If you are new to the stock markets, you may have had people, including experienced investors, tell you to avoid options. Many speak of options trading as a forbidden segment no trader should go near. At the same time, some people talk as if options trading is a piece of cake. No, that is not the case. If you start trading options frivolously, it will make a big dent in your wallet. So, do not start trading options the next day after you open your demat account.
Instead, first, learn how the contract works, so you can trade it to make money while comprehending the risk involved in trading it. Here are five points you must remember before starting trading options.
1. Master Trading Discipline and Risk Management
Whether you trade options, futures, or stocks, or trade in a different asset class altogether, like commodities, if you want to find success, trading discipline and risk management are paramount. If you are not a disciplined trader who cannot manage risk efficiently, you will lose a lot of money. To maintain trading discipline, you must have a solid foundation of technical analysis and follow the most fundamental trading principles. If your techniques are robust, you can predict the price’s direction and construct trading strategies.
However, it is still a prediction, not a certainty, so there is always a chance that you may go wrong. By sticking to a well-defined set of risk-management rules, you can cut short losses early and protect your capital. For instance, always implement a stop loss in your set-up and size your positions diligently.
Furthermore, if you are trading derivatives like options, a slight fluctuation in the underlying asset price can lead to a significant profit or loss. A minor mistake can end up proving to be costly. Hence, adhering to a set of risk-management rules is essential. This is a point most traders learn in theory but fail to apply in practice.
2. Options Trading is Effective in Bullish, Bearish, and Neutral Market
As an options trader, you can purchase call options if you predict the value of the underlying asset may appreciate. In contrast, you can buy puts if you believe the underlying asset will lose value. However, there are no restrictions on buying both calls and puts of the same underlying asset together. Instead, doing so is a common practice among professional option traders.
Buying both contracts of the same asset shapes the way for you to make money if you are uncertain of the direction the price will move, but you expect a significant move nonetheless. You may stumble upon such a scenario during the declaration of earning reports or interest rate hikes. Popular strategies you can implement in such situations include the long straddle and long strangle techniques. So, as an options trader, you can make money in bullish, bearish, and uncertain markets. You can implement various option trading strategies using your demat app for Android or iOS devices.
3. Be Cautious of Time Decay
Time decay is one of the most important aspects of options trading. When you buy calls or puts, you pay a fee called the option premium. So, as the buyer of an option, you pay the options premium to trade options. If the value of the premium increases due to increased demand, you may square off the contract to book profits. However, the premium degrades over time. Moreover, the pace at which it does continuously increases as the contract nears its expiry. This degradation is called time decay.
So, as the contract nears its expiry, the underlying asset’s price movement may have little to no effect on the premium. The magnitude of time decay overwhelms the impact of the price movement. Hence, it is better to stay away from trading options before expiry.
4. Know When To Not Trade
As mentioned above, you can make money trading options in bullish, bearish, and uncertain markets. The caveat here is that you must have substantial experience and skill. So, only trade when you can analyze the market, whether it is rising, falling, or neutral. Sometimes, the markets are volatile and range-bound in a narrow channel. If your strategy is not suited to trade in such a market, you will only risk your capital. It is better to stay not and not trade in such scenarios.
5. Hedging Benefits
Most traders look at options as a means to make money. They forget that they can also use options skillfully to reduce risks. If you are an investor especially, you can use options as a hedge to protect your portfolio from sharp price movements. For example, a long-term investor could purchase put options to safeguard their long positions from a sudden price decline. So, if the value of the underlying asset declines, taking put positions would have let the investor sell their investments at a predetermined price.
So, you need not fear trading options, provided you do it diligently. You may make mistakes, but your goal is to learn from them and improve. Before you start trading options, consider building up trading experience in the cash segment first. Your demat app for android or iOS can have plenty of features to help you start trading.
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