So, you’re curious about options trading? Well, don’t worry, it’s not as daunting as it seems. In fact, with just a few key points under your belt, you’ll be well on your way to mastering the basics.
When investors build their portfolios, they usually diversify across various asset classes, such as stocks, bonds, ETFs, and mutual funds. But have you ever considered options trading as another potential asset class?
While it may seem intimidating at first, options trading can offer several advantages that you won’t find with just stocks and ETFs alone. Ready to learn more? Let’s dive in!
What are options?
Options are like contracts that provide the holder with the right, but not the obligation, to either buy or sell a predetermined amount of an underlying asset at a set price before the contract expires. And the best part? You can purchase them with a brokerage investment account!
Why are options so powerful? They can help to diversify an individual’s portfolio by providing added income, protection, and even leverage. Depending on the situation, there’s usually an option scenario that’s suitable for an investor’s goals. For example, options can be used as an effective hedge against a declining stock market to minimize potential losses. This is actually what options were invented for in the first place – as a way to hedge investments at a reasonable cost. It’s kind of like buying insurance for your house or car.
Here’s another example: let’s say you want to invest in technology stocks but you also want to limit potential losses. You can use put options to limit your downside risk while still enjoying all the potential upside. On the other hand, if you’re a short seller, call options can be used to limit potential losses if the underlying stock price moves against your trade, especially during a short squeeze.
Options can also be used for speculation, which is essentially a bet on future price direction. For instance, a speculator might buy a call option on a stock if they think its price will go up, based on fundamental or technical analysis. This can be more attractive to some traders than buying the stock outright because options provide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared to the full price of a $100 stock.
In conclusion, options are a powerful tool that can be used for investing, hedging, and speculation.
Types of Options: Calls and Puts
Options are a type of derivative security, which means their price is tied to something else. If you buy an options contract, it grants you the right (but not the obligation) to buy or sell an underlying asset at a set price on or before a certain date.
A call option gives you the right to buy a stock at a certain price (called the strike price) on or before the expiration date. Think of it as a down payment on a future purchase. The more the underlying stock price rises, the more valuable the call option becomes (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising. It has unlimited potential for profit, but the maximum loss is limited to the premium (price) paid for the option.
On the flip side, a put option gives you the right to sell a stock at a certain price (called the strike price) on or before the expiration date. If the underlying stock price falls, the put option becomes more valuable (puts have a negative delta). A long put is essentially a short position in the underlying stock.
Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
How to trade options
1. Open an options trading account
Before you dive into options trading, there are a few things you need to know. First off, opening an options trading account requires more capital than opening a regular brokerage account for stock trading. And because options trading is a bit more complex than stock trading, brokers need to make sure you know what you’re doing before they give you the green light.
When you’re ready to start the process, your broker will ask you some questions to assess your experience, risk tolerance, and financial situation. They’ll use this information to create an options trading agreement that you’ll need to sign before you can start trading.
Here’s what you’ll need to provide:
- Investment objectives: What do you want to achieve with your options trading? Do you want to generate income, grow your portfolio, preserve capital, or just speculate?
- Trading experience: How much do you know about investing? How long have you been trading stocks or options? How frequently do you make trades, and how large are they?
- Personal financial information: Your broker will want to know about your liquid net worth (or investments that can easily be sold for cash), annual income, total net worth, and employment status.
- Types of options you want to trade: Do you want to trade calls, puts, or spreads? Will they be covered or naked? Covered options are less risky because the seller already owns the underlying stock, while naked options carry more risk.
Based on your answers, your broker will assign you an initial trading level. This level is based on the amount of risk you’re willing to take on, with 1 being the lowest risk and 5 being the highest. Your trading level determines the types of options trades you can place.
Remember, screening should go both ways. Your broker is your investing partner, so it’s important to find one that offers the tools, research, guidance, and support you need. This is especially important if you’re new to options trading.
2. Choose options to trade
First, a quick refresher. A call option is like a contract that gives you the right to buy a stock at a certain price, which is called the strike price. On the other hand, a put option is a contract that gives you the right to sell shares at a stated price before the contract expires.
