Learn how to trade options with our options trading 101 guide that’ll teach you about call and put options (and how to make money with them).
Options make it possible to have a stake in an underlying asset, without directly owning the asset yourself. Options are a major component of the derivatives market, meaning that the value of any given option will be directly affected by the value of the underlying asset (such as a stock, bond, or other speculative assets).
An option is a formal contract that allows you to buy (call options) or sell (put options) the underlying asset at a specific price at a specific date in the future. Options can be used to protect yourself from the risk of a given position and diversify your holdings as a trader.
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In addition to these possible benefits, there are quite a few reasons why the options market is appealing. Usually, the options market will be more volatile than the underlying securities market, allowing traders to maximize the possibility of earning strong returns on their investments.
Though options are often used as a risk management tool, the options market itself should not be considered “risk-free.” Suppose you are holding a call option giving you the right to buy a stock at $100. If, when the expiration date arrives, the market price is $90, the option will be worthless. In this article, we will discuss how you can use options to protect yourself from risk, while still carefully protecting your potential for strong returns.
Options are derivatives contracts
Options contracts are derivatives contracts, meaning that their value is derived from some other asset. Futures contracts are also derivative contracts, though these contracts impose an obligation to buy once the expiration date arrives. At its face, it is impossible to determine whether a $100 call option is worth nothing, $10, $10,000, or any other value. In order to determine how much this contract is worth, you must know the value of the underlying asset.
The most valuable options contracts are “in the money” contracts, meaning that the strike price is positioned favorably against the spot price. While out of the money contracts have no use on the expiration date, traders still purchase these contracts, hoping that conditions might change.
Options cost less than the underlying asset
Because options merely give you the right to buy or sell—rather than the financial capacity to do so—option contracts will always cost less than the underlying asset. This makes it possible for traders to have access to major companies that might otherwise be out of reach.
As of June 2019, Berkshire Hathaway (BRK.A) stock is trading for more than $300,000 per class A shares. As one of the most expensive stocks on the market, this value is inaccessible to most traders. However, depending on the desired strike price, Berkshire Hathaway options can be purchased for $100 or even less.
Options are most volatile right before the expiration date
Depending on your trading strategy, volatility can either be a good or bad thing. For risk-averse traders, volatility (extreme price movements) is something that will need to be avoided. For profit-seeking day traders, however, volatility means more opportunities for profits.
Many options contracts are issued years in advance, making it difficult to determine what they will be worth in the future. As the expiration date approaches, it becomes clearer whether these contracts will be in the money, out of the money, or at the money. If the price of the underlying asset has experienced major changes over time, the demand for options will either increase or decrease accordingly.
Call options and put options are not mutually exclusive commitments
The question, “is it better to purchase call options or put options?” is not a question that can be easily answered. The answer will depend entirely on your trading strategy, as well as the contracts you are considering purchasing.
The best options trading strategies will often require purchasing call options and put options simultaneously. Head and shoulders options strategies, for example, are ideal for traders who believe the underlying asset will experience a major price swing but are unsure which direction it will go. Many of these trading strategies will also pair options with a long position in the underlying asset.
Consider purchasing multiple call options at once
In addition to developing an options portfolio that has both call and put options, you may also want to consider purchasing call options at multiple different levels. Even if you are unsure where prices will move in the distant future, you can use these strategies to control the amount of money you could possibly stand to lose.
A common options trading strategy—sometimes called “triples”—involves purchasing three call options at once. One will be in the money, one will be at the money, and the third call option will be out of the money. If the market price for the underlying asset is currently $100, a trader might purchase a $90 option, $100 option, and $100 option, respectively. Another way to diversify your options holding is to purchase contracts with varying expiration dates.
Use options to control your exposure to risk
Options are speculative derivatives, but they also function as excellent risk management tools. It is not uncommon for options traders to purchase a share of the underlying asset along with an option as a form of “insurance.” This way, no matter what the future has in store, at least one of their positions will be profitable.
At the same time, many traders will use options to “double down” on their current position. If a stock is selling for $100 and the call option is for anything less than $100, all movements beyond this price will enhance both positions. Whether you primarily use options to control risk or use them to enhance positions will be up to you.
Practice trading options on paper before risking actual money
Understanding the options market can still be rather complicated. Even if you have experience trading stocks, there are still many market-specific nuances that will need to be addressed.
In order to maximize your potential as a trader, it will be crucial to get some experience trading on paper in advance. Back-testing strategies—seeing which ones work and which ones fall flat—can help you be much more confident in your future positions. While paper trading, pay attention to the “option Greeks.” The delta, gamma, theta, and vega figures attached to each option make the market much easier to quantify.
The options market provides traders with opportunities to control their exposure to risk and to pursue long-term returns. By taking the time to understand this unique dimension of the trading world, you can improve your potential as a trader.
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