For investors who want an alternative to the stock market for wealth investment, stock options trading might be a good choice. The complexities of stock options can be overwhelming initially, but it becomes easier to understand once you learn a few crucial points.
What Are Stock Options?
Essentially, a stock option is precisely what it sounds like. It gives the owner the option — but not the obligation — to buy or sell a particular stock at a specific price before a certain date.
While there are many stock option strategies for income, speculation, or hedging, there are two types of options: call options and put options. Call options allow you to buy the underlying stock. Put options give you the ability to sell the underlying stock.
Trading Options vs. Trading Stocks
When you buy or sell stocks, you do so with an expectation about the stock’s future price. If you buy, you are “long” and expect the stock to go up over time. If you sell, you are “short” and expect the stock to go down over time.
In some ways, the act of trading options is similar to trading stocks. However, there are some key differences, and this is where the complexities come into play.
First, when you buy an option, you are not (yet) purchasing ownership in the company. Options are derivatives of the underlying stock and contracts with other investors that give you the ability to buy or sell the stock.
In addition, when you purchase an option, you are expecting more than just the future direction of the price. You also are betting on how much the stock’s price will move and how fast that will happen.
Pros and Cons of Options Trading
Trading options is not recommended for new investors as there are additional risks to consider. On the flip side, there are also potential advantages of options trading that traditional stock market investors cannot realize.
On the advantages side, stock options are not as expensive as some stocks. In addition, because you are buying a contract, your maximum risk exposure is the purchase price of the stock option. The potential profitability is high on options with near-term expirations, especially if the stock price moves significantly.
However, there are downsides to options as well. All options are worthless when they expire “out of the money,” so if your bet is not correct within the expiration period you selected, you could lose your entire investment. To succeed with options trading, you have to be right about the price direction, distance, and direction, making it a complicated trading strategy.
How It Works
When you purchase a stock option, there are several factors you have to decide on. First, if you think the stock price will go up, you select a call option. If you believe the stock price will go down, you choose a put option.
The option’s strike price is the next thing to predict. How far do you think the stock’s price will move? 1%? 5%? For example, if a stock’s price is currently $50 and you believe the price will increase by 2%, you might select a strike price of $51.
Finally, you have to predict how soon this price movement will happen. Do you think the stock price will change within a month? A quarter? Or do you think it will take a year? You select an expiration date based on how long you think it will take for the stock’s price to move to where you think it will go.
Trading stock options can be a lucrative strategy as an alternative to buying and selling stocks directly. There are advantages and disadvantages to know about, though. You need to correctly predict the stock’s price movement, how far it will go, and how soon. If you get all three right, you could see tremendous profits.