both the buyer and the seller to fulfill their obligations to buy or sell the underlying asset at a predetermined price and time
- Options contracts require the buyer to pay a premium to the seller for the right to buy or sell the underlying asset. On the other hand, futures contracts do not require an upfront premium payment
- Options contracts offer limited profit potential, as the buyer's maximum profit is limited to the premium paid for the contract. On the contrary, futures contracts offer unlimited profit potential, as there is no limit to how much an asset’s price can increase or decrease
- Futures contracts are more rigid than options contracts, as they oblige both parties to fulfill the contract terms regardless of market conditions
- Futures contracts tend to be more liquid than options contracts, as they are traded on regulated exchanges, while options are often traded over-the-counter

Determining the risk level of an option contract is crucial in making the right calls when trading. There are several variables that determine the volatility and risk of a given option contract, which are denoted using a Greek letter, hence, they are commonly referred to as the Greeks.

In options trading, the Greeks are a set of measures used to quantify the sensitivity of an option's price to various factors, such as changes in the price of the underlying asset, changes in volatility, time decay, and interest rates. There are five commonly used Greeks traders can use to evaluate the risk associated with a given option contract:

- Delta - Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. Delta ranges from -1 to 1. A Delta of 1 means that the price of the option will move in tandem with the price of the underlying. A value of 0 means that the option price will not be affected by the underlying whatsoever. A Delta of -1 means that the option and the underlying are inversely related and move in the opposite direction
- Gamma - Gamma measures the rate of change of an option’s Delta in response to changes in the price of the underlying asset. A high Gamma means that the Delta will change rapidly in response to changes in the underlying. A low Gamma means that the Delta will change slowly
- Theta - Theta measures the rate of time decay of an option’s price. It shows how much an option’s price will decay as it approaches the date of expiration. A higher Theta means that the option’s price will decrease faster once it nears the expiration date
- Vega - Vega measures the sensitivity of an option’s price to changes in the level of implied volatility. A higher Vega means that the option price will be more sensitive to changes in implied volatility
- Rho - Rho measures the sensitivity of an option’s price to changes in interest rates. It reflects how much an option’s price will change for every 1% change in interest rates

The Greeks are crucial to understanding options risk. Understanding these measures can help you choose the best options contracts for your objectives - helping reduce your overall risk exposure.

Another great use of options data is when analyzing individual equities. Options contracts that use a particular stock as their underlying asset can provide you with great insight regarding the market sentiment and implied volatility of a stock.

Furthermore, options data can help identify potential mispricings on the market. For example, if many traders are holding put options for a stock with relatively healthy fundamentals, this shows that market sentiment towards that stock is quite bearish. However, if the stock moves in the opposite direction and starts gaining, this may prompt those same traders to reverse their positions and further add to the buying spree. While this is particularly true with regard to short and long positions, it also works for put and call options.

Options are also valuable tools for hedging against existing stock positions. For example, suppose a trader buys 100 stocks of XYZ at $100 per share. Unexpectedly, the stock starts to slump and falls to $90. If the trader anticipates a further decline in the future but does not want to sell at a loss, they can buy put options for the stock at their preferred strike price. If the stock does continue to fall, the trader will be able to mitigate their losses from the falling price.

Traders can use a number of common options trading strategies to get ahead in the market. It is important to consider different strategies to understand which one works best for your trading objectives.

A covered call is one of the most popular options trading strategies that involves selling call options for stocks that you already own. The goal is to generate income by selling call options while limiting the potential losses associated with the underlying stock.

Here’s how it works:

- The trader owns a certain number of shares in a particular stock
- They sell a call option on their stock
- The trader collects a premium for selling the call option, which is paid by the buyer
- If the stock price remains below the strike price by expiration, the call options will expire worthless and the trader will keep the premium
- If the stock price reaches above the strike price by expiration, the buyer may exercise the options, in which case the trader must sell their shares. This limits the profit potential for the trader but guarantees income through the collected premiums

A married put works very much similar to a covered call, except the trader sells put options on the shares they own.

