An option is among the most widely traded derivative products in the financial industry. This highly applicable instrument is considered safe for those who have limited buying power and is always used for different purposes. Besides, traders can earn megabucks from options and eschew potential risks if they capitalize on proper strategies, regardless of market conditions. This article will explain why trading options can make you rich and how to do so.
Options Trading: Definition and Application
An option is a derivative contract that entitles the option’s buyer (or the option holder) to the right, but not obligations, to purchase or vend the underlying instrument (i.e. stocks or bonds) at a predefined price before or on a predefined date.
Of which, the option’s price is frequently called “exercise price” or “strike price” which is either identified depending on the market price (spot price) of the asset on the day of making an option or fixed at a negotiated discount. Its price depends much on the movements of the underlying instrument it is dealing in. Moreover, supply and demand in the market are also two key considerations. Whether a considerable number of options traders long for selling contracts prior to the expiry date or collecting a massive option holding is indicative of changes in the option price.
Many traders prefer this derivative product to a direct instrument because they primarily tend to speculate on the price movements of the underlying asset to make money rather than benefiting from its intrinsic value. Therefore, the holding of the option does not translate to the ownership of the underlying instrument, which means the option owner does not receive the same rights as the instrument owner, including voting rights or dividends if any.
Options are widely utilized for different purposes, for example, a hedge against expected fluctuations of the underlying financial product, a part of an employee incentive program or a means to generate additional earnings. What’s more, options help augment the trader’s buying power to manage more of a security than he/she is capable of purchasing and then increase his/her gains. Option holders may even trade large-cap stocks that they hardly approach without sufficient budgets.
How Options Work
Generally, options are classified into two common groups: calls that grant the rights to buy at a determined price, and puts that provide the rights to sell at a determined price. For a hedging purpose, the former is often used as a protection for long positions whereas the latter helps protect short sales. If the option owner executes the option, then the seller takes respective responsibility for conducting the transaction. Accordingly, the buyer will forfeit the exercise price plus probably a premium for the option fulfillment.
However, when the maturity date is approaching but the buyer finds the option no longer profitable, he/she may refuse to exercise the option. Instead, the trader accepts a premium payment to the option writer if he/she predicts the contract accompanies higher losses than a premium.
A call option is exercised or in the money if its strike price is lower than the spot value of the underlying asset. Meanwhile, the trader should implement a put option when its strike price is greater than the spot value of the underlying instrument. Conversely, the option settlement is discouraged when the contract, irrespective of its type, is at the money or out of the money. In case the option holder is unlikely to fulfill his/her obligations, he/she may sell on the contract to another entity in secondary markets.
Where to Trade
Depending on the underlying instrument you aim at, you may trade options on the over-the-counter (OTC) system or formal exchanges. In particular, if you focus on stocks, bonds, share indices (e.g. the S&P 500 or Dow Jones Industrial Average) or callable bull/bear contracts (CBBCs), futures and options exchanges are where you should keep an eye. Those trading platforms offer standardized options executed via a clearinghouse whilst their fulfillment is under the management of the Options Clearing Corporation (OCC). So, the pricing models of those listed options are accurately modified.
Should you want to customize the contract’s terms to meet personal or business demands without confronting multiple regulatory requirements, OTC options which often allow users to trade on interest rates, currency cross rates or swaptions are the best alternatives.
Can Options Trading Make You Rich?
Same as investing outright in financial products like securities or foreign currencies, trading options may turn you into a millionaire or at least help you earn more than a regular job. Even with the leverage tool, you may shorten the way to success with comparably small capital.
Assuming that your financial resource is confined to US$1,000 and you plan to buy Company A’s stock which is priced at US$20 per share, hence you will purchase 50 shares (excluding possible transaction fees from brokerages) with the expectation of a bullish market. You notice that an equivalent call option (100 shares) has a strike price of US$200 and a premium cost of US$5. Hence you will buy 5 calls with US$1,000 and then may profit from 500 shares if the market movements are favorable. Accordingly, you magnify the trading power up to 10 times thanks to options and commence with smaller capital.
Furthermore, you may obtain handsome profits during times of stress or low volatility. No matter whether the market is experiencing an upward or downward trend or a sideways drift, you can earn thousands of dollars as long as the projection of the underlying asset’s direction is precise and suitable options strategies are chosen.
How to Get Rich Trading Options
You may pick call options on your preferred growth stocks with hopes for them skyrocketing after earning reports are released but still before the maturity dates of those contracts. Unfortunately, the market history proves that these stocks are always performing well and spiking, not to mention that a wealth of other factors exert an impact on the options market. So, to boost the winning rate in this derivative, you had better conform to the following rules:
Determine Reasons to Trade Options
Why should you focus attention on options rather than direct investment assets or other derivatives? You may be convinced that these contracts enable you to start small safely, protect open positions or carry out mere speculation on price movements. Only when you look for a sensible answer for the given question, you then establish a corresponding trading goal on the derivative instrument and draw out a detailed strategy to enhance a sporting chance. Without a reasonable justification to trade options, you are advised to engage in other realms that you better acknowledge instead.
Understand the Options Market
One culprit behind the miserable failure of options traders is their lack of knowledge about the derivative. This matter will result in a series of consecutive problems entailing misleading objectives, unprofitable strategies to trade options, incorrect predictions, poor risk management and even financial losses. Although being well-informed of options does not always give you cards of success, it functions as a base for beginners to be attuned to these derivative contracts.
Select the Right Options
There are various considerations to pick up appropriate options. Firstly, it is highly recommended to identify which sectors and underlying assets you would like to trade on. In addition, you should employ implied volatility (IV) which is a common metric to foresee subsequent moves of options contracts as well as their future supply and demand. If the indicator is not so high, for example, 20%, you can ponder the purchase of call options on the security. What’s more, a strike price and the expiry date are worth considering based on whether you prefer a bullish or bearish trajectory.
Seek the Proper Options Strategy
Depending on two fundamental option types named calls and puts, there are four basic options strategies combined as follows:
- Long call: Those who expect the underlying asset’s appreciation may purchase a call option to buy that instrument at a strike price. The potential risk equates to the premium remitted to exercise this option, whilst the maximum reward may be infinite. Having said that, the likelihood of profitable trades is relatively low.
- Long put: Those who expect the underlying asset’s depreciation may purchase a put option to sell that instrument at a strike price. This strategy is a perfect substitute for short-selling the asset outright.
- Short call: Those who expect the underlying asset’s depreciation are liable for writing a call to sell the instrument to the call buyer at a strike price. It comes in two types, known as covered and naked. The former is favored by intermediate or advanced traders, whereas the latter often rests with those who accept high risks.
- Shot put: Those who expect the underlying asset’s appreciation are liable for writing a put to buy the instrument from the put buyer at a strike price. This strategy is awash with risks, so often suiting advanced options traders.
Beyond that, you may factor in an options spread strategy that encourages you to purchase one option and concurrently sell a cheaper counterpart to make profits.
Work With Reputable Partners
Inevitably, trading on formal options exchanges will bring several outstanding benefits such as the transaction execution backed by competent organizations with high credit rating, the security of the counterparty’s identity, financial transparency or the maintenance of orderly trading environments.
However, many traders may choose the OTC options to trade independently of market regulations and tailor contract terms with ease. Under no supervision of any exchanges, these dealer options accordingly come with higher default risks when option writers fail to meet their obligations for any reason. Therefore, transacting with well-capitalized and credible institutions is among the top priorities for OTC option holders.