If a stock’s price goes down, can you still make money? Yes, if you’re investing in options. Options trading can benefit your investment portfolio in many ways. However, learning how to trade options can seem intimidating. This options trading guide will tell you what you need to know.
You can decide if investing in options is the right investment decision for you.
What Is Options Trading?
An option is a contract that allows but doesn’t require an investor to buy or sell an underlying asset at a predetermined price by a specific date in the future.
Options get their name from the fact that you have the option but not the obligation to buy or sell.
Many investors use the term “stock options” to refer to all types of options trading. However, stocks are just one of the possibilities for options. Certain exchange-traded funds (ETF) and stock indexes, as well as assets like bonds, currencies, and commodities, are available for options contracts.
Options are derivatives. This means that they derive their value from another asset. For example, the value of a stock option depends on the price of the stock.
Options differ from stocks because an option doesn’t give you ownership in the company. Options differ from futures because you can withdraw from an options contract at any point before it expires.
Call and Put Options
An option that lets you buy shares at a later time is a call option. An option that lets you sell shares at a later time is a put option.
For both call and put options, the option contract has a strike price and an expiration date. The strike price is the price that the investor and the seller agree on to either buy or sell the shares.
The expiration date is the end of the contract. You can exercise the option at its strike price until the expiration date of the contract. The length of an option contract can range from a few days to several months.
Call Options
A call option is a contract that lets you buy a certain amount of shares in an asset by the expiration of the contract. Contracts usually include 100 shares of the underlying asset.
When you buy a call option, you expect the price of the stock or other security to go up. You make a profit from your contract by buying those stocks at the strike price of the contract, which is less than their new higher price. You can also sell the call option and earn the difference between what you paid and the current price.
Put Options
A put option is a contract that lets you sell a certain amount of shares in an asset by the expiration of the contract. Put contracts are also usually for 100 shares.
If you want to make a profit with a put option, you want the price of the underlying asset to go down. You can then sell the option for the strike price of your contract, which is more than the asset’s reduced price. If you think the price will go up, you can sell the put option before the contract expires.
Options Pricing
The price you pay for an option contract is called the premium. You pay the premium upfront.
The premium depends on the price, intrinsic value, and extrinsic value of the underlying asset. The strike price also affects the premium.
The intrinsic value of a stock or other asset is the difference between the strike price of an option contract and the asset’s current price. The extrinsic value includes factors other than those in the intrinsic value. The length of the option contract is an example of an extrinsic value factor.
Pros and Cons of Options Trading
Options trading has many benefits for your investment portfolio. It also has potential risks that you should evaluate before investing in options.
Benefits of Options Trading
Options trading gives your investment portfolio several advantages.
First, you lock in a strike price and an expiration date, but if the asset doesn’t rise or fall like you expected you don’t have to make the trade. Instead, you could let it expire and the most you’ll lose is the premium you paid (your upfront investment).
You also have a lower upfront financial commitment with options trading than with stock trading. This is because options let you control (i.e., have the option to buy or sell) a large number of shares for much less it would cost to buy those shares outright.
Beyond the perk of controlling a lot shares with little money, you don’t need large movements in a stock price to profit.
Finally, options trading is a good hedging tool. For example, if you own shares of a company, you could buy put options to reduce your potential losses if the stock price goes down. Many investors use options for market indexes like the S&P 500 as a hedge for possible short-term declines in the market.
Potential Negatives of Options Trading
There are also downsides of options trading. First, options trading requires a hands-on investment approach. If you don’t want to actively and consistently monitor your investments, options trading may not be a good choice. The investing process is also more complicated than for other asset classes.
Second, options are very time-sensitive. Even if you correctly predict the direction of a price change, you could still lose money if the price doesn’t change enough by the expiration of your option contract.
Third, trading fees and commissions can add up with options trading. You’ll need to take these fees into account when evaluating the potential profits of an options strategy.
Finally, you’ll probably have to pay short-term capital gains taxes as well. Options trades are shorter-term investments. Any investment you hold for less than a year falls under your ordinary income tax rate instead of the lower long-term capital gains rate.
It’s never fun to pay “Uncle Sam” a higher tax rate, so you’ll definitely want to take this into account.
How to Invest in Options
As with most asset classes, you can buy options with a brokerage investment account.
You can use an online trading platform like E*Trade or TD Ameritrade. Some of these platforms have an investment app as well. You can also use a traditional brokerage service.
Opening a Brokerage Account
The US Securities and Exchange Commission (SEC) requires that brokers evaluate potential customers who want to trade options before approving their accounts. To open an account, you’ll need to fill out an options trading agreement. This agreement helps the broker see how well you understand options trading and the risks associated with it.
You have to keep at least $2,000 in your brokerage account.
Choosing a Broker
You should consider several features when choosing a brokerage service.
First, compare commissions and fees. What you pay to make a trade impacts your profit or loss. You’ll find that how much you pay can vary significantly from one broker to another.
If you’re using an online platform, consider the platform itself. Some online brokers have a full-featured platform as well as one that’s easier to use.
Beginning investors may prefer a more user-friendly interface. More experienced traders usually like a platform with more features.
Many online brokers offer educational resources. These can be very useful for investors who are new to options trading.
Options Trading Guide Summary
This options trading guide has given you the basics to decide if options trading is right for you. Investing in options lets you profit from changes in an asset’s market price at a lower upfront cost. With most types of options trading, your risk is limited to the premium you pay.
Options trading is more complex than some other investments, but with a little education, you can learn this powerful investment approach.
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