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Options Trading Basics

Options

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Options trading can be a dedicated speculative strategy or assist investment strategies targeting the underlying assets. Your first decision is trading forwards contracts on an exchange or over the counter.

Exchange Based

Exchanges standardize the listings for options on the market, resulting in all traders buying and selling a specific set of financial options. Standardizing contracts increases the amount of liquidity. All investors are trading the same instruments. This creates a liquid after-market for options exchanges, and results in easy to trade purchases and sales.

Over the Counter

The alternative to exchanges is the “Over the Counter”, also referred to as the OTC market. This market has advantages and disadvantages when compared to exchanges. Over the counter trading removes exchanges as the middlemen. It also removes the restraints, standardizations, and requirements they place on the trading process. Options have higher customizability: premiums, expirations, and underlying assets can be modified as long as both parties agree on terms. The downside is a result of this benefit: Costs are higher, and liquidity is lower. It’s harder to find someone who wants to buy your customized option than it is to find people who trade market standards.

Hedging or Speculation

In either case, you have many reasons to trade options if they are available to you, since they have multiple functions. The first is hedging (reducing) risks in the marketplace. Hedging with options controls some risks, usually by taking an opposite position to a lesser degree of the current position. Very useful tools for risk management, but typically require giving up at least a little profit as cost.

They can be used for speculation, the direct opposite of hedging. Speculation is raw bets on underlying assets. Options are used for raw directional bets often. Hedgers have an existing collection of control over the underlying assets, and are trying to reduce the effects of adverse movements against their position. Speculators are chasing pure profits, have little or no existing control of underlying assets, and are usually increasing risk exposure to adverse movements.

Arbitrage

Options are also traded for arbitrage profits. Arbitrage attempts to gain from discrepancies in prices between two similar or same investments. The similarity can be relation to the same underlying asset, similar function, or complimentary pricing. The difference is reduced by active trading: an overvalued asset is short sold for a decrease in price, and an undervalued asset is bought, which increases price. Option traders may use calls and puts to increase profits from their activities.

Options Trading Purposes

Options trading for speculation or arbitrage requires constant devoted attention and participation. Expect to actively watch your option positions. You’ll need to know if your options, especially American options, have gone “in the money” or not. You need discipline to earn money from options.

In terms of value options trading is an almost perfectly balanced game, with very little financial leaks in the system. Virtually all money lost is gained by someone else. Trading still requires substantial amounts of capital, which can be rapidly lost. Brokerage accounts will acquire a small amount of capital as margin, but your margin can be quickly eroded by bad trades. Large open positions can be eroded just as quickly if you move large amounts of money into bad trades.

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