Things to Watch Out For When Trading Options 

Trading options involve placing trades on the future prices of underlying stocks or other assets. Option trading demands precision and strategies to maximize the profit potential and mitigate the risks involved. To help you with that, in this article, we will cover things you need to consider when trading options. 

Considerations When Trading in Options 

Here are six important things to be careful about when trading options.

1. Know the Expiration Dates

Expiration dates are dates by which the option must be exercised or becomes void. As this date approaches, the option’s value is affected by time decay. That means the option loses value because of the diminishing time it takes for the underlying asset to move favorably. 

Near-dated options are less expensive but riskier due to the limited time for the underlying asset to change. On the other hand, options with larger maturity cost more, but the chance of them moving in your direction is higher. 

2. Monitor Implied Volatility 

Implied volatility (IV) represents the market’s forecast of a security’s price volatility. It is illustrated by the Greek letter sigma (σ) and is expressed as a percentage. You can use this metric to estimate the range in which an underlying asset’s price might move.

Usually, a higher IV leads to higher premiums. This is because it reflects greater risk or uncertainty about the asset’s future price movements.

3. Beware of Liquidity Traps

Liquidity traps can significantly impact the ability to enter and exit positions. A liquidity trap arises when there is a lack of market depth, leading to wide bid-ask spreads and reduced trading volumes. This can make it impossible to execute trades at desired prices or even at all without incurring substantial costs. Moreover, in a liquidity trap, the absence of willing counterparties can force you to hold positions longer than intended. This would increase exposure to market risk.

4. Don’t Ignore Dividends

When a stock goes ex-dividend, its price usually drops by the dividend amount. Call options tend to decrease in value leading up to the ex-dividend date due to the anticipated drop in the underlying stock’s price. Conversely, put options may increase in value for the same reason. 

Additionally, unlike stockholders, option holders do not receive dividend payments. This difference in cash flow can make options less attractive and influence trading decisions. Early exercise of in-the-money American call options may occur to capture dividends, which can alter expected outcomes. 

5. Keep Up with Market News

Market news can include updates on company earnings reports, economic indicators, geopolitical affairs, and changes in government policies. These can all lead to volatility in the underlying assets, which can impact the options’ premiums and implied volatility. 

Moreover, news events can trigger sudden and significant price movements, presenting traders with advantageous opportunities to enter or exit positions. Finding the best options trading app which offers real-time data, global news and tools to execute trades on time is very important.

6. Know Different Strategies

In options derivatives trading, key strategies include covered calls, protective puts, straddles, and strangles. Covered calls suggest holding a long position in any underlying stock and selling a call option on the identical stock to make income from the option premium. This strategy is beneficial for earning income and hedging against minor price drops.

Protective puts involve buying a put option on stocks you own, providing downside protection. Straddles and strangles are ideal when you expect significant price swings, but the direction is doubtful. A straddle involves buying a call and put option with the identical strike price and expiration, while a strangle involves options with different strikes or expirations.

Conclusion

Options trading requires diligence, education, and a proactive approach to risk management. By keeping these six points in mind, you can steer the options market more effectively and increase your chances of success.