Investing in the various financial markets and their instruments brings a lot of opportunities with risks. These risks of markets are due to market volatility, where the prices keep fluctuating because of factors impacting their environment. This is where traders have to manage their investments with appropriate trading strategies, platforms, and styles.
One cannot always be a winner and a loser; if traded with proper information and knowledge, investors can make most of their funds. The financial markets provide a number of trading services and strategies that could be used to minimize the risks and have a good risk management technique.
In the article, we’ll be exploring options trading and how investors could use this trading strategy to make money in a falling market. By the end of the article, readers would understand what options trading is and how they can apply it to instruments for a profitable investment.
Options trading is a unique way of investing in the financial markets with an already open position. It is a derivative trading style where the two trading parties get into a contract written by the seller. It conveys the buyer the right to buy or sell the trading instrument in the market without any trade obligation. The trading has an expiration date, and a specific price called the strike price.
For a better understanding of the options trading process, let’s take an example. Stocks are the best instrument for comparing options trading. Suppose an investor buys stocks of a company thus, having a share in the company with the designation of a shareholder of the firm.
So, when an investor buys shares of a firm, they believe it will grow in the future and make money out of it. Hence, the share price of the company and its market position both will enhance in the near future. Once the share reaches this position, the investor or shareholder would sell it in the market for a profit.
But, in options trading, we take a different approach. In this, the trader gets the right to buy or sell the stock or any other underlying asset. These are usually in bundles of 100 and are pre-negotiated by the traders at a certain price and date. Although, it does not make it obligatory for the investor to buy or sell the instrument/stock on the date of expiration.
Investors are allowed to let the contract expire, but they have to pay a premium amount for buying the options at the beginning of the contract, which they will lose if the contract expires and traders do not take any action.
Options contracts are available for all market securities, and traders can invest in the one they want to trade. The options are divided into two types primarily:
- Call Options
- Put Options
Types of Options
Options contracts are of two types, call and put; they have different qualities that make inventors earn profit by using them as investments. The paragraph describes the call and puts options and how investors can use them for a beneficial trade.
Call options are agreements that give investors the right to buy the instrument of the market for a certain period of time and price thus, having an expiration date and strike price.
While the put options are the opposite of call options, where investors get the right to sell the instrument of the market for a certain period of time and price.
Traders can choose the one that is suitable for their trade instruments and make a huge profit from it. Below are some of the things that traders can know about trading options; these are the rights that traders can have from the purchase of options till their expiration:
- Exercising options mean the traders will buy or sell the trading instrument at a strike price and expiration date.
- Traders can sell the options contract to another trader in the market.
- Investors are allowed to walk away with the expiration of the contract without any obligation.
- If a trader does not act on the expiration of the options contract, they have to lose their premium amount paid.
Reason for Trading Options
Investing in options contracts is beneficial for traders because of its no obligation rule and having to pay only the premium amount. However, options require expertise and knowledge of the market and instruments for earning huge profits. One cannot simply go and invest in options. They have to be professional in the market with years of experience to take advantage of the market.
The reason for which investors invest in options are listed below for an understanding the readers:
- Buying the options contract gives the investor more rights or control of the instrument. If a trader buys the instrument simply with the same amount, they won’t have much control over the instrument.
- The options contract is a kind of leverage that investors can enjoy trading with at high market positions. In addition, these offer the investor magnified returns on the trade.
- Options contracts provide the trader time to know the market and instrument movements and, based on that, decide their actions. Hence, helps in making informed decisions.
- The trading of options protects the investors from downside market risks as this locks the price of the instrument without any obligation on the investors to buy.
Risks Associated with Options Trading
Investing in any market or form always has its risks, and so does options trading. Traders can watch out for these risks of the trading style for convenient investing and making good market returns. Below mentioned are the risks of the options trading:
- Options trading requires excellent market knowledge; otherwise, the trader would end up losing money and the entire investment within a short duration of time.
- Trading with options is complicated as traders don’t easily understand the process.
