Understanding option trading and its fundamentals is vital to trading success. Options are one of a number of things called "derivatives" and are called this because their price is "derived" from the price movements in an underlying asset such as stocks of shares, commodities or currencies.
But of all derivatives, option trading is considered to be the safest alternative. The reason is, because unless you sell "naked" positions, which is never recommended, your maximum risk will always only ever be the amount you invested.
Other derivatives such as futures, spot forex and Contracts for Difference do not carry this safety net ... although some CFD brokers such as IG Markets will offer traders a 'guaranteed stop loss' these days.
But from my experience, I have found that the extra leverage, combined with a 1:1 value movement in these derivatives with the price action of their underlying asset can often stop you out before your position goes in the direction you believed it would.
So understanding option trading is certainly a worthwhile exercise. The more challenging feature however, is that, unlike futures, spot forex and CFDs, option pricing is much more complex.
But their very complexity is what makes them not only interesting, but also versatile and flexible.
You can construct combinations of buy (long) and sell (write/short) positions with the same, or different, expiration dates and exercise prices - called "option spreads".
Or you can as it were, take a bet both ways, by purchasing both call and put options simultaneously, in anticipation of a large price move.
Due to this marvelous little thing called "leverage" in combination with the unique way that options values are calculated, the profitable option will do so well that it will not only cover the cost of the losing option but make you a nice profit as well. Variations of this strategy are called "straddles" and "strangles".
Or if you already own shares, or wish to purchase them, you can also write call options at exercise (strike) prices above or below your share purchase price and make extra income selling "covered calls".
Educating yourself in options trading should also include knowing how to hedge your investment positions. Hedging is a process whereby you spend a small amount of money to create a position that will make sufficient profit or loss, to offset the effect of price movements in your asset portfolio, which cost you a much larger sum. The leverage available in derivatives is what gives you this power.
So have a look around this site for a while. Follow the links on this page to begin your exciting journey of discovery and self education. Empower yourself to become financially self sufficient.
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