Stock options trading has never been easier thanks to the rise of the internet. Everyone ranging from a high schooler with a smartphone, to grandparents phoning into their brokerage to make some moves has the opportunity to get into the bull market.
But getting into stock options trading can be risky, and sometimes, the risk can scare many investors away.
Here’s everything you need to know about stock options trading and how to get started.
What are Stock Options?
Stock options are a contract set up by a company and an investor for the right to buy, but not an obligation to fulfill, a set amount of shares at a set price.
These contracts consist of 100 shares for a company that must be executed before the contract expires or let the contract expire, which the time frame is agreed upon before putting the premium down. This time frame can range from anywhere between a week to a year. Each time frame has its own benefit and risk associated with it.
There are two types of options, one being calls, where an investor thinks the company stock will rise. The other is puts, where an investor thinks the company stock will fall.
How Do They Differ From Normal Stock Trading?
When you decide to place an order for a share of a companies stock, you are agreeing to buy it at the current listed price on the stock exchange on which it resides. You have no set amount of shares you need to buy and can even buy fractions of a share if your brokerage lets you.
The issue with trading stocks normally is the volatility of the stock market. The stock market changes from day-to-day, and with the increase in individual trading, even by the hour. You could purchase a share of Apple stock at 11 am at $400 and by 12 pm it could be up to $450 or down to $350.
The stock markets’ extreme volatility makes it hard to guess what is going to happen on any given day and makes trading directly much riskier. This is where trading stock options come into play.
What are the Pros of Stock Options Trading?
The pros of stock options trading start with the increased reward from investing your money.
When trading options, you put down a 10% premium on your contract to ensure you have good faith with your offer. So you want to buy 1 contract of Apple stock at $450 per share, you only have to put down $4,500 instead of investing all $45,000 all at once.
There are two ways the stock could head, up or down. If Apple then releases the next greatest smart technology overnight and heads to $500 per share, you decide to execute the contract and only pay the $450 per share you initially agreed upon.
Now say it went the opposite way and Apple had a huge lawsuit on their hand which dropped the stock to $350 per share. Someone who invested traditionally would be out $10,000, whereas you would only be out $4,500 if you decided to cancel the contract and lose the premium.
For those looking to learn why else they should get into stock options trading, check out this article on the 7 reasons you should start trading options.
What are the Cons of Stock Options Trading?
One of the bigger cons of trading stock options is the initial requirement to get started. Many brokerages require a certain amount to be present in your account before being granted the option to trade options (no pun intended). The average required amount for getting started is around $2,000.
The other dilemma is that not all stocks offer the ability to trade options. Small companies you believe in doing well may only want upfront capital compared to letting people possibly invest in the future with them. This will require you to go the traditional route of investing, which is an even greater gamble when it comes to small businesses.
Contracts also require a watchful eye of the stock markets. Those who are serious about investing should already be doing this. But for those who like to sit back and let someone else do the work for them, this may not be for you.
Options Trading Tips
There is no true way to stay ahead of the market, but there is a way to be mindful of investing. Always do research on the company you are planning to trade options with. Going in blind to a company you only know by name and nothing else makes the risk to reward ratio even greater and is borderline gambling.
Know your personal risk to reward ratio as well. The stock market is an animal that can be unpredictable at times. You need to be comfortable with forfeiting or letting contracts expire and losing those premiums if it means cutting your losses.
Utilize different time frames for different companies. If you are hearing good news about a company and see them performing well over the next few months, but nothing more, than put a call up for that time frame. But if you feel this company can reach for the stars and keep going, think about increasing the amount of time you hold onto those contracts.
Don’t let your brokerage account be leveraged too harshly. Leveraging is the practice of using borrowed capital as a funding course when not enough cash is present in your account. It can quickly go into negative leverage and you could be in debt to the financial institution if you are not keeping track of your contracts effectively.
Stock Options Trading: The Future of Investing
There is no questioning on whether you should be getting into stock options trading. The potential reward for getting started will far outweigh the risk associated with it. In fact, it carries even less risk than your normal investing routes.
Be sure to check out our courses on options trading to learn about different strategies to maximize your return. For those looking to learn more about options trading, be sure to check out our other articles. Feel free to share this article with friends who want to make their money work harder for them.