When you think about, “What is options trading?,” many people will come up with words like “complicated,” “risky,” or “overwhelming.”
But the truth is, trading options, especially the way professionals do it, can be one of the safest and most reliable ways to generate extra income for yourself and your retirement on a regular basis.
Options can seem complicated. Not gonna lie. But if you learn a few simple basics as well as a few strategies and trading techniques, you can skip the complicated math and analytics and just make some options trades.
Many people today are interested in trading options, and with good reason. It’s simply a way to make extra cash. So let’s get started. In this article, you’ll learn what an option is, what options trading is, and the associated risks and rewards of options trading.
What Is an Option?
Here is the most simple definition: An option is a mini-contract.
An option is a binding agreement and it gives one person the right, but not the obligation, to buy or sell an underlying stock or some other investment at a specified price at a specified date in the future.
Let’s take a look at some of the lingo you need to know and the basic types of options available.
When it comes to options, here is some of the vocabulary you’ll need to know:
- Strike price: The specific price at which the options investor has the right to buy or sell a security.
- Premium: The amount the options investor pays for the option. Essentially, an option’s premium is the price of the option.
- Expiration date: The specified date in the future when the option expires and no longer holds value.
Basic Types of Options
There are many sophisticated strategies to buy and sell options — iron condors, straddles, and strangles, to name a few. And these strategies can generate profits in a variety of specific situations.
For the purposes of this article, we’ll be addressing the basic two types of options contracts: call options and put options. Both can be bought and sold.
Call options give the option buyer the right to buy a specific number of shares at the strike price at any time before the expiration date. They “lock in” a buy price for some shares. The call option seller must sell the stock to the option buyer if the buyer exercises the option.
You buy a call option if you expect increasing price moves for the underlying security, because the call option would let you buy the stock for less than its market price.
You would sell a call option, if you expect the stock price to decrease.
Put options give the option buyer the right to sell a specific number of shares at the strike price any time before the expiration date. In other words, the put buyer “locks in” a sell price for their shares. The put option seller must buy the stock if the buyer exercises their option.
Put options protect the option buyer from losses should the price of the stock decrease, enabling them to profit from market price dips.
You would buy a put option if you expect the price of the underlying stock to decrease, because the put option would let you sell the stock above its market price.
You would sell a put option if you expect the price of the underlying stock to increase.
To make options trading as simple as possible to understand, it’s best to use some examples.
Example: Market Goes Up
Let’s imagine you think that shares of Starbucks (NASDAQ:SBUX), trading at around $110 a share, will likely increase in value over the time frame covered by your option to, say, $120 a share.
So you purchase an options contract to buy 100 shares of Starbucks. The contract has an expiration date of two months from now and a strike price of $115. You pay a premium of $3 per share — or $300 for the option on those 100 shares.
Before two months have passed, if the Starbucks stock has risen above the strike price to $120 per share, you can exercise your option. This means that you buy shares of Starbucks at the strike price of $115 per share even though the shares are selling at a current price of $120 per share.
You’ve acquired Starbucks at a discount. Should you choose to do so, you could turn around and sell your shares at the market price of $120 per share and realize a profit of $5 per share. So, your total profit would be $500. And your net profit, after subtracting the $300 premium you paid, would be $200.
Example: Market Goes Down
Of course, what goes up also comes down. So there is always the possibility that the stock price of Starbucks could decrease. Or the stock price might increase, but not enough to make the option profitable.
If during those two months until expiration, Starbucks shares dip or do not rise enough to make your option valuable, you simply do nothing and the option expires worthless.
For example, let’s say Starbucks stock price fluctuated during the two months and never rose above $114. You’re not going to exercise an option to buy something for $115 per share that has a market value of $114.
So, you let the option expire. You’ve risked $300 and lost it.
This is actually what happens most of the time. Options expire without being exercised and the seller of the option keeps your money and their Starbucks stock.
Benefits of Options Trading
Like any form of investment, there are benefits or rewards associated with options trading, and there are risks. Let’s take a look at the benefits first.
Dabbling in options contracts can complement any existing investment strategy in the following ways.
During times when interest rates are at all-time lows, the decision to trade options can provide investors alternative sources of income generation. Interest-bearing investments have typically been a solid building block of any well-balanced investment portfolio. But that was when interest rates were keeping pace with inflation rates.
So options, much like dividend stocks, provide investors with a much-needed alternative for income generation.
Options traders who sell options instead of buying them receive the premium payment for the option. And if the option is never exercised, it’s easy money for you.
When saving for retirement, trading stocks can feel risky considering the volatility created by the algorithms and high-frequency trades that are so common in today’s marketplace. Especially when approaching retirement, investors don’t have time to recover from a significant downturn and, therefore, have lower risk tolerance.
Options trading can reduce the risk in your investment portfolio. Because you can combine an options trading strategy with investment in the shares of the underlying asset itself, you can essentially protect your portfolio from a certain portion of potential loss should stock market values plummet. This is known as hedging your risk.
Unlimited Profit Potential
Even though the odds of stock options contracts succeeding are not sky high, professional investors use them every day. So what does that tell us? There is money to be made.
Let’s say you expect a biotech company with a low-cost stock to announce a cure for a certain virus in the near term. Right now, you would likely be able to purchase a call option for next to nothing. This would provide you potential control over many shares of stock.
If the stock does announce a cure, those low-cost options could skyrocket in value and be worth hundreds of thousands of dollars to you. There is a low risk and a high reward potential.
Risks Associated With Options Trading
You’ll often see brokerage firms making disclaimers in order to alert investors to the fact that trading stock options is speculative and inherently risky. But every investment comes with risk. Nonetheless, it’s important to understand the risks associated with trading stock options before you begin.
Risk of Time Decay
Options are time sensitive. As the expiration date approaches, your risk of loss in the option position increases. Time decay is the ratio of change in option price to the proximity in period of time to expiry.
You’ll hear the term “theta” when investment professionals talk about time decay in options trading. Theta is simply a mathematical term that’s beyond the scope of beginner options trading but becomes important if you really get deep into options trading down the road.
Dividend investing is an essential part of any solid retirement plan. So it’s important to note that when investing in stock options, you do not obtain the right to collect dividends.
Getting Started With Options Trading
Even if you’ve never ventured into any financial product other than stocks, keep your options open. No pun intended. You’ve taken an important first step toward understanding options trading.
Still not ready to go it alone? No problem. To find the right options trades for your portfolio, subscribe to Investors Alley’s “Options Floor Trader PRO” newsletter, and we’ll walk you through finding and making the right trades.