Many investors are afraid of investing in options. Option investing requires a full understanding of how volatility affects an underlying stock, and some options strategies involve a lot of risk even if you know exactly how options work.
The key to successful options trading is understanding how options work, and how to make them work for you. Used properly, options can generate income, reduce risk in your portfolio, or increase your upside – all depending on your preferences. Let’s get started with the basics.
What is an option?
An option is a contract between two parties who agree to trade a stock or other underlying asset if the buyer of the option chooses to do so. The option will specify the underlying investment, how many shares or how large an investment is covered by the contract, the strike price at which the trade will occur, and the expiration date by which the buyer of the option must make a decision on whether to exercise the option's rights. For more details on what an option is, take a look at this article on options contracts.
What options trading strategies are available?
One intimidating factor about options is that there are many different strategies that investors use involving options. Many of them have unusual names, such as the iron butterfly or the condor. However, there are plenty of basic options strategies that investors can use that aren't nearly as complicated.
This article on options strategies talks about two trading strategies that even beginners can use effectively. Both involve using single options positions involving call options, and one generates income while the other serves as an alternative to owning stock outright. Other simple options strategies are also available to meet other needs.
How does trading options actually work?
Finally, it's important to understand the mechanics of investing using options. Most brokerage companies incorporate options trading into their list of offerings, but it typically takes some additional paperwork to activate options trading in your brokerage account. You'll usually have to read through and acknowledge that you've received disclosure information from the Options Clearing Corporation in order to get permission from your broker to trade options.
Once you've gotten past the preliminaries, the next step is to learn how your broker has options trading set up on its trading platform. For many brokers, buying and selling options is similar to how you trade stocks, where you choose the appropriate options contract for the stock, strike price, and expiration date that you want. Once you've found the correct option, you can either place a market order to buy or sell the option at the available market price, or you can place a limit order at a specified price for other market participants to consider.
One key aspect of options trading, however, is that you'll sometimes want to make certain trades contingent on other trades happening. For simple options strategies involving a single type of option, this isn't a factor. However, some options strategies involve two or more separate options contracts that combine into a single trading position. In order to avoid undesirable situations in which some but not all of the necessary trades go through, brokers will allow options traders to link certain trades together so that they'll either execute at the same time or not at all.
Finally, it's important to know how your broker handles the exercise of options. If you buy options, many brokers have rules that will automatically exercise options on the expiration date if it makes financial sense to do so. For those who sell options, brokers have rules governing assignment of exercised options across all the sellers of a particular option. If you don't know how those rules work, then you can get caught in several different ways. You might not have enough cash in your account to handle your funding needs in exercising an option in which you need to purchase a stock. Alternatively, you might end up having to sell stock that you didn't want to sell in order to meet your obligations under an option contract.
Trading options is intimidating to some investors, but it doesn't have to be. By knowing how to trade options, you'll be in a better position to get the benefits of options in your investing.