Ever wondered what an option is and how it works? In this article, we will take a detailed look at what options trading entails and how to include these types of investments.
What is Options Trading?
Options are financial instruments that work with a unique process. This is where you can purchase or sell a stock at a certain price at a later date. This can be done with the risk of what might happen in case the value of that stock drops or rises.
In short, an option is a contract that gives you the right, but not the obligation, to buy or sell a stock’s index or future at a given price before a given date in time.
An option is a security, just like a stock. That means it possesses a right to own something else. Unlike stock, however, an option is a derivative. That means it draws its value from something else. But how do options work?
We’ve seen that options are a contract that provides the right to purchase or sell something else. You, the buyer, will pay for that right in the hope of making more money than you spent buying the option.
What this means is that by purchasing the option you aren’t acquiring the underlying asset but the right to purchase or sell that asset at a specific price.
If you’re having a hard time understanding the concept, maybe this simple example will make some sense:
Imagine that you’ve identified a nice house that you want to purchase, but you don’t have enough money at the moment. You offer the salesperson $2,000 that gives you the right to purchase that house for $50,000 in three months. The salesperson agrees, so you have a “call” option on the house.
When the three months elapse, you can either purchase the house for $50,000 or opt not to purchase the house and lose $2000. The value of the asset you plan to purchase (house) may also change over the three months.
If the value of the house rises to $60,000, for example, the salesperson will still sell you the house for $50,000 as he is bound by the contract. That means you’ll bag a $10,000 profit. That will be $8,000 net profit after deducting the $2,000 contract cost.
There’s also the possibility of the value of the asset going down. For example, a home inspector evaluating the house may discover some structural defects, and the value drops to $30000.
If you decide to go ahead with the purchase, you lose $22,000 if you include the $2000 contract cost. Fortunately, you are not obligated to buy the house with an option. With this example, you probably now understand how options work.
Types of Options
There are several different types of options that can be traded, and they can be classified in various ways. In a broad sense, there are two major types of options.
Call options are contracts that grant you the right to buy the underlying asset at a later date in time at an agreed price. You might consider buying a call if you believe that the value of the underlying asset is likely to increase over a specific period.
Calls have an expiry day. However, depending on the contract terms, you can buy the underlying asset any time before the expiry date or on the expiry date.
Put options are the opposite of call options. If you are the owner of a put, you have the right to sell an underlying asset at a later date in time at a predetermined price.
That means you would purchase a put if you believe that the underlying asset is likely to drop in value. Puts also have an expiration date.
Besides calls and puts, options can also be categorized based on whether they are European Style or American Style. That doesn’t mean they have a connection with the geographical locations.
The classification is based on when the contracts can be implemented. Moreover, options can be classified according to the method in which they’re traded, the underlying security to which they relate, and their expiration cycle.
Also, there are other specific types and various exotic options that exist.
Opening an Options Trading Account
Before you can even start trading options, there are several things that you need to get out of the way. Trading options involves a significant amount of capital, and predicting various moving parts can be complicated.
As such, brokers will need to know more about you before they can grant you a permission slip to begin trading options.
Your prospective broker will want to know your level of experience trading options, your current financial situation, and how much you understand the risks associated with options trading.
This will help the broker determine which trading level to assign to you. You will need to furnish your prospective broker with the following details:
- Your financial information, including total net worth, liquid net worth, annual income, and employment information
- Investment goals, such as income generation, speculation, growth, or capital preservation
- Trading experience, including your investing knowledge, the period you’ve been in the options or stocks business, size of your trades, and the number of trades you make in a year
- The type of options you’re looking to trade
The broker will use your answers to determine the appropriate initial trading level to assign you. That can be any level from 1 to 4, and it’s your key to placing specific types of options trades.
You should also use this opportunity to evaluate your broker. It would help if you realized that your broker is a key investing partner.
Therefore, it is imperative that you find a broker who offers the tools, advice, and support you need when you are just getting started with options trading.
Why Use Options
While options have been around for over four decades, they are just now starting to gain popularity. Many investors have been apprehensive of options trading, with the belief that they are sophisticated and hence too difficult to understand.
Other investors have had nasty initial experiences with options largely because they or their brokers never got proper training on how to use them.
It is for such experiences that options have been labeled risky by various players in the market. However, it is advisable that when you start to invest you do their own research and get to understand the value of options.
While options can result in serious problems if not properly handled, they can benefit an investor in several ways, including the following:
One of the major advantages of using options is leverage. We’ve seen that options can grant you the right, but not the obligation to purchase a stock at a given price for a specific period of time.
Purchasing an option exposes you to price fluctuations in the underlying stock at a fraction of the underlying stock’s full purchase price.
Hence, for a certain percentage change in the underlying price, the change in the value of the option in terms of percentage is much bigger.
That means you can enjoy the benefits of leverage, with just the predetermined risk of losing the premium or the price you’ve paid for the option.
Another great advantage of using options, when compared to stock trading, is that you can preview the market direction with minimal risk while at the same time having limitless profit potential.
This can be attributed to the fact that options buyers are given the right, but not the obligation, to implement the contract for the underlying asset at the agreed price.
If the price is not favorable when the contract expires, the buyer can forfeit their right and just let the contract expire with no value.
- Insurance – Investors might also use options for portfolio insurance. With option contracts, a risk-averse investor can get a way to safeguard his downside risk in case a stock market crashes.
With such benefits, you can see how the investors who have been using options for some time would have no reasons to justify options’ lack of popularity.
So, this gives you more reason to use options as well and enjoy the benefits. Just make sure you are doing everything right.
Alternatives to Options Investing
- Mutual Funds – If you have listened to any personal finance talk then mutual funds will be one of the recommended long term investments.
- ETFs – Exchange traded funds are a popular alternative to mutual funds and a great way to diversify.
- Stocks – Investing in stocks is available to any budget. Just do your research if you are purchasing individual stocks.
- Bonds – Used as a hedge against downturns in the stock market, bonds are a stable means of investing.
- Real Estate – For most of history was the only measure of wealth, real estate investing continues to be a top way to make money.
- Small Business – Even if you only have $1,000 to invest, you can really get big returns from small business investing.
- Commodities – Anything that comes from the earth is a commodity and you can invest in them like a stock or own them straight out.
- Peer to Peer Lending – Much newer than the rest of these, P2P lending allows you earn interest by lending to other people.
Pros and Cons of Trading Options
Options have their upsides and downsides, as outlined below.
- Need a smaller initial investment compared to buying stocks
- Investors have enough time to see how things play out
- Investors are protected from downside risk on stocks they own
- Can subject an investor to unlimited losses
- There’s a need to predict short-term price movements
- Margin requirements can run up trading costs
Final Thoughts on Options Investing
There’s so much excitement about options trading today. These simple contracts can significantly increase your returns in the stock market. That’s why many investors want to get into them.
However, some investors jump in before they even understand what option contracts entail, and they end up making losses. Find a broker who understands the ins and outs of trading options before rushing into this type of investment.