Options are a derivative, which means they derive their value from an underlying asset. In the case of stock options, this underlying asset is a stock or shares in a company. Stock options are traded on exchanges such as the Australian Securities Exchange (ASX). They can be used to speculate on the future direction of a stock’s price or to hedge against potential losses in the value of a portfolio of stocks.
The critical thing to remember is that stock options are a speculative instrument and come with inherent risks. Investors should only trade stock options if they’re prepared to lose all their investments.
To participate in trading options, you can do so with a live account at Saxo Markets.
Know your objectives
Before trading stock options, it’s essential to have a clear understanding of your investment objectives. Are you looking to speculate on the future direction of a stock’s price? Or are you looking to hedge against potential losses in the value of your stock portfolio? Once you know your objectives, you can identify which options strategy will suit your needs.
Consider the risks
All investments are risky, but some are riskier than others. Stock options are high-risk investments, and it’s essential to understand the risks before trading. The most common risks associated with stock options include:
Volatility risk is when the underlying asset will experience sudden, dramatic swings in price, which can make it challenging to predict which way the market will move and lead to losses.
Liquidity risk is when there may not be enough buyers or sellers in the market to allow you to buy or sell the options contracts you want. It can make executing your chosen strategy difficult and lead to losses.
Counterparty risk is when the other party in a transaction will not honour their obligations. It can happen if a broker goes bankrupt or an exchange defaults on its obligations, leading to losses.
Choose your strategy
There are several different options strategies that investors can use to trade stock options. Some of the most common include:
Buying call options
It is a bullish strategy that involves buying call options on the underlying stock. It gives you the right to buy the stock at a set price, known as the strike price, before the expiration date.
Buying put options
It is a bearish strategy that involves buying put options on the underlying stock, enabling you to sell the stock at the exercise price at any time before the expiration date.
Writing call options
It is a bearish strategy involving selling call options on the underlying stock, which enables you to sell the stock at the exercise price if the buyer exercises their option.
Writing put options
It is a bullish strategy that involves selling put options on the underlying stock, enabling you to buy a stock at the exercise price if the buyer exercises their option.
Decide how much to trade
Once you’ve chosen your option strategy, you must decide how many contracts you will trade. The number of contracts will depend on several factors, including your portfolio size and risk tolerance. Remember, stock options are a high-risk investment, and you should only trade as much as you’re prepared to lose.
Monitor your positions
Once you’ve entered a position, it’s essential to monitor it closely, which means paying attention to the underlying stock price and any market changes that could affect the value of your options contract. It would be best also to have a stop-loss in place to protect your position from potential losses.
Manage your risk
There are many ways to manage the risks associated with stock options trading. One way is to use a stop-loss order, which is an order to sell your options contract if it decreases below a specific price. Another way is to use a limit order, which is an order to buy or sell your options contract if it reaches a specific price. Finally, you can use a hedging strategy, which involves buying or selling another asset to offset the risks of your options position.