Trading options means you're trading an asset that's based on a stock's trading price. With options, you're predicting whether a stock's price will rise or fall within a certain time period.
How to trade options
If you’ve spent any amount of time on this website, you probably already have a pretty good understanding of the things you can invest in: stocks, mutual funds, real estate, bonds, etc. Well, now’s the time to add options to that list.
What are options? Assets that function as a derivative of a stock. An option is basically a contract that stipulates that the owner has the right to buy or sell a particular stock at an agreed-upon price, at an agreed-upon date or throughout a certain period of time. An option allows you to buy or sell shares — usually a set amount of 100 shares — at a specific time, but an option is not a stock itself, meaning it doesn’t represent ownership of a company and the owner of an option is not entitled to benefits like dividend payouts. Think of it more as a prediction you’re making on what direction the stock’s price will move in.
Because of this, an option’s value depends on the price of the stock it’s based on. The most common use of options is probably something you’ve already heard of, if not benefit from it yourself: companies giving their employees stock options. Yep, employees aren’t given options as in choices, but options as in assets. Depending on how that particular company is doing, this could be a useful perk.
As is the case with stocks, you’ll need to go through a brokerage before you can start buying and trading options.
Predicting factors like price, rises, and falls
The main reason options are considered quite risky is that a lot of the methodology around trading options hinges on speculation. You’re essentially speculating on whether a stock’s price will rise or fall, which will determine what kind of option you choose. Will you pick a call option, which indicates you’re counting on the stock’s price to rise and are therefore choosing to buy the stock at an elevated price at a determined future date, or will you pick a put option, where you’re speculating that a stock’s price will decline and are therefore choosing to sell shares at a specific price during a certain time period.
Keeping the “strike price” in mind
An option needs to fall above or below a certain price (depending on what kind of option you’re trading) within a certain time period or by a certain date. So for call options, you want the stock price rising above your strike price before the time period of your contract is over, and for put options you want the stock price below the strike. This is how option traders make a profit.
So let’s say you have your eye on a stock on the S&P 500 that’s currently trading at $100 per share. You think that the stock might rise to $150 a share by some future date, so you’d buy a call option at a strike price below $150, so let’s say $120 a share. Your option is valid for six months, so you can buy shares at $120 a piece if the stock rises, even if the price goes above $120, meaning you’ve bought the share under market price and can then sell it for a profit. That’s how option traders make their money.
As you can probably guess, it’s also extremely risky; if the stock doesn’t actually rise above your strike price, you will have lost money. That’s why options trading is really only advisable to experienced traders who have the time and energy to keep abreast of the market and its developments.
If it’s so risky, why buy options? Well, it can be a great way to maximize profits if you’re an experienced trader, but it’s also a good way to test out the strength of new companies. Say there’s a hot new Company X on the market, and you think they’ll probably grow quite quickly but you’re not 100% sure. So you buy a call option that’s valid for a six-month period: If the stock price rises above your strike price during that time, then congratulations, you’ve acquired some hot stock below market price. But if it doesn’t and the company is a bust, your losses are limited to what you paid for the option contract.
Resources for learning to trade options
Despite the risks, options can be an attractive choice for investors looking to add new assets to their portfolio or branch out in their investing strategies. Options do have the potential to deliver high returns, and can be a cost-effective strategy to acquire new stock in a growing business (or to mitigate losses if a stock’s price starts dropping). But entering an options trade is not for the unprepared, and it pays to do your homework.
Here are a couple places to learn more:
What are stock options. An even more in-depth look at what stock options are and how to trade them.
The six worst ways to trade options. Some common mistakes to avoid.
