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Options trading has become increasingly popular for individual investors in the last few years. In fact, if you consider time value, volatility, and interest rate, trading options can be a profitable strategy to protect against risk. But first, you need to know what you’re getting into including the lingo.
Let’s get started with some basics.
Options: An option is simply a contract that lets you buy or sell an investment. These can be stocks, Exchange Traded Funds (ETFs), or other assets. Your contract includes the pre-negotiated price of your asset and how long that price is good for
Premium: The price at which you can buy or sell an option
Expiration: The time and date your contract expires when you can no longer buy or sell
Strike price: The pre-negotiated price of the asset if it’s bought and sold according to its contract
Instead of directly buying a security outright, the options contract allows you to buy or sell shares or sell to another investor. You can also choose to do nothing with your security and let the contract expire without any further financial obligation. Contracts are typically good for 100 shares though you can have more when trading in higher volumes.
You can also trade options contracts. By trading options, you can try to predict their price the same way people try to predict whether stock prices will rise or fall. In this case, you’re predicting if your options contract will go up or down.
Finally, you can buy and sell options contracts. When you buy options, you’re trying to increase your profit, and when you sell, you’re trying to mitigate your losses.
Options are divided into call and put options.
Call Options: Are the right to buy shares at the strike price before the expiration. The current owner is obligated to sell those shares to you according to the contract.
Put Options: Are the right to sell shares at the strike price before the expiration. If you sell and exercise the put option, your shares must be sold at the strike price.
Buying and Selling Options
Now that you understand how options contracts work, you’re ready to learn about buying and selling them. You pay a premium when buying or selling options contracts. This small fee allows you to choose to buy or sell at the strike price.
Unlike stocks, where you purchase them when you’re ready, you’re not buying options contracts now, but you’re paying a premium to buy or sell in the future. For example, if you expect the asset to increase, call options could be profitable if the strike price is lower than the market price.
Alternately, when you think the price will drop, put options are the way to go since you’re likely to sell at a price that is higher than the market price and make a profit.
Getting Started with Options
Essentially, with options, you’re not paying to buy a stock right now, you’re paying a smaller fee for the opportunity of buying or selling assets at a later time in the future. While investors may think options can be tricky, more and more investors use them as part of an advantageous strategy for their portfolios.
They require less of a financial commitment than buying stocks and if the market price drops, you’re only out the premium you paid. On the other hand, if the market price soars, you have the opportunity to buy at the strike price and make a profit.
A few more things to know before you go:
- You’ll need a broker
- You should compare fees among brokers to see if you’re getting a fair deal
- Options strategies can depend on your goals and risk tolerance, but you should have a strategy to understand and try to meet your financial goals buying and selling options
- To make a profit, you’ll need the ability and willingness to predict the price of an option, which may require research, investment savvy, and luck
- With options, you won’t have ownership like with stocks, but the value comes from having the choice of the options contract
As with any investment, there is a risk in options buying and selling.