An Investor’s Guide to Options Trading | Invest 101

Options trading allows savvy investors to harness the power of stock price swings and increase returns. But investors beware: trading options are not for everyone and the risks can outweigh the rewards.

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

Dan Raju, founder and CEO of Tradier, a stock market technology company, says the people who get into options are traders trying to take advantage of the fluctuation in stock prices.

“Options (are) a tool that traders use to manage or profit from the changes in price and are basically limited by what that price is and how long they have that right,” says Raju.

Options may not be suitable for all investors. But there are several benefits to options trading if you want to manage investment risk and increase returns. Here’s what else you need to know about options and whether they’re the right investment strategy for you:

Options are contracts that give you the right to buy or sell an underlying asset, be it an equity fund or a publicly traded fund, at a specified price over a specified period of time.

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

You can hold an option contract for a day or a number of years. Market participants have the opportunity to exercise their option trades, but are not obliged to do so. If you choose to buy the options contract, you will do so at a premium.

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

There are several factors that influence the price of option contracts. But in general, many of the factors that affect the market also affect the price of options. More specifically, Raju says, securities with flagship names or retail appeal tend to be more in demand for options.

There are two types of options: calls and puts.

Call options. Call options give you the right to buy shares of a security at a specified price, known as the strike price, on or before a specified date, known as the expiration date. Call option buyers believe that the price of a stock will rise in the future, while call option sellers believe that the stock price will fall.

When you buy a call option contract, you are typically buying 100 shares of a particular stock at a premium. If the price of the stock rises above the strike price, the buyer makes a profit. Your net profit is the total you make after the cost of the premium. But if the stock doesn’t rise beyond the option’s strike price, the call option buyer loses the money paid for the premium.

Set options. A put option gives the holder of the option the right to sell shares at a specified price on or before a specified date. You buy put options if you think the price of an asset will fall and sell puts if you think it will rise. Puts can become profitable to own if the price of a stock falls. So if you think a stock will fall in the future, you can exercise your put option when the stock’s price falls.

Buying a stock versus trading options. The main difference between a stock purchase and an option contract purchase is that a stock represents ownership in a publicly traded company while options are contracts between investors that represent an interest as to whether the stock’s price will rise or fall.

In general, the goal of investing in a stock is to bet that the value of the company will rise, which means that the market value of the stock will also rise over time. If the stock price rises from the price at which you bought the stock, you can sell the stock in the future to make a long-term profit. In other words, stock investors have the potential for unlimited gains, with their downside limited to their original investment.

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

The benefits of options trading include protecting investments from market risk. The risks of trading options can include heavy losses.

As for the benefits, traders can protect their investments by using options as a hedge, which is often seen as insurance to protect your trades.

Since you can exercise an option at a specific price even when a security’s market price falls, this gives you insurance to sell a stock at your previously agreed upon price. Also known as a put option, this strategy can help you limit your losses if you hold the stock individually.

There is a difference between stocks and options trading, but one rule is consistent: only put money in options trades that you feel you are losing.

“The biggest risk I see is that people don’t really think about the exposure they have in terms of the true cost of options trading,” Raju says.

The most common way people lose money, he says, is to buy the security and only protect themselves from one side of the market fluctuations, leaving them completely exposed on the other.

“One of the biggest mistakes people make is buying an underlying asset and then (buying) a put or a call contract depending on which direction the stock will go, but then the market goes in the opposite direction Raju says. .

When buying call options, traders have an unlimited advantage and the disadvantage is the original premium paid on the contract. But when you sell a call option, your downside risk can be unlimited if the stock price rises.

When you buy a put option, you expect the price of the stock to fall and your risk is limited to the premium paid for the option contract. As long as the stock price doesn’t go above the strike price, you’re fine. When selling a put option, you expect the stock price to remain neutral or to rise. If either happens, the seller earns the premium, which is the maximum you can earn from selling a put option. Selling put options carries a higher downside risk. Your losses could be greater than your original investment if the stock price drops significantly or goes to zero.

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

A mistake some traders make is choosing cheaper options. These contracts can be cheaper because the probability of a stock going to its quoted price in the available time is small.

For that reason, John Carter, CEO of SimplerTrading.com, says he doesn’t always go for the cheap option contracts. “There’s a good chance 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 option contract is “in the money” when the current price is higher than the previously agreed price. By selling an “at-the-money” put credit spread, you can make money if the stock moves higher or moves sideways.

Other components that investors should consider when determining strategy are the factors that affect the price of an options contract. One of the most important factors is how much time it has left before it expires.

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

When you buy an option, gift yourself the time, Carter says, because the premium loses value as the expiration date approaches.

Carter says the goal with options is consistency and to turn the odds in your favor. If you buy it out for 30 days, you keep the value of your premium.

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

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

Therefore, Ushman says, it’s best to hone your common stock trade before leveraging your trades. That’s because a majority of the time options contracts can expire worthless.

Your options strategy should align with your market outlook and your prediction of how the stock will perform over a period of time. These factors will help determine which option strategies work best for you.

Experts say a general rule is to start slowly with simple options trading strategies before moving on to more complex ones.

Retailers may think of options as a quick way to make money. But that is not the case. Take the time to learn a strategy before trading and educate yourself about the approaches that work best for you.