How do you trade options?


Quick Answer

Trading in options involves acquiring the right to sell (put) or to buy (call) an underlying asset over a set period of time. An investor has three ways of buying options, which are: waiting until maturity, trading before the expiration date, or letting the option expire. They may sell options using covered or uncovered calls - covered calls involve the investor selling the right to buy a stock they own, while an uncovered call is selling the right to buy a stock that they don't currently own, but will have to buy if the buyer's stock price increases.

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Full Answer

Common mistakes that new investors make when trading options include exclusively trading out-of-the-money calls or using one trading strategy for all market conditions. An OTM call refers to an option whose strike price is higher than the currently selling market value. While they look like a quick way to make money, the actual potential value of the option can decrease rapidly as it moves towards expiration. It is more efficient for a new option trader to sell a covered call, as it has significant potential for profit accompanied by minimal risk. They makes a profit if the stock price rises and their call is exercised.

Trading "long spreads," in which a lower-cost option is sold and a higher-cost option is bought simultaneously, is an effective strategy for a beginning option trader who is keen on minimizing his risk exposure, but it also limits the maximum potential profits. A successful investor must always have an exit plan when making a trade, as it limits the downside risk on his trades and encourages disciplined trading. In most cases, an options trader should avoid "doubling up" to recoup past losses, as it does not work.

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