If you’re a stock market investor, you may have heard other traders talk about trading stock options. Much like other forms of investing, options trading can be a profitable way to boost your portfolio once you master the skills needed to succeed. While it’s highly advisable to do plenty of research before completing your first options trade, we’ll give you a quick breakdown of options trading to help you decide if it sounds like something you’d like to pursue.
What Exactly Is Options Trading?
Stock options are contracts that give buyers (or option holders) the right, but not the obligation, to buy or sell a certain amount of shares in a company by a specific date. While options can be traded on a variety of assets from EFTs to indexes, for the sake of simplicity, we’ll focus on options that cover stocks.
Why not simply buy or sell the stocks instead of purchasing the right to buy or sell them? The following trading terms will help beginners make sense of this:
- Expiration Date- An option’s expiration date is the date on which the option expires. Options can have expiration dates as close to a few days away to as far as two years away. Regardless, once this date has passed, the option can no longer be traded or exercised.
- Strike Price- The strike price is the price at which the option holder can purchase the stocks if they decide to exercise the option.
- Option Contract Multiplier- This is the number of shares that the option holder can purchase at the strike price if they exercise the option. One hundred shares tend to be a typical amount of shares that many options cover. Say you are looking over possible options and see one for an asking price of $3.00. While this may look like a bargain, remember that this price only covers one share out of the 100 offered in the full contract. So to arrive at the full price, you’d need to multiply $3.00 x 100 to arrive at the contract’s full asking price of $300.00.
Why Trade Stock Options?
The goal of options trading is to attempt to benefit from the price movement of a certain stock by correctly guessing whether it will go up or down over a certain period of time. Imagine, for instance, that company XYZ is currently trading at $25 per share, but you foresee its price going up over the next month.
Rather than take a chance on being right, you could purchase a stock option that gives you the right to buy 100 shares of XYZ at $30 per share anytime within the next 30 days. Say that you turn out to be correct, and XYZ ends up trading at $50 per share within the next month. You could then exercise the option and purchase 100 shares at a deep discount, netting yourself a nice profit.
If, on the other hand, XYZ suddenly tanks and ends up trading at $10 per share in 30 days, you’re under no obligation to make the purchase. While you will lose the money you spent on the option (aka your “premium”), it will likely be a lot less than the loss you would have sustained if you had purchased the shares outright.
It’s also possible to make a profit by trading options you have no interest in exercising. If you’re able to purchase an option that increases in value, you can always sell it to another buyer before it expires.
Different Types of Stock Options
Once you become more advanced at trading, you’ll discover that there are a great many different options strategies and techniques to employ. When it comes to understanding stock options for beginners, however, there are two main types of options that you need to know.
Call options give the option holder the right to buy 100 shares of the given stock at a particular strike price at any point before the option expires. If you think a stock is likely to experience a strong upwards price move, then buying a call option will hopefully allow you to purchase the stock at a discount strike price after the price has spiked. Just make sure that the difference between the stock’s price and the strike price will net you a nice profit even after covering the premium you paid for the option.
Put options give the option holder the right to sell 100 shares of the specified stock at a particular strike price any time before the option’s expiration date. If you think the price of a given stock may go down or simply want to mitigate the risk that it might, you can purchase a put option. Say, for instance, that you have 100 shares of a company on the verge of reporting earnings. Even if the report turns out to be unflattering and causes the company’s shares to take a nosedive, your contract will allow you to sell your shares at a pre-agreed price.
How To Start Trading Options
In order to begin trading options, you’ll need to open a brokerage account on a trading platform such as Schwab, TD Ameritrade, or WeBull. Due to industry regulations, you’ll also need to apply for permission to trade options, which usually takes a day or two. Approval is usually based on things like your financial situation, risk tolerance, and experience.
If you’re brand new to options trading, then options paper trading platforms for beginners are a great way to learn without actually risking real money. Platforms like TD Ameritrade’s PaperMoney and Interactive Brokers paper trading simulator allow you to make beginner mistakes with fake money instead of your hard-earned cash.
When you feel confident enough to start placing actual trades, you’ll simply navigate to the stock you’re interested in purchasing an option for in your trading platform. Navigate to the stock’s options section and you’ll find a list of available calls and puts from which to choose. After having done your due diligence and research, select the option that aligns with your goals and strategy. Make your first purchase and monitor your option daily in order to decide on your next move.
Hopefully, we’ve given you a good idea of what options trading is and what it entails. If you already have a brokerage account, be sure to check out the educational section of your platform, as many have content geared towards free options trading for beginners.