Options are contracts that give the purchaser the right to buy or sell a security at a certain price during a fixed time period. When done right, options trading can produce tidy profits without a huge initial investment.
But is options trading difficult? The option itself might seem difficult to understand — especially for beginners — but the truth is that options trade on exchanges just like stocks, so they are accessible even to novices.
If you want to buy or sell an option, you enter an order just like you would if you were buying a stock. Most online brokers will let you trade options through their self-directed trading platforms.
Follow these options trading strategies and soon enough, you will be ready to open an options trading account.
What Is Option Trading in Stocks?
Options trading can be a good way to boost income from your stocks or to hedge against losses. Here’s a quick primer:
What Is an Options Trading Account?
You don’t usually need a specific account just to trade options. But since options can be complex and hard to understand, you must get your regular brokerage account approved for trading options before you can begin.
For more information regarding options trading for beginners, refer to this article on the Commodity Futures Trading Commission.
Options Trading Explained
What is options trading in stocks, and does it work? This review will help answer that question. A good place to begin is by understanding the two types of options:
- Call options
- Put options
You can buy or sell either type, typically at a standard contract of 100 shares of stock.
When you buy a call option, you get the right to buy 100 shares of the underlying stock at a certain price within a specific time period. Buying a put option is similar, except your right is to sell the stock rather than buy it.
There are also two types of positions:
- Long: You own the security in question because you think it will increase in value.
- Short: You don’t own the security because you think it will decrease in value. You are borrowing the stock at one price with the hope that the stock drops in value. If it does, you make a profit. If the stock price rises, you will incur a loss. Selling short is only recommended for more experienced investors.
Options are derivative securities because their performance is derived from an underlying asset, security or index. Here are some other types of derivatives:
- Futures: These are standardized, exchange-traded contracts to buy or sell a commodity, such as silver, at a future date for a specified price. These settle daily.
- Forwards: Forwards are private contracts that can be customized between two parties to buy or sell an asset on a future date for a specified price.
- Swaps: These contracts allow one party to exchange the values of one asset for another.
Futures, forwards and swaps typically are used by more experienced traders and companies.
Risk Factors of Options Trading
As with any other investment, options trading involves a certain degree of risk. There is no guarantee that your trade will go in your direction by the option expiration date. Other risks include:
- Volatility in the market or underlying asset near the option’s expiration date could cause a price change that negatively affects your option’s value.
- You could lose money in a short time period, especially during extreme market volatility.
There’s also the possibility that you lose more than your initial investment, depending on which side of the option you’re on — holder or writer. The buyer of an option is called the holder. The seller is known as the writer.
An option holder could lose the total amount of the initial investment if the option expires “out of the money.” Some types of options contracts carry even higher risks, where the writer could have unlimited potential losses.
These risks underline the importance of gaining knowledge about options before diving in. In fact, brokerages are required to provide their options trading customers with a copy of The Characteristics & Risks of Standardized Options to ensure that they understand the risks involved.
Options Trading Strategies
In terms of strategy, there are even more ways to trade options than there are to trade stocks. As leveraged, derivative securities, options are flexible enough to be used in countless ways.
For example, options can be used strategically to do the following:
- Generate speculative gains
- Protect your portfolio against market declines
- Generate income on your current portfolio
Conservative investors might sell “covered” calls against existing stock positions, earning income off the sale and not having to forfeit their stock unless it moves above the strike price. On the other side of the equation, aggressive investors might sell “naked” calls, in which the underlying asset is not owned — a strategy that theoretically could result in unlimited losses. Day traders often use options aggressively as a way to significantly boost their possible profits.
Saddles and Strangles
Between these two extremes are a variety of exotic-sounding strategies such as “straddles” and “strangles.” Both strategies give aggressive investors a chance to profit on big moves — up or down — on a stock’s price. You also can use these strategies on trading an underlying index.
You build a short straddle by selling a call and a put on the same stock with the same expiration date and strike price. With a long straddle, you buy the call and put it with the same expiration date and strike price.
With a short strangle, you sell a call and put on the same stock with the same expiration date and a higher strike price on the call. A long strangle involves purchasing a call and a put for the same expiration date, and with a higher call strike price.
How To Trade Options
Trading options is a relatively straightforward process. Here’s what you need to do:
- Open the trade and decide how the stock will move.
- Predict the price and determine the time frame.
- Read the options tables.
Here’s an options trading example to explain the process:
- It’s October, and the price of IBM stock is currently $122 per share. If you think the price of IBM will go up, you might buy the IBM $135 calls.
- If you think the price might move up to $150 per share within six months, you might buy an April 16 call.
- Look up IBM on your stock trading platform. The table might look something like this:
|| Expire at Close, April 16
If IBM moves to $150 on April 16, you exercise your option, paying $135 for the stock. Your total per-share cost is the strike price plus your price paid for the option.
Common Mistakes When Trading Options
Here are some common errors that can lead to losses when trading options:
- Choosing the wrong expiration date
- Ignoring volatility
- Choosing the wrong position size
- Trading without a plan
One of the most important steps before trading options is to develop a sound trading plan. Think through the level of risk you are willing to take and build an understanding of how to find the best trading opportunities. Next, determine when to enter the trade. Finally, know your exit strategy.
Should You Trade Options?
Options can be a rewarding financial tool — but only if you educate yourself on the process and potential risks.
A good way to begin is to sell covered calls on stocks you already own. It’s like renting your stock for a set period of time. This works particularly well if you own a stock with a price that tends to move sideways or slowly upwards.
Another lower-risk way to get your feet wet is by selling puts. Perhaps you have your eye on a certain stock but aren’t willing to pay the current price for it. You can sell a put that obligates you to buy the stock at a price in the future.
Once you have perfected these option strategies, you can move on to more complicated methods of trading.
Now that you have finished this guide, you should know what options trading is and how it works. If you’re ready to take the plunge, click to see the best brokers for maximizing your investments.
This article has been updated with additional reporting since its original publication.