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Your Guide to Buying Options

T here are a lot of different ways you can invest in securities, including trading in stock options. Even though they can be overwhelming when you first start learning about them, stock options are a great way to earn income on the market without making the large investment of buying shares of stock directly. This guide can help you better understand how stock options work and whether this is a type of trading you might want to learn more about.

  • Stock options give investors the right, although not obligation, to buy or sell shares of an underlying security for a specific price and within a set time frame.
  • Stock options provide flexibility for earning income and allow investors to earn income on high-priced stocks with a low upfront investment.
  • Different options strategies can allow investors to earn income with options in both volatile and neutral markets.

What Are Stock Options?

stock option

Image via Flickr by CreditDebitPro

A stock option is a contract that gives an investor the right, although not the obligation, to buy or sell shares of a particular stock at a specific price within a certain amount of time. Options give investors the ability to earn income in stagnant markets or limit their losses. There are two types of stock options: call options and put options.

Call Options

Call options are contracts that give an options trader the right to buy a specific number of shares, usually 100, of a specific stock at a certain price within a set period. The price that the trader locks in when they buy a call option is called the strike price.

Options traders who buy call options do so because they expect the price of the stock to go up on the open market. When the prices rise above the strike price, they can make a profit by exercising their right to buy the shares and then immediately turn around and sell them for a profit. They could also sell the in-the-money option to another trader for a profit, and avoid ever having to buy the shares. For call options, the lower the strike price in comparison to the price on the open market, the higher the value of the option.

Put Options

A put option is a contract that gives an investor the right to sell shares, usually 100 per contract, of a particular stock at a specific price within a predetermined amount of time. Like with call options, a trader who buys a put option is in no way obligated to exercise on their right to sell. They could allow the option to expire, and the only loss they would incur would be the premium they paid for the option. In contrast to call options, the higher the strike price is in comparison to the price of the share on the market, the more value the option carries.

Long vs. Short Options

For most investors, options trading is usually “long.” In other words, the investor is buying the stock option with the hope that the market prices will go up if they bought a call option, or down if they bought a put option. In either case, you are buying a long option.

To short options means you are selling the options. While you will see the immediate income from the premium payment that the buyer of the option paid, the risk can be unlimited.

Benefits of Trading Options

There are several reasons why you should strongly consider trading stock options:

  • Low risk for options buyers: When you’re buying and selling call or put options, you aren’t in any way obligated to follow through and exercise your option. That means that the most considerable risk when you buy options is the cost of the premium payment.
  • Flexibility: While many investors choose to exercise their option and then turn around and sell for a profit, that isn’t the only choice. They could sell options that are “in the money” to another investor, or they could add the shares of stock to their portfolio and hold on to them to see if they go up even further in value.
  • Low upfront investment: When you buy shares of stock outright, you have to fork over a large sum of money to own the shares. However, when you buy an option, you only have to cover the cost for the premium plus the trading commission. This allows traders to pay less money out of pocket for high-dollar stocks while benefiting just as much as the investor who bought the stocks directly.

Options Trading Strategies

Let’s take a look at the most common strategies for trading options:

Straddles vs. Strangles

In a situation where the market is highly volatile, but you don’t know which direction it will go, a straddle option may be an excellent strategy to go with. With this strategy, you buy both a call and a put option that have the same strike price and expiration date. You may want to do this after an earnings report, for example, when you don’t know if the price of the stock is going to skyrocket or plummet. With the straddle, the trader profits when the price rises or falls at an amount more than the cost the investor paid for the premium.

A strangle is a similar strategy, except that the call and put options have different strike prices. They do, however, have the same underlying asset and expiration date. A strangle is a good strategy if you think that there will be a big movement in pricing but you don’t know which direction it will go.

Buying a strangle is usually less expensive than the cost of buying a straddle, but that strategy typically carries a greater risk, since the stock needs to move more to generate the profit you need.

Covered Calls

If you own the shares of stock already, then a covered call could be a great options trading strategy for you. This strategy is ideal for traders who are slightly bullish or neutral. A covered call is when you own 100 shares of a stock and then sell a call option for every 100 shares that you own. This gives you the ability to make a profit in a market that’s relatively stagnant.

However, you could potentially lose money with this type of trade if the price of the stock falls too much on the open market. You also have to keep in mind that if the options buyer exercises the option, you’ll have to sell your shares. This can make selling covered calls risky if you ultimately hope to hold on to your shares.

Iron Condors

This is an options strategy that involves four different contracts. This spread is constructed by selling a call spread and put spread with the same expiration date on the same underlying security. All four of those stock options are usually out of the money, and the call and put spreads are of equal width. The reason a trader might consider this type of strategy is that it allows them to generate a larger net credit for the same amount of risk.

Understanding the maximum amount of profit and loss you would see is crucial for this type of trade. With this strategy, you only will generate a small profit. The potential loss is higher than the potential profit; however, the loss potential is capped. This means that you’re trading off upside profit potential for the increased likelihood of a profitable trade.

There’s no doubt that options trading can be overwhelming when you are first getting into it. However, options trading does provide unique opportunities for investors who want to profit on the stock market. Understanding the ins and outs of trading options can help you decide if this type of trading is for you. Ultimately, if you do want to get into options trading, finding and sticking with consistent strategy can help you have the greatest success.