What Is Options Trading?
A Beginner’s Introductory Guide
If you want to make money on the stock market, you’ll have to branch out from basic trades and only purchasing stocks and exchange-traded funds (ETFs). Options trading may represent a path to serious stock market success, provided you understand what you’re getting into and how to practice options trading successfully.
Want to know more? Let’s take a closer look at options trading for beginners in detail.
First, you need to understand “options.”
An option is a buying or selling contract that gives the owner the right to purchase or sell some stock or other asset at a predetermined price, either at or before the contract expires. Note that this is a right, not an obligation – think of an option as reserving the right to purchase or sell an asset, like a stock, at the price noted on the option up to the expiry date and time.
Options are normally used to let investors reserve the right to purchase or sell a stock without having to commit to the transaction upfront. This enables options traders to minimize risk and take advantage of good stock market conditions while avoiding market declines.
You can also think of options trading as making a bet on how a stock will perform. For example, if you think a stock will increase significantly in the future, you can purchase an option to buy that stock at the current price up to a week ahead. Then, if the stock price does increase, you can purchase that stock at a discount, then turn around and sell it to another investor for a major profit.
How Does Options Trading Work?
Options trading works when someone enters a contract to purchase or sell a company’s stock at a specific price and up to a specific time. There are two primary or basic types of options contracts: calls and puts.
A contract to call means you have the right to purchase a stock at a certain price, while a contract to put means you have the right to sell a stock at a specific price. Options trading works due to two parties:
Holders, who purchase options contracts. The holders then exercise their right to buy or sell an underlying stock before the contract expires or let the contract expire if the conditions aren’t right. This is part of the risk of options trading; if a contract expires, the contract holder loses their initial investment.
Sellers or writers, who create the options contracts. Options writers make profits on the premiums they charge buyers.
It’s important to note that options trading involves finite, heavily defined contract expiry dates. You can only buy or sell a security/asset up to the expiry date.
Say you have a call options contract to purchase a security for $100 up to May 5 at 5 PM. If you wait until May 6, you can’t purchase the security for $100 – instead, you have to buy it at whatever market price it’s now listed for.
Reasons to Trade Options
There are lots of reasons why stock market investors choose to trade options. These include:
Market hedging. Options can be a hedge or insurance against market risk, as you can purchase a protective put contract for a stock you own, enabling you to sell it for a specific price even if the market price is lower than the contract price.
Speculation. Options are often used for market speculation, during which investors bet on how well or poorly a stock will perform over time. They purchase options contracts that potentially allow unlimited profit (if they speculate correctly).
Your profit. Many traders use options to earn most or all of their profits. Contract writers can profit from contract premiums, but holders can make lots of money if they guess stock actions and prices accurately.
Advantages of Options Trading
Given the inherent risk in trading options contracts, you might wonder why traders participate in options trading at all. In truth, there are lots of advantages to options trading.
For starters, options trading is usually more accessible because options are cheaper than stocks in many cases. You can start trading options with much less capital than that normally required for stock trading (especially for stocks with very high prices). The premium for purchasing a contract is usually lower than purchasing shares directly.
Options can also be low risk and high reward if you place smart “bets”. The more market knowledge and financial management skill you have, the better you will be at making money through options.
Last, you can use options contracts as insurance policies as described above. You can hedge your losses against potential market downturns.
Disadvantages of Options Trading
That all said, there are some disadvantages to trading options that you should be aware of before jumping into this market arena.
Naturally, options trading is inherently risky. If you bet incorrectly, you could lose your initial investment for your options contracts, resulting in null spending that doesn’t result in any profits. Careful trading analysis is required for success, but the extra risk can result in major stress.
Furthermore, trading options is more technically demanding and requires more education. Therefore, while trading options can be cheap, it usually requires some investment in terms of time and attention on your part before you make any significant money. Strong numeracy skills are required, too.
Finally, don’t forget taxes. Options have shorter timelines, so any profits you make are usually considered short-term gains. These are taxed at less favorable rates compared to capital gains taxes.
Is Trading Options Right for You?
Options trading can be an advantageous way to play the stock market, particularly if you already have some experience. But if you don’t, you should be aware of the risks and first educate yourself on options trading so you know how to purchase options contracts, tell whether a stock will perform well or poorly in the future, and when it’s wise to purchase an option as opposed to an underlying asset.
It takes time to master options trading, but the rewards are more than worth the effort. Good luck!
About the Author
Kate Noether is a PR Specialist, SEO expert and all-round tech enthusiast. Apart from that she enjoys biking on weekends and spending time in nature.