An Investor’s Guide to Options Trading

Options trading allows savvy investors to harness the power of stock price fluctuations and boost returns. But investors beware: Trading options isn’t for everyone, and the risks can outpace the rewards.

Options traders have several factors to consider, such as entry and exit points, market volatility, and how to implement their trading strategy. This requires diligence, experience and a fundamental understanding of why you want to trade options in the first place.

Dan Raju, founder and CEO of Tradier, a brokerage technology firm, says the people who get into options are traders who try to gain from the fluctuation in stock prices.

“Options (are) an instrument that traders are using to manage or gain from the changes in price and are basically limited by what that price is and how long they have that right,” Raju says.

Options may not be suitable for all investors. But several advantages come with options trading if you’re looking to manage investment risk and amplify returns. Here’s what else you need to know about options and whether they’re the right investment strategy for you:

— What are options?

— What are call and put options?

— Options trading strategies.

— Benefits and risks of options trading.

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What Are Options?

Options are contracts that give you the right to buy or sell an underlying asset, whether it be a stock or exchange-traded fund, at a certain price in a given period of time.

Options trading allows investors to buy or sell a security based on its market movements. If investors believe the price of a particular stock will rise or fall, they could play that move to their advantage using options.

You can hold an options contract for a day or a number of years. Market participants have the chance to exercise their options trades, but there is no obligation to do so. If you choose to buy the options contract, you do so at a premium.

Options tend to be known for managing risk in the stock market. Investors can use options as a hedge against a stock that is falling in price or to limit risk in an investment that may be experiencing volatility.

There are a variety of factors that influence the price of options contracts. But generally, many of the factors that impact the market also impact the price of options. More specifically, Raju says, securities with flagship names or a retail appeal tend to have more demand in options.

What Are Call and Put Options?

There are two types of options: calls and puts.

Call options. Call options allow you the right to buy shares of a security at a certain price, also known as the strike price, on or before a certain date, known as the expiration date. Call option buyers believe the price of a stock will go up in the future, while call option sellers believe the stock price will decrease.

When you buy a call options contract, you are typically buying 100 shares of a particular stock for a premium. If the price of the stock increases beyond the strike price, the buyer secures a profit. Your net profit is the total you make after the cost of the premium. But if the stock does not increase beyond the option strike price, the call option buyer loses the money paid for the premium.

Put options. A put option allows the holder of the option the right to sell stock shares at a given price on or before a certain date. You buy put options if you think the price of an asset will decrease and sell puts if you think it will increase. Puts can become profitable to own if the price of a stock goes down. So, if you believe a stock will fall in the future, you can exercise your put option when the price of the stock falls.

Purchasing a stock versus trading options. The primary difference between a stock purchase and an options contract purchase is that a stock represents ownership in a publicly traded company, while options are contracts between investors that represent a stake as to whether the stock’s price will go up or down.

Generally, the purpose of investing in a stock is betting that the company’s value will increase, which means the stock’s market value will also increase over time. If the stock price increases from the price at which you purchased the stock, you can sell the stock in the future to secure a profit over the long term. In other words, equity investors have the potential for unlimited upside, with their downside limited to their original investment.

This is a more straightforward approach than options trading. With options, you tend to work within a shorter time frame, given that all options contracts have expiration dates. Options trading requires you to determine several factors, including the direction of the stock’s price, how much the stock could fluctuate and when you want the contract to expire. Depending on the options trade, the upside and downside potential will vary.

[READ: Should Investors Have Multiple Brokerage Accounts?]

Benefits and Risks of Options Trading

The benefits of options trading include protecting investments against market risk. The risks of trading options may include heavy losses.

On the benefits side, traders can protect their investments by using options as a hedge, which is often thought of as insurance to protect your trades.

Since you can exercise an option at a specific price, even when the market price of a security is falling, this gives you insurance to sell a stock at your previously agreed-upon price. This strategy, otherwise known as a put option, can help mitigate your losses if you’re holding the stock separately.

There is a difference between equity and options trading, but one rule is consistent: Only put money in options trades that you are comfortable losing.

“The biggest risk that I see is that people are not really thinking through exposure they have in terms of the actual cost of the options trade,” Raju says.

The most common way people lose money, he says, is by buying the security and only protecting themselves against one side of the market fluctuation, leaving them completely exposed to the other side.

“One of the greatest mistakes that people make is buying an underlying security, and then (buying) a put or a call contract depending on what direction the stock will go, but then the market ends up going in an opposite direction,” Raju says.

When buying call options, traders have unlimited upside , and the downside is the original premium spent on the contract. But when you sell a call option, your downside risk can be unlimited if the stock price goes up.

When buying a put option, you expect the stock’s price to fall , and your risk is limited to the premium paid for the option contract. As long as the stock price doesn’t go higher than the strike price, you’re in a good position. When selling a put option, you expect the stock price to stay neutral or increase. If either happens, the seller earns the premium, which is the most you can make from selling a put option. Selling put options carries higher downside risk. Your losses can be more than your original investment if the stock price significantly falls or goes to zero.

Option Activity Upside Potential Downside Potential
Buying a call Unlimited Premium spent
Selling a call Earns premium Unlimited
Buying a put Strike price minus current market price Premium spent
Selling a put Earns premium Limited to stock value

[READ: Forex Brokers: Are They a Scam?]

Options Trading Strategies

Investors can make money by buying and selling call and put options when the market moves up or down. Options provide the investor with flexibility and many new trading strategies.

A mistake that some traders make is homing in on cheaper options. These contracts may be cheaper because the chance of a stock going to the price listed in the time available is low.

For that reason, John Carter, CEO of SimplerTrading.com, says not to always go for the cheap options contracts. “There’s a high probability that the options will expire worthless,” he says.

His go-to options strategies are to buy an in-the-money call and sell an at-the-money put credit spread.

A call options contract is “in the money” when its current price is higher than the previously agreed-upon price. Selling an “at-the-money” put credit spread is where you can make money if the stock goes higher or moves sideways.

Other components for investors to consider when determining strategy are the factors that impact the price of an options contract. One of the main factors is how much time it has left before it expires.

“The biggest mistake I see people make is that they’re buying options and they’re not giving themselves enough time,” Carter says.

If you’re buying an option, give yourself the gift of time, Carter says, because the premium loses value as the expiration date approaches.

Carter says the goal with options is consistency and to put the odds in your favor. Buying it 30 days out will help preserve the value of your premium.

A great way for beginners to develop their options trading strategy is to first become familiar with trading common stocks, says Dan Ushman, CEO of TrendSpider, a software platform built by retail traders.

“It’s hard enough to be right about the direction of the pricing of a stock, and it’s even harder to find the direction of how far it could go. And that’s what options are,” he says.

That’s why, Ushman says, honing your craft with common stocks is best before you start using leverage on your trades. That’s because a majority of the time, options contracts can expire worthless.

Your options strategy needs to align with your market outlook and your prediction on how the stock will perform in a given period. These factors will help determine which options strategies work best for you.

Takeaway

Experts say a general rule to is to start slow with simple options trading strategies before you graduate to more complex ones.

Retail traders may look at options as a quick way to make money. But that’s not the case. Put in the time to learn a strategy before trading and educate yourself on approaches that work best for you.

More from U.S. News

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Forex Brokers: Are They a Scam?

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An Investor’s Guide to Options Trading originally appeared on usnews.com

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