Options are a secret weapon for many traders; a silver bullet that adds two new tools to their trading arsenal. Not only can you limit your risk to a fixed (and known) amount, options also allow you to profit from volatility in the market and craft profitable trading strategies.
But how, and where, exactly do you get started? In this guide on how to trade options, we’re going to cover the necessary steps to take before you start trading.
1. Educate Yourself
This first step is paramount, especially for beginner traders.
While options trading is relatively easy to learn and can give you a serious edge in the market, that doesn’t mean it is risk-free.
You should never jump in blindly without a strategy in place and a solid understanding of the basics, including how options work.
You must understand the ins-and-outs of options, including how they work, how their price is determined and what factors affect their prices.
Knowledge is key – spend some time practising on a free demo account before you risk your own money. Failing to prepare is preparing to fail; without a clear plan, chances are you will lose your money and investment.
Key questions to ask yourself when formulating a plan:
- What trading strategy are you after?
- What market conditions are you looking for?
- How will you implement your plan?
- Which strategies work under which market conditions?
- What you will do if the market turns against you?
- How will you get out of a trade, and when do you get out?
- What is your maximum loss?
- What is your profit goal, when do you get out?
- How do you let the winners run?
You need to have a clear, well-formulated plan and you need to follow that plan. Until you get there, you are gambling – and your results will resemble those of a gambler.
2. Determine The Instrument
Did you know that options are available on stocks, commodities and big currency contracts (not those mini spread trading contracts), but not on CFDs? Or that binary options are not the same as options?
If not, you need to go back to step one.
If you knew the answer to that question, then you should consider which one is right for you. For example, if you are interested in currencies it might be better to trade currency commodities.
3. Find A Broker
Compare and research brokers before you commit your money, including their terms, fee structure and limitations.
Finding the right broker for you is a lot like finding a pair of gloves and deciding whether or not they are the right ‘fit' for you.
For example, many brokers today are investing in and creating their own trading software. If you prefer to trade using third-party software such as MT4, then you'll need to a find broker that offers MT4 compatibility.
You'll also need to figure out if the brokers offers options on the stuff you want to trade. Take stock, for example – does the Exchange allow the trading of Stock Options?
Above all, the broker needs to allow you to trade options.
Some might only allow you to buy options, while others may allow you to sell options – but only if you ‘cover' those options. Covering is a risk mitigation method whereby the broker will only allow certain trading strategies.
On the other hand, other brokers may allow you the full range of options.
Generally, the more freedom the broker allows, the better. But traders first starting out with small trading accounts cannot afford the margin requirements and minimum account sizes charged by these brokers.
In this case, it's probably better to live with the restrictions the broker has and slowly build your trading account.
4. Open & Fund An Account
How much money are you going to put at risk on a trade?
The more risk you take, the more margin-money (safety deposit) you will need and therefore you will require a larger account size.
Selling options carries about the same risk as buying or selling the underlying instrument.
With instruments such as commodities, the margin requirement for a single position may well be anywhere from around $1,200 to around $7,000 (depending on whether it is a currency or crude oil).
In some cases, it might be even more.
That's just the margin. You also need money to cover daily price fluctuations and will, therefore, need a large margin account to be able to trade.
However, if you limit yourself to buying options, you only need to pay the premium for the option – that is the maximum risk you take; you can get away with around $600 – $3,000.
Then there are certain options trading strategies where you may limit your exposure to $250 – even with Crude Oil!
Here, you only need $300 in an account to trade these strategies. If you lose $250 then of course you will only have $50 left. But if you win, you are $250 up (or $550).
You have to restrict yourself to these specific low-risk strategies if you are patiently building up your account.
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