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The Secrets Of Online Option Trading

If you're trading shares or bonds, you probably are aware of a whole range of strategies you can follow, which range from the long term buy and hold, right through to day trading using technical analysis. Online option trading is very similar.

What exactly is Option Trading?

Understanding exactly what an option may appear difficult when you're starting out. An option is a contract that gives you the right to buy (a call option) or sell (a put option) a share or bond at a set price (the strike price) on or prior to a set date (the expiration date). There are different types of options available in the marketplace, with 'American' options able to be exercised anytime between purchase and expiration, and 'European' options only able to be exercised on the expiry date. Although the terms are geographical, nowadays the location where you buy options does not automatically mean you've bought one type or the other. As a general rule of them, American-style options are mostly used for shares and bonds, whereas European-style options are for indexes.

Officially, options expire on the Saturday after the third Friday of the expiry month of the contract. However as US markets are shut on Saturdays, which makes the Friday the effective expiry day. This may all sound confusing, but is definitely worth remembering.

Your first step to Option Trading

The first thing you had better do if you are thinking of getting into online options trading is to become acquainted with the terminology. You need to learn just what share options are, and the difference between call options and put options. You need to become acquainted with option premiums, and their outcomes on the costs of your trades. If you don't understand these basic principles, you will never be able to become a successful online options trader. There is a plethora of information about these subjects available on the web, just do a search on "online option trading" or "option trading schools" and you'll see tons or results. You may also want to join an option trading forum or newsgroup as well, so that you can learn from other options traders. This is often one of the better techniques to learn something new, by having a mentor who has already made it through the mistakes. You can also join option trading courses or seminars, or buy e-books on the internet with respect to this. Whatever you do, make sure you educate yourself before heading into the markets.

How much disposable cash are you prepared to invest?

Once you've taken the time to become comfortable with the terminology of options trading, the next thing you need to do is work out just how much disposable cash you have to trade with. If you don't know this, you can't even start to trade. Don't consider putting any money in this that you cannot afford to lose, as there are no guarantees in the share market, no matter how skilled you may be. If you're a person who pays their bills and has little to no cash leftover, then you shouldn't even try to invest until your financial state of affairs improves, but again, that is of our own choice. Just know that if you invest or trade with money that you can't afford to lose, and you do lose it, it can be very hard to get caught back up again.

Start by ‘Paper Trading”

When you first begin online options trading, start by "paper trading". After you have acquired some confidence and your paper trades are doing well, then possibly you are able to jump into real trading. Always remember to try and downplay your risk, so when you first start you should try to trade options that have lower option premiums, so that you don't risk a lot, and don't stand to lose a lot of money if you make an error. Many novice online options traders will invest in many small share counters, so that they have a wide spread, which gives them better financial trade protection. It unquestionably isn't a good idea to invest everything you have in one option, at least not for most novice traders.

Evaluate your performance

Set yourself a success time frame, and then appraise your trading at the end of that time to see how you have done. Most novice online traders begin with 6 months, which gives them time to create an option trading system, and fine-tune it so it works for them. If you feel that you have become a good trader and have made more cash than you have lost, then by all means, continue if you wish, and maybe even move on to larger trades. If you have made bad selections, and have finished up in the minus side, then you might want to go back to paper trading or spend some more time learning from other people, and try again in the future, or at least stay with small trades until you hone your skills.

A few basic strategies you can use

Now that you have a basic understanding of what an option is and how it works, you can look into some basic strategies for online options trading.

When you buy or sell an option, you basically have two choices - you can hold it to maturity, or you can choose to exercise it prior to expiry. A majority of online option traders hold their options until maturity before exercising it to trade the underlying asset.

For example you purchase a call option for $1, with a strike price of $25. As options contracts are generally for 100 share lots, your purchase (ignoring commissions) would cost you $100, and you'd have the right to purchase $2500 of share through the option. Now, if the expiry date arrives and the share is worth $27, it makes sense to go ahead of buy the share, because you only have to pay $25. That means you've made an immediate profit of $2 per share if you sell them again immediately on the share market. However you still have to factor in what you paid to buy the option, which was $1 a share. So after your purchase costs are deducted, your overall profit is $1 a share. Well done!

On the other hand what happens if the share price doesn't hit $27 - or even $26, which is your break-even point for this option. If there is still time for expiry and the share price is above $26 but appears to be dropping, it may be a good idea to exercise the option immediately so you can get out of the contract without loss. If the share price is under $26, you might still be able to sell the options for a smaller amount than you paid, for example 20c a share, and recoup some of your losses. If the option is now worthless, you can just let the contract run in the hope that the price might jump up again, but accept that you've lost your $100. One of the good things about online option trading is that you've only bought the option to purchase or sell - you're not under any obligation to do either upon expiry. So your risk is limited to the amount you spend buying the option in the beginning.

One thing to be aware of is that option prices aren't just influenced by the price movements of the underlying assets - they're also affected by their time to expiry. As the expiry date approaches, option prices tend to drop rapidly. So if you have an option that you don't want to hold until expiry, it may be worth selling out early to avoid being too badly hurt by the price dropping as expiry approaches.

As you know, when it concerns investing money in the share market, or any other sort of exchange, there's always going to be a reasonable measure of risk involved. You could make an immense amount of money and retire, or you could turn a loss and lose your shirt with a poor decision. In the end, you'll have to find the best method that works for you. Just be sure that you don't invest money that you can't lose, take time to learn as much as you can about options trading, and then just give yourself time to become comfortable as a trader.