So, how do you know what type of options contract to go for? Well, it depends on which direction you expect the underlying stock to move.
If you think that the stock price is going to go up, then it might be a good idea to buy a call option or sell a put option. If you think that the stock price is going to stay stable, then you can sell a call option or a put option. Lastly, if you think that the stock price is going to go down, then it might be a good idea to buy a put option or sell a call option.
Think of options as an insurance policy. You don’t buy car insurance hoping that you’ll get into an accident. You buy car insurance because you never know what could happen, no matter how careful you are. The same goes for options trading. It’s always good to be prepared!
3. Predict the right strike price for an option contract
When you buy an option, the key to making a profit is choosing the right strike price. The strike price is the price at which the option can be exercised and is only valuable if the stock price closes “in the money,” which means either above or below the strike price for call and put options, respectively. To pick the best strike price, you need to predict where the stock price will be during the option’s lifetime.
For instance, if you expect a company’s share price to rise from $100 to $120 by a future date, you should buy a call option with a strike price less than $120. Ideally, the strike price should not be higher than $120 minus the cost of the option so that the option stays profitable at $120. If the stock price rises above the strike price, your call option is “in the money.”
Conversely, if you anticipate that the company’s share price will fall to $80, you should buy a put option with a strike price above $80. Ideally, the strike price should not be lower than $80 plus the cost of the option so that the option remains profitable at $80. If the stock price drops below the strike price, your put option is “in the money.”
Bear in mind that you cannot choose any strike price you wish. An option chain or matrix contains a range of available strike prices, and the increments between strike prices are standardized across the industry, such as $1, $2.50, $5, or $10, based on the stock price.
The option’s price, also known as the premium, has two components: intrinsic value and time value. The intrinsic value is the difference between the strike price and the share price if the stock price is above the strike. Time value represents the remaining portion and factors in the stock’s volatility, time to expiration, interest rates, and other elements. For example, if you have a $100 call option while the stock costs $110 and the option’s premium is $15, the intrinsic value is $10 ($110 minus $100), while the time value is $5.
4. Determine the option time frame
If you’re considering buying an options contract, you’ll need to pay attention to the expiration period. This refers to the last day on which you can exercise the option, so it’s important to choose a timeframe that suits your needs. Here’s what you need to know.
American vs. European Options
First, it’s important to understand the two styles of options: American and European. American options can be exercised at any point up to the expiration date, while European options can only be exercised on the day of expiration. Because American options offer more flexibility for the buyer (and more risk for the seller), they usually cost more.
Choosing the Right Expiration Date
Expiration dates can vary widely, from just a few days to several years. If you’re a seasoned option trader, you might consider daily or weekly options, but these are generally riskier. For long-term investors, monthly or yearly expiration dates are usually preferable. The longer the expiration period, the more expensive the option, but this gives the stock more time to move and for your investment thesis to play out.
The Benefits of a Longer Expiration
One advantage of a longer expiration is that the option can retain time value, even if the stock trades below the strike price. As the expiration date approaches, an option’s time value will decay, which can cause the option to lose value. If the stock finishes below the strike price, the option may expire worthless. However, if the option has a longer expiration, there is a greater chance that any remaining time value can be sold.
What does it mean to exercise an option?
Exercising an option means executing the contract and buying or selling the underlying asset at the stated price.
Is trading options better than trading stocks?
Options trading is often used to hedge stock positions, but traders can also use options to speculate on price movements. However, options contracts, especially short options positions, carry different risks than stocks and are often intended for more experienced traders.
What is the difference between American options and European options?
American options can be exercised anytime before expiration, but European options can only be exercised on the stated expiry date.
How is risk measured with options?
The risk content of options is measured using four different dimensions known as “the Greeks.” These include Delta, Theta, Gamma, and Vega.
What are the three important characteristics of options?
The three important characteristics of options are the strike price, expiration date, and option premium. The strike price is the price at which an option can be exercised, the expiration date is the date at which an option expires and becomes worthless, and the option premium is the price at which an option is purchased.
How are options taxed?
Call and put options are generally taxed based on their holding duration and incur capital gains taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they are naked or covered.