Get the Low Down on How to Trade Options

Before you trade options

Are you wondering how to trade options? If so, you’re off to a good start by finding this article and doing some research. We’ll be blunt, options are high risk, high reward investments. We encourage people to invest risk capital into options. However, we also encourage newbies to study up and learn the basics (at the very least) before trading in them.

How we trade options is very important for determining investment strategies. Options should definitely be a part of your strategy, but due to their exceptionally high risks, you need to be very careful when trading them. For this reason, we generally recommend that you limit your investments to risk capital, which basically refers to money you could afford to lose. Of course, no one wants to lose money, but when trading options make sure you don’t “bet the house” on your investments.

Options basically give traders the right but not the obligation to buy a certain stock or commodity at or before an agreed upon date for an agreed upon price. Sound confusing? Don’t worry, it is, so being confused is nothing to be ashamed of. We’ll go into some details so you can see how trading these financial vehicles work.

How to trade binary options

Learning how to trade binary options is a great first step to investing in options in general. Binary options are a special type of option. As we always recommend when looking at investment definitions, you should break down the terms. Binary, for example, means “two”. To illustrate, binary code is code written in  “0” and “1”. Binary star systems, meanwhile, have two stars.

Binary options, for their part, have two potential outcomes. They are “yes” and “no” propositions and they center around whether or not prices will rise (yes) or fall (no). With a binary option you look at the value of an asset, and then you guess whether that value will rise or fall over the coming weeks and months.

So let’s say you trade a binary option based on the Dow Jones Industrial Average. In this case, you’ll be “betting” on whether prices for the average will rise or fall within a given date. All options have expiration dates, meaning that if the contract is not exercised by that given date, it is invalid. This means you will lose all of your money that you paid to buy the option.

How to trade stock options

So now you’re wondering how to trade stock options? Stock options are based on stocks. This means the underlying value of the option is tied directly to a specific stock. You can trade binary stock options, which means you guess, yes or no, on what way stock prices will rise in a given period of time.

When people refer to just stock options, however, they normally mean “regular” options. Don’t be turned off by the term “regular”, these options are just as exciting as other types of options, though in a sense they are a bit more complex.

As stated, the options are tied to the value of a stock. When you buy an option, you will buy the right to buy the stock at a specified price by a future date in time. Let’s say Acme Motors stocks are trading for $50 dollars a share. You believe that Acme stocks are going to rise substantially in the months to come.

So let’s say options with an expiration date set six months from now and an execution price set at $50 dollars are selling for $5 dollars a piece. You are very confident that Acme stocks will hit $60 dollars within six months but only have $1,000 dollars to invest. You could buy twenty shares of Acme, but you’ll only about about $200 bucks off your investment. Or, you could buy 200 Acme options. If the stocks do reach $60 dollars a share, you’d make $10 dollars per option, or $2,000 overall (minus your initial costs, which in this case was $1,000).

Difference between binary options and options

Understanding the difference between binary and “regular” options is important for understanding how to options trade. With binary options the expiration date is often set for a much shorter period, sometimes as short as one hour. For regular option, dates are often set much farther in advance, often several months.

With binary options you know exactly how much the payoff will be. With regular options, how much you earn will depend on how much the value of the asset rises or falls before the expiration date.

These two differences are the most important distinctions between these two different types of options. There are some more nuances, however, so consider this merely an introduction to what is admittedly a complex trading instrument.