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Investing 101: Is Options Trading Safer?

20 September 2021 | 0 comments | Posted by Allison Palmer in Money Talks

What are options trading

Investing has no doubt brought fear to many. Given that lack of knowledge in the matter could bring confusion as well as make people have uncertainties. Luckily, there are a couple of advisory subscriptions that individuals could look into to guide them in this move.

Suppose you've been conducting research or are possibly taking part in investment projects. In that case, it's likely that you also look up to the world-renowned investor, Jeff Clark, for his great methods to turn the investing opportunities into his luck!

Even so, you might still be doubtful of the potential of options trading as most investors generally stick with mutual funds to feel secure. But little do they know that options could be a lucrative way to increase one's net worth when done the right way.

What are these Options?

Options refer to contracts that give you the right to purchase or sell a security. In other words, it's an investment where the option you buy allows you to bet on the direction of its stock price. Often, this term is interchangeably used with stocks.

Yet, it's critical to clarify that though they may seem similar, stocks reserve a difference from the former by representing the share of ownership in the individual companies you partake in trading.

For additional explanation of options, suppose that you're interested in availing the 100,000 shares from ABC's stock with a price of $5 per share when you've come to realize that you don't have that much of money at hand to purchase that much or you're terrified that its price could sink.

For that reason, you've decided to buy a $5 each per share of option that summed up to $5,000. Ergo, you're now legally permitted to buy that company's share at the same price regardless of the changes in the market for a contract of about a month.

Then, let's assume that ABC company released improved expected earnings a couple of days later, owing to the company's machine invention that could eradicate world hunger. Overnight, their stocks skyrocketed from $5 to $50 per share. At this point, you could choose to exercise the option you bought and spend about $500,000 to have a stock that's worth at least $5,000,000.

Before long, you could decide to sell these for $4,495,000 hefty profit.

If the opposite happens, where the worst could happen is that ABC declares bankruptcy, the options then drop from its $5 per share to $0. Consequently, you could choose to let this option expire with only a loss of $5,000 from your pocket.

Are they risky?

There's no such thing as risk-free investments. The good news, though, is that you could reduce that risk by a lot if you compare several investment choices in front of you.

In the case of options trading, however, not all carry the same weight of risks. Being the seller (writer) brings a different risk from being a buyer (holder).

The example above is a great model of a situation of call holders. Upon buying the call, they have the right to purchase a share at a specific price, giving them an unlimited upside potential but with a downside of losing the premium they spent on the stocks.

In simple words, this situation likely begs the opportunity to see the rise in the value of the purchased shares that you bought from a lower price before selling them for a considerable profit.

Now, if you went on to buy a put, you become a put holder and avail yourself the right to sell that share at a specific price where you'd get the upper hand on purchasing the stocks based on the difference of the share prices. For instance, you want to buy a $5 per share and witness its value downgrade to $3 per share.

In this way, you're likely to want to see its price go down a lot so you could have the chance to sell it for a higher price.

On the other hand, call writers are the individuals who sell a call or have the right to purchase from others. Usually, its upside potential is the premium, yet it's worth noting that the downside potential it carries is commonly unlimited.

People who take on this role want the price to stay stagnant or just have a slight drop in prices once in a while so that whoever avails the call couldn't exercise the said option and force you to sell it instead.

Apart from this, writers sell the right to sell to others and share the same upside potential with call writers. Yet, its disadvantage is the stock's amount of worth. So it's likely that you'd want it to stay above the so-called strike price to discourage buyers from forcing you to sell it for a relatively higher value than its worth.

How can I offset the risks?

There are various strategies that you could use. But the most common of them are covered calls and protective put.

The one selling it has already owned the equivalent amount of the stocks' underlying security in the covered call. Compared to other techniques, it's a reasonably simple method to utilize.

Moreover, you could also opt to use a protective put instead if you're much comfortable with risk-free management strategies. These offered options contracts by investors shield you against any potential loss that comes with owning an asset or stocks for a fee known as "premium."

Bottom line

Before putting your foot forward in investments, make sure to do your thorough research before deciding. Truthfully, the risk associated with trading options is just as identical to the trade of individual bonds and stocks.

But bear in mind that as long as you're informed in the investment process you want to bet on and have a solid strategy to achieve your financial goal, then options trading could be a great source of income for people like you.

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Recommended reading

If you enjoyed this post and have the time to spend diving deeper down the rabbit hole, then we suggest you check out the following posts about improving your finances in South Africa.

Disclaimer: This is not investment advice and is for informational purposes only. nichemarket cannot be held liable for any investment decisions made based on the information given by independent financial service providers. Under the ECT Act and to the fullest extent possible under the applicable law, nichemarket disclaims all responsibility or liability for any damages whatsoever resulting from the use of this site in any manner.

Tags: Trading, Options Contracts, Guest Post

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