The Basics of Option Trading

When used properly, options can be a powerful tool for speculating on the future direction of stock prices. But they also carry potentially disproportionate risks, and investors need to be careful before taking on these types of trades. This article is designed to help you understand the basics of option trading so that you can make smarter bets and reduce your risk.

There are many ways to trade options, but the most important thing is that you take time to research each position before you execute a trade. This means not just looking at the company’s financial statements and competitive environment, but understanding¬†See this the industry and what type of investor you are. It is also a good idea to understand the different types of options, including calls and puts, and whether they are covered or naked. A covered option is one in which the seller (or writer) has an obligation to deliver the underlying asset if exercised; a naked option is not.

Buying or selling options is only profitable if the contracts remain “in the money” throughout their lifespans. This requires the share price of the underlying asset to move above or below the option’s strike price, depending on which type of option you’ve bought. To be in the money, a call option needs the share price to rise above the strike price and a put option needs the share price to decrease below it.

Another key to success with options is the use of proper stop-loss and limit orders. It is critical that you set up your stops and limits well in advance of the trading day. This will allow you to manage your risk and stay in the game longer. If you don’t set up a stop-loss, or if you don’t stick to your limit orders, then you may end up taking big losses that will wipe out your account balance.

It is also important to have a clear exit plan, whether you’re long or short an option. It is crucial to establish an upside target and the worst-case scenario you are willing to tolerate on the downside, and then work with your broker to place your orders accordingly. This will allow you to make more consistent profits, reduce your incidence of losses and sleep better at night.

One of the most common mistakes that new traders make is taking on too much risk. As a general rule, you should never invest more than 10% of your total net worth in any single trade. Taking on too much risk can easily wipe out your portfolio in weeks or months, even if you’re a great speculator. Think of it like car insurance: You don’t buy it hoping that you’ll crash, but rather to protect yourself from potential disasters. If you are an aggressive speculator, you may want to consider trading options that are backed by major indexes as a way to protect your investments against large unforeseen news events that could shake individual stocks for a while.