What is Options Trading?
I’ve had my fair share of learning how to buy and sell stocks, but a few weeks ago, one of my close friends brought this topic to my attention. He said that the return on investment is higher through options trading. Sounds too good to be true? I couldn’t help it but spent hours going through the fundamentals of options trading and basic strategy to trade options.
What is an Option?
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 exercise the contract but is under no obligation to do so.
What are the benefits of Options Trading?
1) Options give you leverage in your investing. An options contract can give you cheaper exposure to a stock than buying shares outright.
2) 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 or married option strategy. This strategy gives you the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.
3)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.
After looking at the benefits, I asked myself why didn’t I learn options trading earlier? Probably because not all market offers options trading. Today, I buy and sell stocks in NYSE through the Robinhood platform, and lucky for me, they do offer options trading. Conceptually, all of the above benefits seem pretty easy to digest, but I wonder if its easy enough to understand the risk and execute a perfect trading plan.
What are the risks of Options Trading?
You are risking your principal as an option contract has no guarantees. You only own the option contract with a specific expiration date, and you do not own any of the stocks. The principal in this context refers to the premium you pay for the contract.
In a comparison of buying a stock, regardless of the price movement in the market, you are guaranteed ownership. If the stock increased in value, you profit from it and vice versa.
In my opinion, options are riskier than stocks trading, but there are ways that we can combine these two to minimize loss exposure in a trade. One that I am a big fan of is the “Married Put” strategy. When using this strategy, the trader buys put options on stock for every 100 shares of the underlying stock owned. This set as insurance as the trader anticipates that the stock may fall in the short-term, but wants to continue holding it in the long run.
On the other hand, if the trader wants to pocket the difference in an option premium price, the trader can do the following:
Long Put – buys a put expecting the stock to be below the strike price before the expiration.
Long Call- buys a call expecting the stock to be above the strike price before the expiration.
The options strategy above gives cheaper exposure to trade; however, the risk, as mentioned above, is the capital paid for the premium if the stock goes sideways. Traders often can salvage some of the value by selling the put, as long as it has substantial time to expiration.
To date, I have a few put and call options that I bought without understanding the fundamentals. Luckily for me, the expiration date is at the end of the year, so I still have time to lock in the premium profits if the market recovers.
Stay safe, and keep on learning new things during this pandemic!