Even though the jargon used in options trading can be a little intimidating, don’t let it fool you. Things like bull call spreads, derivatives, premiums, strike prices, calls, puts, and bear put spreads are just the language you’re supposed to use when trading options.
And, why would you delve into options trading? Well, they are flexible, and almost any investor can use them – even if they’re a beginner. Furthermore, they can also help you manage risk.
But, before you step into options trading, there are a few facts you should know. In this guide, we will explain what options are, how to start trading them and why do other investors use them.
When you purchase an options contract, you get a chance to sell or buy a stock at a specific date at a previously established price. Usually, the options contract states that you will buy or sell about 100 shares.
To explain it further, we’ll compare it to stock trading. For instance, you can buy a specific stock because you believe its price will surge. Likewise, you can also short sell a stock when the price plummets.
An option is similar to that – basically, you are betting on a stock and determining in advance in which direction it will go. However, instead of buying or selling immediately, you can buy an options contract that gives you a few choices – and they are not obligatory. With this contract, you can:
- Sell or buy shares at a certain price during a limited time window (this price is also called the “strike price”)
- Sell the options contract to another interested investor
- Let it expire without any consequences (no financial obligation)
Even though options contracts sound like something short sellers would usually use, buy-and-hold and long-term investors can also find them useful. Of course, you can use them to capitalize on price fluctuations, and trade in and out of them, but that can be quite risky.
Why Should You Use Them?
There are many reasons why you should use options. Here are some of the main benefits:
- You don’t need a huge initial outlay to buy an option.
- It will give you extra time to think about your next decision.
- It’s not that risky – the contract locks in the price, and you are under no obligation to buy the shares.
You might find an interesting company with a great stock. But, if you’re not sure if the stock price will rise in the future, you can use a “call” option to lock in the price. Thus, you will be able to purchase the shares at a later date at a specified price.
If the stock price does rise, you can buy the shares at a lower price. Meanwhile, the open market will have to pay more money for it. However, if the stock price doesn’t go up, your loss will be limited to the contract price.
You can also use options trading for risk reduction. For example, you might have stocks of a certain company. But, you think that these shares are set to be wiped out by the volatility. In that case, you can hedge against the risk and buy a “put” option. Thus, you will be able to sell the shares at a pre-negotiated price. If the price does go down, the option will then save you a bit of money (you won’t lose as much), and it will offset a part of the financial loss when you sell.
What do you Need for Options Trading?
If you want to delve into options trading, you will have to find a broker. Search for the best ones and pick a few of them. Afterward, compare their minimums, commission fees, and other factors that directly influence you.