Strike prices, premiums, calls, puts, bull call spreads, and bear put spreads—these jargons are just some of the complex aspects of options trading. But, don’t let any of it scare you off.
Options can provide you flexibility and help you to manage risks. To determine if options trading fits into your portfolio, here are the basics of what options are, what are the benefits of using them and how to get started.
What Are Options?
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An option is a financial product that allows you to trade on the future value of a market. When you buy an option, you are paying for the right to either buy or sell a stock at a pre-determined price on or before the expiration of the contract. Options work like futures, but unlike futures, you are not obliged to trade if you don’t want to. For instance, say that you have an option contract that enables you to buy gold at $1,325 for the next week. If gold reaches $1,350, you have the option and buy it for $1,325, which is $25 less than the current price on the market. If gold remains below $1,300, then you are not obliged to buy it for $1,300. If you don’t trade, however, you will lose the premium you paid for the option.
The Benefits of Using Options
You can use options for a variety of reasons, but the main advantages include:
- Smaller initial outlay compared to buying stocks
- Options allow you to buy time to see how things play out
- Options protect you against price fluctuations by locking in the price without the obligation to buy
If you want to invest in a company and you believe the stock price is going to increase, a “call” option allows you to buy shares (usually 100) at a specified price at a future date. If the stock price increases, you can buy the stock for less than its selling price on the open market. If it doesn’t, however, your financial losses are limited to the contract’s price.
How to Start Trading Options
While it sounds complicated and can include a wide range of strategic approaches, it’s fairly simple to start trading options. You need to look for a broker that offers fees that match your investment style. And from there, it’s time to come up with effective options trading strategies. Like most investment vehicles, your options trading strategies depend on your financial goals and risk tolerance, and can range from simple to quite complex.
Some of the most simple strategies you can use to get started include “the long call,” which is useful if you expect the price of the security to increase significantly in a short period of time; “the long put,” which is effective if you are expecting an asset to decrease significantly in value in a fairly short time frame; and “short put,” which is useful if you believe the price of an asset will stay the same or increase through the expiration.
As with all investment vehicles, there’s a risk in options trading. But, once you understand how it works and find a reliable broker, there’s a great investment potential if you apply the right strategies at the right time.