Here’s how married puts work:

- The trader owns a certain amount of shares of a particular stock
- They buy a put option on the same stock
- If the stock price declines, the put option will mitigate the losses on the original stock position
- If the stock price rises, the trader will still benefit from the capital gains of the underlying stock
- The premium paid by the trader to buy put options act as a form of insurance against potential losses in the stock

Bull call and bear spreads are also common strategies that involve buying and selling call and put options.

How a bull call spread works:

- The trader buys a call option with a lower strike price, which is also known as a “long call”
- The trader then sells a call option with a higher strike price, which is also known as a “short call”
- Both options have the same expiration date
- The premium received from selling the short call option offsets the cost of buying the long call option
- If the stock price increases, the long call option will become more valuable and the short call option will expire worthless
- The profit potential of the trade is limited to the difference between the strike prices, munis the net premium paid by the trader

Conversely, a bear put spread is done by buying a put option with a higher strike price and selling a put option with a lower strike price.

A long straddle and long strangle strategy involves buying both call and put options on the same underlying asset with the same expiration date. These strategies are deployed when the trader expects a drastic move in the price of the underlying asset but is unsure of the direction of the movement.

Here’s how a long straddle works:

- The trader buys a call option and a put option with the same strike price and expiration date
- If the price of the underlying asset moves significantly in either direction - the trader makes a profit
- If this does not happen, both options will expire worthless and the trader will lose the premium paid for both options

Conversely, here’s how a long strangle works:

- The trader buys a call option with a higher strike price and a put option with a lower strike price, both with the same expiration date
- If the price of the underlying asset moves significantly in either direction beyond the strike prices, the trader makes a profit
- If the price does not move significantly, or moves within the ranges of the strike prices, both options may expire worthless and the trader will lose the premium paid for both options

Both of these strategies are quite risky and require the price of the underlying asset to move significantly in order to generate profits.

Trading options may not be for everyone, as the approach involves unique risks and opportunities and traders should consider each carefully to decide whether options trading is the best course of action for their trading objectives.

- Leverage - options allow traders to control large amounts of an underlying asset with a relatively small investment, which can lead to significant profits
- Risk management - traders with existing assets can use options to mitigate the risks associated with holding those assets
- High-profit potential - options trading can offer traders significant profit potential if the right trades are made, as they involve more risk than simply holding assets
- Flexibility - options offer much more flexibility than buying and selling assets and traders can resort to a number of different options strategies to meet their objectives

- Volatility - option prices can be highly volatile and dependent on multiple factors, such as time till expiration, price and implied volatility of the underlying asset, etc
- Time-sensitivity - options are time-sensitive, as they have an expiration date, which adds to the overall risk associated with options trading
- Limited liquidity - options are often traded on unregulated OTC exchanges, which reduces liquidity on the options market
- Complexity - options strategies can be complex and require a deep understanding of options pricing, the Greeks, and other technical concepts

- Options are financial derivatives that allow traders to buy or sell the underlying asset at a predetermined price and date
- There are two main types of options, namely call and put options. Call options represent upward shifts in price, while put options represent a downward movement
- Options data, such as the Greeks, gives stock traders relevant information regarding market sentiment of the underlying asset
- Traders use a variety of options strategies to hedge their existing positions or to make a quick profit on the market
- Options trading involves a lot of risks, which is why they are often not advisable for complete beginners and why some brokers restrict inexperienced traders from accessing options

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Options are financial derivatives that allow traders to buy or sell the underlying asset at a predetermined price and date in the future. An option comes with a strike price, which is the price level that must be matched for the option to be exercised or sold for a profit.

Options trading involves multi-variable risks, which are described by the Greeks and show the relationship between the price of the option, to the price and implied volatility of the underlying asset.

While options trading may be risky, experienced traders can significantly boost their profits by deploying options at the right market conditions. Buying call options just as the price of the underlying is about to jump can yield much higher profits than simply buying and selling the underlying asset at a higher price.