- Options trading requires a huge amount of money for trading in the market, which is possible with only the experts in the trade.
- The risks of trading with options are high as traders can have losses more than their initial investment.
Thus, trading with options needs proper risk management techniques and accurate knowledge of the market and options trading. To be successful in options trading, investors have to be experts in the trade and make the best use of call and put options to earn from financial markets.
How to earn profits in a falling market with Options?
Options trading is a profitable investment for those who take it as a good source of earning from the market and not a derivative product that is meant for the market speculators. However, fewer investors know that options trading is an excellent way for protecting the market instrument or portfolio against the uncertainties of the market or the downside risks.
When an investor uses the options in the proper way, they will be able to have more profits than a stock trader can have from dividends. Options are a good investment strategy that traders can use to minimize their risks in the market and generate income from their investments in falling market situations. Mentioned below are the options trading ways for making money in a falling market:
Sell a Covered Call
Options trading has many strategies which could be used by investors for making profits, and one of those is to sell a covered call. The options trading strategy is used by investors to enhance their profits and have protection against market loss. The trading strategy generates income from the market investors who believe that instrument will not have a price rise in the near future.
Here the trader will have a limit on the profit as the trader can have a minor increase or decrease in underlying asset price.
For example, an investor buys 100 shares of a company, XYZ, at $50 on 1 February 2022 and then sells it on the same day with a call option, having a premium amount of $10. The contract expires on 1 June 2022 with a strike price of $52. On 1 June 2022, the shares of the firm closed at $60. In this situation, the trader can exercise the option right as the closing price is higher than the strike price of $52, and the trader earns $52 for the share.
Thus, the investor made a profit of $8 and a premium of $10 collected already. Traders earn $18 from the investment of options.
But, in contrast to this, suppose the shares of the company XYZ close at $40 on 1 June 2022. So, the trader would not exercise the option as the share is offered at $40 in the market. The trader in this condition would not buy the shares at $52. Here the trader will have a loss of $10 per share, and if we minus the premium of $4, then the net loss on share was $6.
The put option is the profitable options trading style where inventors can earn when the value of the traded instrument falls. It is in contrast with the sell a covered call option. The trader with put options gets the right to sell the underlying trading asset for a fixed price within a set time frame.
In put options, the trader will gain from the investment when the traded asset will have a falls in its price. This is the perfect example of how to make money in a falling market with options. Put options are similar to short selling, where investors earn from the decrease in the price of the instruments. However, short selling has high risks.
But if the price of the traded instrument increases in the market, there will be a loss for the options trader. If the instrument price increases and goes higher than the strike price set, it would expire, and the trader will be at a loss. So, a trader should use the put option when they feel the market will see a downfall.
For example, there are shares of a company, Wonders, which are currently trading at a market price of $45. However, the investor believes that the price of the shares will decline. So, the trader buys a put option at a strike price of $40 with a time period of a month. Let’s say after a month, the price value of the Wonders shares is $30.
In this condition, the trader would exercise the put option and sell the shares at a higher rate of $40. Thus having a net profit of $10 and in addition to the premium paid on the shares. If we say the premium paid was $5, then the investor would have a profit of $15.
With the put option, the value of the asset will increase with the decline or fall of its market value. In contrast, the put option price will decrease if the underlying asset will get closer to the strike price of the asset.
Buying puts is less risky than short selling in the market as the traders have no obligation and can let the option expire. They will only have the loss of premium on this trading that is paid by traders at the beginning of the investment.
Options trading is a risky job, but if a trader does it accurately, they can have several market benefits. The derivative trading agreement is beneficial for speculators and other market investors who want to trade in the rise and fall of the market instruments.
However, options trading requires expertise and market knowledge to make the best out of investments. A trader can earn from buying puts and writing covered call options in a falling market. The article has covered all the aspects of options trading and how investors can earn profits in a falling market with options.
Traders can use options trading strategies with online brokers such as Investby, which has ample services and instruments to invest with the best trading platforms and analysis tools.