What Is Options Trading?
by Dan Caplinger | Feb. 4, 2019
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Investors need brokerage accounts in order to invest in the stocks they hope will turn their initial investments into life-changing wealth. But it's crucial to pick a broker that gives you access to all the kinds of different investments that are important to you. Although most brokers can meet simple needs, those who want to take advantage of sophisticated investment strategies have to be careful to choose brokers that can provide them with the ability to trade as well as the services needed to make smart decisions in those areas.
One way to step up your investing game is to look at the options market. Options trading is a lot different from trading stocks or mutual funds, but it can come with some real advantages for investors as well. Below, we'll take a look at what options trading is and how it can help you.
The basics of options
To trade options, you first have to know what they are. An option is a contract between a buyer and a seller relating to a particular stock or other investment. The buyer of the option has the right to force the seller of the option to do whatever the contract specifies within the period of time set by the option. Once the buyer exercises the option, the seller must follow the instructions set by the option.
For example, a call option on a stock gives the option buyer the right to buy a set number of shares at a given price at any time before a specified expiration date. The option seller must sell the stock to the option buyer if the buyer exercises the option.
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The most important aspect of an option is that as its name suggests, the buyer of the option has the right to exercise the contract, but is under no obligation to do so. Therefore, the option buyer will only exercise the option when it's smart to do so. In the example above, say that the call option let the buyer pay $100 per share for a given stock. If the stock traded in the market for $50 per share, the option buyer would never exercise the option, because it would be silly to pay $100 under the option for a share the buyer could purchase for $50 on the open market. However, if the share price in the market were $175, then the buyer would exercise the option, since $100 would be a bargain compared to the prevailing share price.
There are many different ways to trade options. In addition to call options as described above, put options give the option buyer the right to sell stock at a given price, protecting the option buyer from losses in a stock position. You can also combine various call and put options to use more sophisticated options strategies that will turn a profit under a variety of situations.
What are the benefits of options trading?
There are many reasons why options trading can be a great complement to your existing investing strategy. They include the following:
- Options give you leverage in your investing. An options contract can give you cheaper exposure to a stock than buying shares outright, magnifying both profits and losses if the stock price moves.
- Options can also reduce risk in your overall portfolio. For instance, you can combine buying a put option to sell stock at a specified price with ownership of the shares themselves. That trade, known as a protective put, gives you the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.
- Options can offer a source of portfolio income. By selling options rather than buying them, you're the one to receive the payment for the option. Even if the option goes unexercised, you get to keep that payment as compensation for having assumed the obligation for the contract.
What are the risks of options trading?
Offsetting these benefits are some real risks to options. First and foremost, options often expire worthless, resulting in a total loss of whatever the buyer paid for the option. For those used to seeing stock moves of even 5% to 10% as a really big deal, the volatility of options can come as a huge shock.
Second, there's a learning curve involved with options trading. Many brokerage companies offer options trading, but you'll have to meet some added regulatory requirements before your broker will let you trade options. For instance, you'll have to read some educational material about the options market as well as learn how your broker handles accepting orders for options. In addition, you'll need to know what you have to do to tell your broker that you want to exercise an option -- as well as what'll happen if you sell an option and the buyer decides to exercise it against you.
Finally, there are some options strategies that only work well when you make multiple trades simultaneously. Because options markets aren't always as liquid as the stock market, those simultaneous trades don't always work perfectly -- and that can introduce the risk that your strategy won't work the way you intended or hoped.
Picking the best options broker
If you want to trade options, then picking a good broker is crucial. Here's what to look for:
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- Low commissions. Brokers often have different commission rates for options than they have for stocks. Just because a broker offers cheap stock trades doesn't mean that the commissions on options will be competitive.
- Good research. Special tools for evaluating options can be very useful, but not all brokerage companies offer them.
- Great customer support. Options traders are more likely to have to talk to customer service agents in order to get their trades done the way they want, especially for more complicated strategies. Nothing's more frustrating than having a broker's customer service representatives not really understand what you're trying to do with your options trading.
Take a closer look at options
Options trading takes more effort to do well than stock trading, and options can downright scare some investors. But by understanding the pros and cons involved with trading options, you'll be able to decide whether options are right for you -- and then find a broker that'll help you get the job done.
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About the Author
We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.