Maybe you have heard about trading options and were cautioned to stay away because they are too risky. While it may be true options trading is not suitable for everyone – options can be a valuable tool in a trader’s arsenal. Like many trading instruments, options have their risks and rewards. The first step to trading and understanding options is to ask some questions.
So, what are options?
Options are contracts which grant the owner the right to either buy or sell an underlying asset, for a predetermined price, called the strike price, on or before a predetermined expiration date.
Why trade options?
In short, options provide more ways to trade different market conditions than stocks or ETFs alone. Buying options sets a predefined maximum risk when you enter the trade. And, options provide traders with a way to better leverage their capital, controlling more shares than they could by purchasing a stock or ETF outright.
For example, a stock option contract represents 100 shares of stock. Let say you want to go long a $100 stock – rather than coming up with the $10,000 to purchase 100 shares, you can purchase an option that controls the same 100 shares for much less capital.
What’s not so great?
Options expire. If you buy an option, you have a limited amount time for the underlying asset to move in your favor – every day closer to expiration the time value in an option decreases – If the underlying asset doesn’t move beyond your strike price the option will expire worthless.
What else can options do for me?
Options also provide traders and investors with tons of flexibility. Below are some of the things you can do with options:
- Ability to make money when the underlying is moving up, down, or sideways
- Can be used to hedge underlying positions or stock portfolios
- Can profit from changes in volatility or time decay
What makes them risky?
- You can lose 100 percent or more of your initial investment
- You could be assigned the underlying shares of stock or ETF unexpectedly
- Cannot be traded outside of the regular session hours
How can I trade Options?
Options can be traded in a cash or margin equities account. However, you will need to complete an options trading application with your broker to see if you qualify to trade options and what type of options strategies you can put on.
Okay got it, so what are my options?
Despite the many different options strategies, it all comes down to two types of options; calls (when you think the market is moving higher) and puts (when you think the market is moving lower). Calls and puts can be traded individually, but they are also the building blocks that form many other option strategies.
When you buy a call, it gives you the right (but not the obligation) to buy 100 shares of an underlying asset, for a predetermined price (called the strike price) on or before a predetermined date. People who buy option contracts are referred to as “Holders,” since they hold the rights of the contract. If the underlying asset price moves up, your call increases in value.
When you sell a call, you have the obligation to sell 100 shares of the underlying asset at the strike price to an option holder. For accepting this obligation, you collect a credit upfront which gets deposited into your brokerage account. If the underlying asset price is below the strike price when the option expires, the option is considered worthless and you keep the credit you received.
Basically, these work the same way as call options, but in reverse.
When you buy a put, it gives you the right (but not the obligation) to sell 100 shares of an underlying asset, for a predetermined price (called the strike price) on or before a predetermined date. If the underlying asset price moves down, your put increases in value.
When you sell a put, you have the obligation to buy 100 shares of the underlying asset at the strike price to an option holder. For accepting this obligation, you collect a credit upfront which gets deposited into your brokerage account. If the underlying asset price is above the strike price when the option expires, the option is considered worthless and you keep the credit you received.
Do you need some help getting started with options?
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Disclaimer: The author is not a financial advisor and the following should not be taken as financial advice. This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.