If you have any experience with the stock market, you’ve probably heard of options trading. You may even have some idea that it involves buying or selling something to do with stocks. But what is options trading, and how can you use it to make money?
Options trading is a more flexible, lower-risk way to manage investments and assets. Read on to discover more about this market, as well as some option trading strategies for beginners.
What Is an Option?
Before we dive into all the intricacies of options trading, let’s talk some about what an option is. An option is a contract that gives you the opportunity to buy or sell a share of an asset for a certain price on a certain date. You are not obligated to do so, however – you can let the contract expire with no consequences.
For instance, let’s say you buy 100 shares of a stock for $2 each on January 1. An option will let you sell them for $3 each on March 31, assuming the underlying stock is worth that. If it isn’t, you can still sell and take a loss or break-even, or you can let the option expire and keep the shares.
What Is Options Trading?
As you might guess, options trading deals in those contracts and opportunities for purchases and sales. This is one step removed from dealing in stocks and other assets since you aren’t actually buying the shares themselves when you engage in options trading. Rather, you’re buying the opportunity to buy those shares later on down the line.
Options trading offers a little more flexibility than traditional stock investments since you aren’t limited only to stocks and bonds. You can buy options on commodities, indexes, and exchange-traded funds, as well as stocks and bonds. A good options trader can predict how the values of these assets will fluctuate over the predetermined period of time and will buy and sell their options contracts at peak value points for them.
Before we can get into buying and selling options, we need to talk about the two different kinds of options you can buy or sell. A call option gives you the chance to buy an asset at a later date for a predetermined price. You’ll have to pay a premium for this and all other option types; that may take the form of a down payment or a simple fee.
For instance, let’s say you’re interested in buying a house in a neighborhood that hasn’t yet been built. You can put down a payment of $15,000 to buy an option with the developer to allow you to buy a house for $300,000 when they’re finished in two years. Even if the market value on those houses in two years is $500,000, you’ll still be able to buy for $300,000 thanks to your agreement and the premium you paid.
However, call options are not without risk. If those houses wind up not getting built or only having a value of $200,000, you can pass on your purchase option, but you’ll still be out $15,000 for your premium.
Put options are the exact opposite of call options – they give you the chance to sell an asset for a predetermined price at a specific date down the road. This acts as something of an insurance policy on your investments. Even if the market value of your assets is lower at the time of sale than was predicted, you can still sell your shares for the agreed-upon price.
So let’s say you have $500 worth of stock with a company, but there’s an election coming up, the CEO is getting close to retirement, and you worry the company’s stock value might drop in the next few years. You can get a put option to sell your shares in two years for a total of $450, paying a premium of $50 for the option. If the stock drops below $400 in value, you’ll have made money, since you can still sell the stock for $450, recoup your premium, and avoid losing more money on a failing market.
Buying and Selling Options
Before your option expires, you have the chance to sell it to someone else and/or purchase more options. Whether you choose to buy or sell will depend both on the type of option you have and what you expect it to do over the time period of the option.
If you have a call option that you expect to go up in value, you may want to hang onto it so you can get the maximum profits from it. If you expect your call option to go down in value, you can sell it early and get out before the option loses too much money.
If you have a put option that you expect to go up in value, you may want to either sell it or let it expire, since you won’t make much off the sale of the asset. However, if that option starts decreasing in value, you may want to hang onto it before you sell so you can get the maximum profit.
Exercising Your Options
It’s a little rarer, but you do have a third choice beyond buying and selling your options. You can choose to exercise your option by the time the term expires. This means you actually do buy or sell the asset the option controls at the agreed price.
For instance, let’s go back to our housing investment example from earlier. Many options traders might sell that option to someone else, giving up their opportunity to buy the house for $300,000 in exchange for a direct profit from the premium. But you could also choose to exercise that option, buy the home for the agreed-upon price, and then use it as an investment property going forward.
Likewise, with our $500 stock example, if the market does drop out, you may not be able to sell that option for more than the $50 you paid for the original premium. It might benefit you more to hold onto the option, wait until the stock value is low, and sell at the $450 price to turn a profit.
