Options trading for beginners might seem confusing, but it can be a money-making strategy to add to your investing toolkit if you’re an experienced trader.
You might have heard about people making money by trading options and want to give it a shot but don’t know exactly what it is. Here’s an overview of what options trading is, what the opportunities and risks are, as well as critical advice to keep in mind if you're going to get started.
What Are Options?
“First, it is important to understand what options are and how they work. Options are a type of derivatives contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a set price on or before a certain date,” said Michael Ryan, an experienced Financial Planner.
The two main categories of options are calls and puts. A call lets you buy an underlying asset at a specific price point within a particular time. The purchase price is called the strike price. Generally speaking, the closer the strike price is to the asset's current price, the more expensive a stock option will be.
On the other hand, a put lets you sell an asset at a set price point within a particular time horizon. If you buy put options, you're likely hoping for the asset's price to go down so that you can exercise your options and make a profit.
Think of call options as going long on a stock and put options as shorting a stock. Options traders often combine these two strategies to develop their own methods with varying degrees of success.
“If you are not comfortable with taking risks, then options trading is probably not for you,” said Ryan. “In fact, options trading is not right for 99% of people. Options are high risk/high reward, complex, and almost all options contracts eventually expire worthless.”
So Why Trade Options, Then?
Options are a popular investment vehicle among more experienced traders because there is an opportunity to make money. But it’s important to note that options trading could also lead to a considerable loss of your invested capital.
“There are many reasons to trade options. First, options offer traders an opportunity to speculate on the direction of an underlying stock or asset without taking on the risk of owning the asset outright. This flexibility is one of the key reasons options are such a popular trading tool,” continued Ryan.
- Add income to your investment portfolio
- Protect from market volatility
- Increase leverage
One popular reason people trade options is to use them as a hedge. Buying put options can help you limit your losses if the stock market experiences a decline. Similarly, if you're a short seller, buying a call option can help limit your losses if your stock experiences a short squeeze or rapidly rises.
You can also use options to limit volatility in a portfolio. For example, financial planner Doug Oosterhart from Life Point Planning states, “a very legit way to use options and protect investment portfolios is by using a collar strategy.”
“Let's say an investor has a large exposure to ABC company which trades at $100 per share. So first, the investor would sell an out-of-the-money call, let's say, at a $107 strike price. Then, they would also buy an out-of-the-money put, let's say, at a $93 strike price. This strategy would cap the investor's upside but hedge and limit their downside. So it's a way to dampen volatility in years like 2022,” continued Oosterhart.
Options Trading For Beginners: 8 Basic Strategies
Here are eight of the most common options strategies to learn about if you’re considering this type of investing. Each trading strategy can work if implemented correctly, and each has varying levels of risk and reward.
1. Buying Calls (Long Calls)
Buying calls is one of the most common option trading strategies. When you buy a call option, you gain the right to purchase shares of a stock at the strike price before the expiration date.
Most investors buying calls are using it to add leverage to their portfolios because purchasing the right over a certain number of stocks through options is much cheaper than buying the assets themselves.
2. Covered Calls
Covered calls are the other side of the call option transaction. A covered call is when an investor owns underlying security and then sells call options on them. The call is “covered” because if the buyer of the call option chooses to exercise their options, the seller is “covered” because they can deliver the shares.
Covered calls are a popular way for long-term investors to generate short-term income on their holdings. For example, investors who execute covered calls get paid in options premiums and do not expect the underlying asset price to move much.
The main risk of the covered call option strategy is that the writer of the call options will lose any upside potential on the underlying asset they are holding for the duration of the call option.
3. Long Straddles
If you're unsure whether a stock will go up or down, but you're convinced that it will experience a lot of short-term movement, employ the long straddle option trading strategy. Investors use long straddles to bet on volatility. They can be helpful if there is a piece of news coming out that could dramatically affect stock price movement either positively or negatively.
A long straddle combines a call and put option with the same strike price and expiration date. The idea is that, at worst, the trader will lose the premium they pay for the options, but if the asset price swings wildly in one direction, the trader can exercise their options and take profits.
4. Buying Puts (Long Puts)
Traders who think the price of a stock will fall can use a long put strategy. The term “long” can be confusing in this context, but it just refers to the act of the trader buying an option and hoping to profit from it in the future.
Short sellers who want to add leverage to their position, but also potentially limit their losses in the event of a short squeeze, can use long puts.
5. Short Put
Similar to a covered call, a short put is the other side of the transaction for long puts. The main difference is the level of risk.
The maximum profit for the short put strategy is the premium price paid on the put. However, the losses could be significant, especially if the security falls well below the strike price and the premium earned can not offset the losses.
6. Protective Puts
Traders still long on a stock or security but want to protect their downside may consider protective puts. They will usually buy a put to limit their potential losses, as any fall in the security price below the put strike price will be offset by the profit from the put.
Using protective puts to guard against loss works similarly to buying insurance as you pay a premium but limit your downside scenario. A married put is nearly identical to a protective put, but the difference is when the investor purchases the underlying security. Investors who are worried about short-term volatility but are still very bullish on a security typically use married puts.
Options Trading for Beginners: The Pros and Cons
Options trading can be a profitable investment strategy if used correctly, but there are still many risks that traders should seriously keep in mind.
Pros of Options Trading
For those looking to make money from home, trading options is one way to generate income. “An options trader can sell options to other traders, collecting the premium as income. This is a great way to generate income on a stock that is not currently paying a dividend,” said Ryan.
Additional reasons to consider options trading for beginners include:
- Options trading provides investors with greater flexibility to create an investment strategy that suits them
- Using specific options trading strategies, traders can realize sizeable returns with very little capital committed
- Options traders usually control how they want to execute particular trades and implement risk into their portfolio
Cons of Options Trading
There are cons to almost everything, including trading options, which have various downsides to consider.
“The most significant one is the risk involved. When buying options, you take on the risk of the stock price going up or down. If the stock price goes down, you will lose money,” said Ryan. “Additionally, if the stock price doesn’t move in your desired direction, you will lose money when the options expire.”
Other things to think through before starting options trading include:
- For many people, options trading can seem complicated and challenging to learn
- Traders might need to meet specific requirements, such as holding a certain amount of money in their accounts, before their brokerages allow options trading
- Options trading requires traders to put a lot of effort and knowledge into their investments and should not be considered a way to make passive income
Options Trading for Beginners: Things to Know Before Getting Started
If you decide to trade options, research which brokerage accounts offer the best features. Some popular ones are TD Ameritrade, Charles Schwab, Fidelity Investments, Interactive Brokers, and TradeStation.
“Typically, there is an investment minimum of $1,000 to open and trade options. Consider no less than $5,000 to $10,000 to start, as anything less will likely not be profitable enough to cover your trading costs,” said Ryan. “If you're just starting, you may consider trading options with a broker with low commission rates. This will help you keep your costs down.”
Lastly, it bears repeating. Before you start options trading for beginners, assume you will give away all the money you invest.
“No matter how much money you have to trade options, it's important to remember that options trading is a risky business. You can lose money if you don't know what you're doing. So, educate yourself before you start trading,” Michael concluded.
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This post was produced and syndicated by Finance Quick Fix