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Making Your First Option Trade

Sebencapital

Published
22/12/23
Making Your First Option Trade

You might know what an option is and think you understand how it works, but it's crucial to be patient before risking your money. Feeling excited and eager to start making profits is natural, but trading options isn't as simple as it seems. Let's explore the downsides of buying options before you're fully prepared to trade.

Key Takeaways

  • Traders need to think carefully about how things like the strike price, expiration date, and implied volatility of options might affect how much money they could make or lose.
  • Newcomers might feel tempted to purchase numerous cheap out-of-the-money (OTM) options. However, it's better to spend more money on fewer options that are closer to the strike price.
  • Remember, stocks don't move independently; they're influenced by the overall market.

A Typical Example of Buying Call Options


Let's say you really like a stock called FAVR, priced at ₹42.50, and you believe it'll go above ₹50 soon. Excited about this, you buy 10 FAVR call options, each with a strike price of ₹50, expiring in 90 days. However, when the options expire, they're worthless, and you lose all the money you invested.

Surprisingly, FAVR did go up to ₹46 after 90 days, just as you expected. But even with the right prediction, you still lost money. This situation, where you lose money despite predicting correctly, happens a lot in options trading.

Losing money despite being right is a common problem in options trading. So, before buying options, it's essential to understand some crucial things about how options work. This aims to give you important information before delving into the detailed concepts of options trading.

Earning a Profit

When trading options, the price of an option isn't just about buying calls and waiting for the stock price to go up. There are many other factors involved that traders, especially new ones, may not know about.

If you're expecting the stock price to increase, it's crucial to consider how much it might change. For instance, if FAVR's price history shows that the stock typically moves by a small amount daily (its volatility), then buying out-of-the-money (OTM) call options with a ₹50 strike price might not be a good idea. However, if the stock usually changes by a larger amount daily, let's say ₹0.50, it could be a reasonable move.

Knowing how much the stock price usually changes in a day can help make smarter decisions when trading options. Understanding the stock's past volatility is important before making investment choices.

Strike Price

You don't have to buy out-of-the-money (OTM) options just because they're cheaper. Many traders choose them hoping their predictions will be right and because they can buy more options for less money.

This approach is a bit like buying lottery tickets. The chances might not be great, but the potential for a big win is hard to resist. Instead, based on how much the stock typically changes in price, consider buying options that have a good chance of being profitable before they expire.

For instance, if FAVR typically moves a certain amount, buying options with strike prices closer to the current stock price, like ₹40, ₹42.5 (if available), or ₹45, might be more reasonable. Figuring out the right price to pay for options takes some trading experience, but understanding a few key points is important.

  • Was the option price fair, or was the implied volatility too high for this option?
  • Did purchasing these options at this price offer you a reasonable opportunity to profit based on your anticipated price increase?
  • Was the difference between the bid and ask prices too large? Wide spreads in the market can make trading more challenging. Did you mistakenly pay the asking price? It's advisable to aim for better prices whenever possible.

Holding for Too Long

When buying options, avoid the plan to hold them until they expire. Options lose value over time, so your strategy should involve exiting the trade when it becomes practical. While it's tempting to hold onto a profitable option in hopes of a bigger gain, it's essential not to do so. Sometimes you reach your profit goal, but other times it's better to sell the options while they still have value. When the stock price hits your target or comes close, it's a good idea to take your profits by selling the option.

The Stock Market

Was this the right time for a positive move? Have you considered the overall market direction? Stocks don't operate independently; their rise or fall is tied to other stocks' performance. So, are you confident the market is optimistic or pessimistic?

It's crucial to weigh these factors. Ignoring any of them decreases your chance of making money and might lead to losing your entire investment, especially with out-of-the-money options.

Just believing the market will move a certain way isn't enough. When buying options, the option price matters a lot and sometimes matters more than the stock's price change. So, avoid paying too much for options, especially considering implied volatility.

Note

Understanding the risk of losing money is crucial when buying options. Many traders focus on potential earnings without considering the downside. Avoid using options as a form of gambling to protect your investments.

Frequently Asked Questions (FAQs)

How can you learn and practice options trading?

Certain brokerages provide "paper trading" or "demo" accounts, which simulate trades using pretend money. These accounts are helpful for testing new strategies and products before investing real money, ensuring profitability and minimizing risks.

What is binary options trading?

Binary options, like those offered by Nadex, involve traders making predictions on specific statements. Unlike regular stock or ETF options, binary options focus on various assets like stock indexes, commodities, or currencies. They can also revolve around economic events such as job reports. For instance, a binary option might ask, "Will the price of gold per ounce be over ₹1,800 at 1:30 p.m.?" Traders who believe it will buy the binary option, aiming to profit if correct. Those who think it won't can sell binary options and take a short position.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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