Benefits of Options
There are a number of benefits to options trading, beginning with the fact that it’s lower risk. Because you aren’t dealing directly with stocks, bonds, or other assets, you don’t have to hang your investment on their actual value. If the market drops out, you’ll lose your premium, but you don’t actually have any additional funds invested in that asset.
Options also give you a little more flexibility to diversify your profile, since they aren’t limited to stocks and bonds. Take the economic shifts of 2020 in light of the coronavirus pandemic, for example. Although the stock market experienced a significant drop, the housing market went through something of a boom as people refinanced mortgages, sold homes, and took advantage of low interest rates to buy homes.
Risks of Options
Of course, the major risk of options is that the entire venture is based on speculation. You’re guessing how much an asset may be worth months or years in the future. While some market trends may stay stable, and you can predict some fluctuations, you never know when a scandal or a natural disaster or a deadly global pandemic might hit and tank market values.
And, as with any investment, if you want to see big results, you have to take big risks. The longer the term of your option is, the higher the profit you’ll get if you call the value correctly. But it’s also harder to predict what the market might do over a year than over a month, and you might find yourself looking at a lost premium and no other profits.
Find a Broker
If you want to begin options trading, the first thing you need to do is find a broker. A good broker will help you decide which options are good choices for you and will handle those trades when they need to happen. Their job is to help you get the greatest profits out of your investment possible.
Of course, a broker will charge fees, and they may have minimum investment amounts for your account. Shop around for different brokers and find which one will work with the amount you’re wanting to invest. You should also make sure to review their credentials and find a broker you will trust to make the most of your money.
How to Calculate Profits and Losses
Just because you’re working with a broker doesn’t mean you should put everything blindly in their hands, however. Knowing how to calculate potential profits and losses on your options is crucial to making smart investments. There are a few tools online that can help you with this process so you can figure out what the best option for you will be.
You’ll need to start with the price of each option you want to buy and decide on the number of contracts you want – each contract typically includes 100 options. This will give you an entry cost, and once you enter the stock you want to get options for, these calculators will create projections based on recent stock activity. You can enter different dates of expiry and determine which one is most likely to get you the highest profit on your investment.
Spreads and Combinations
You can buy options together to gain strategic advantages when you’re trading options. One of these groupings is called a spread, and they use multiple options positions of the same class. For instance, you may buy two call options, one with a higher strike price (the amount you can sell the call for later) than the other.
Combinations include both a call and a put option and can allow you to reduce your risk a little more. One combination, called a straddle, buys a call and a put option for the same asset with the same expiration date. Another, a synthetic combination, gives you an options position that behaves like an asset without you having to actually control the asset.
There are several strong strategies you can use if you plan to engage in options trading. One of these is a covered call, also called a buy-write, and it’s a great way to reduce risk of buying stock alone. To begin, you purchase a stock share through the usual methods, but you also sell a call option on those same shares you purchased.
If your stock value goes up, you make back the money you lose on the call options with the value of the underlying asset. If the price of the stock goes down, you cover the losses from that purchase with your call options. You get a reduced profit in either case, but you do get a more assured profit.
You may also want to look into married put options, which also involves buying options on stock shares you own. In this case, rather than selling call options on your stock, you buy put options. This acts as an insurance policy in case of a serious market drop.
If the stock stays steady or goes up in value, you can let your put options expire with no financial harm. But if your stock does drop in value, you can ensure that you don’t lose more than a certain percentage thanks to the strike price you negotiated when you bought the option. This doesn’t generate direct profits, but it can save you from serious losses.
Discover More Option Trading Strategies for Beginners
Options trading can seem overwhelming at first, but really it comes down to what you think the market is likely to do in the future. Call options give you the chance to buy assets at a prearranged price, and put options allow you to sell them at a prearranged price. Find a good broker, work out some strategies that protect your investment no matter which way the market swings, and start watching the profits roll in.
If you’d like to discover more option trading strategies for beginners, check out the rest of our site at Consistent Options Income. Our courses help teach you how to make money consistently in the options trading market. Watch our free videos today and discover for yourself how you can improve your financial strategy.