Interested in acquiring or selling an investment asset sometime soon at a set price? If so, your financial adviser or broker may have suggested that you purchase an option so you’ll have the flexibility you’re looking minus the full commitment to buy or sell if the market behaves differently than expected. But what exactly is an option? How does it work? Are there different types, and how do you move forward with a purchase?
These are all valid questions that are discussed in this comprehensive guide to options trading. Read on to learn the answers to these questions and much more.
How Options Work
Simply put, an option is a contract that allows you to buy or sell assets on terms that work best for you. But there’s no pressure to move forward with the transaction; it’s simply a move that if executed properly, can afford you a competitive advantage against other investors.
Here’s how they work:
The option, which is a legally binding contract is purchased by you, the buyer. With this option, you are locking in a strike price (or exercise price) for a specific window of time. So even if the price of shares changes, the figure that’s listed in the contract remains the same as long as you make a move before the option expiration date.
And the same rules apply for selling. If you buy an option to sell your shares at a higher rate in the future and the price per share drops significantly, you will avoid taking a major hit to your pocket.
How Long Do Options Last?
There’s no hard and fast rule regarding the length of options. The length range between several days to months. And in some instances, options will be valid for many years.
Are Options Expensive?
As with most investment products, there are costs you have to be mindful of. So when exploring call and put options, you want to make sure you leave space for any administrative costs you will incur.
Call Options vs. Put Options
Not all options are created equal. There are two types of stock options available for purchase.
As a holder of a call option, you’ll have the right to purchase stock at a later date at the strike price. If the price per share shoots up before the option expires and you decide to exercise it, you will save a load of cash. But if the price per share falls below the strike price, you will lose your investment in the option since it won’t make sense to exercise it.
To illustrate, if a share you’re interested in has a trading price of $100 and you anticipate that it will raise to $150, it may make sense to buy a call option for a strike price that’s below $150 to get a good deal while covering any associated costs. If things do pan out the way you predicted them, you will be what’s referred to as in the money or turn a profit.
By contrast, as the holder of a put option, you’ll be protected you from sustaining major losses when selling in the event the market tanks. So, if the market takes a tumble and the price per share falls drastically, you will still be able to sell the shares at the exercise price indicated in the put option to cut your losses.
To illustrate, if you own shares that are priced at $100 but you’re thinking they will drop to $50 per share, you may buy a put option to lock in a strike price that is below $100 but above $50 to minimize your losses. Assuming the share price does indeed fall below $50, you’ll be in the money.
An Important Note
If you’re a call or put writer, you’ll be on the other end of the equation as a seller. While there are some benefits, particularly if the holder decides not to exercise their option contract and you keep the dough for yourself, there’s also a ton of risk if they do.
Assuming there’s an uptick in the market, you could miss out on profit potential if you have to buy at a much higher rate than you anticipated, despite the value of the stock, or sell for a much lower rate than what the shares are worth.
Is It Smart to Trade Options?
It depends on what you’re trying to accomplish. There’s no way to know for sure which direction the stock market is going to go. While there are trends that can lend some insight, you’re ultimately banking on the predictions to be correct when buying options so you can get the biggest bang for your buck. But if they’re wrong, you could still sustain losses because options come at a cost.
The good news is that options contracts can be sold from investor to investor. So if you decide to walk away without exercising the option, you may be able to recoup some of your investment.
How to Start Trading Options
Options trading isn’t something you can just start doing one day in your spare time. There are specific steps you have to follow.
Step 1: Find a brokerage firm.
Before you can start trading options, you’ll have to go through a screening process with a brokerage firm. But since you get to select who you work with, do your due diligence before moving forward.
When evaluating brokerage firms, pay attention to:
- Any costs you’ll incur
- Commissions they’ll generate
- Account minimums (more on this in step 3)
- Reviews by consumers and others in the industry
- Support and educational resources they extend to clients
Remember, there are tons of brokerage firms out there that would love to work with you, so don’t settle for an option that does not fit your needs.
Step 2: Undergo screening.
As mentioned in the last step, the brokerage firm you select will perform your screening. But what’s the purpose? Simply put, you have to be assigned a trading level, which spans between one and five before you can conduct any transactions. Your trading level will also determine the types of transactions you can execute.
During the screening, expect the broker to inquire about your financial background, investment goals, and trading experience.
Step 3: Fund your account.
Brokerage firms require that you maintain minimum reserves of at least $2,000 in your account to comply with industry standards. In some instances, you may also need to open or attach a line of credit for collateral if you’re purchasing a call option, so it’s best to inquire with the firm to seek clarity before devising a plan of action to start trading options.
Step 4: Begin trading options.
Once you’re cleared to start trading options, it’s off to the races. This can be an exciting time, but you want to remain grounded and keep your investment objectives at the forefront when making decisions.
The Bottom Line
Options are an investment tool you can use to maximize or protect your hard-earned funds while working diligently to meet your goals. But if you aren’t quite ready to go all-in, it may be best to experiment with the stock market to get a better feel for the investing landscape.