The stock market has always been an exciting way to earn money and millions of investors all over the world are always looking for new strategies to do it. While it can be unpredictable, the global market cap soared to a record $95 trillion in 2020 and investors are hoping this trend continues in the following years.
One strategy that grew in popularity within the previous year was options trading, which is a great way to grow your income. Those who are looking for more than just stock trading are jumping on this new trend, and if you’re one of those people, here is what you need to know.
Understanding options
While historically stock options have been around for centuries, modern stock options came to be with the establishment of the Chicago Board Options Exchange in 1973.
To get a better understanding of options, you can compare them to stocks. When you buy a stock, you own a bit of the company whose shares you purchased with the hope the value of the stock will grow so you can sell it for a profit later.
An option is a contract that gives you the right to either buy or sell a stock by a certain date at a price that was pre-negotiated. Options usually come in bundles of 100 and when you purchase them, you will have to pay a premium which you will lose if your contract expires.
Here we talk about options in the context of stocks but they can come in multiple kinds of securities. However, let’s stick to stocks.
There are two different kinds of options:
- Call options. They give you the right to pay a “strike price” for purchasing a company’s stock within its expiration date.
- Put options. Here, you have the right to sell a stock at the “strike price” which was already agreed upon before the expiration date.
When you purchase the contract, you will have three different choices. Exercise the option (buy/sell the stock), sell it to a different investor, or wait until the contract expires where you will have no further financial obligation.
Are options risky?
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Most traders consider options trading to be very risky, mainly because it’s very complex and hard to understand. If you’re looking for steps to help you buy your first stock, you aren’t ready for stock trading just yet. This is why investors who want to get into options trading need to have a firm grasp of the concept and be well-informed.
For example, you shouldn’t get into options trading if you don’t follow real time options data which provides you with data on market liquidity from various exchange venues. With this information, you can manage infrastructure demands much more easily.
The risk you’re putting yourself in depends on what role you play in the contract and what strategy you want to implement. You might only use your premium, but you also might lose much more than your initial investment.
That being said, there isn’t a strategy that is guaranteed to succeed, but you still need to know all of the different strategies you can use.
Strategies for options trading
Here are some of the strategies you can use when trading options.
- Long call. When a trader buys a call with the expectation the stock price will rise more than the original strike price before expiring.
- Covered call. Selling a call option while also buying the stock underlying the option is known as going short. Traders use this strategy when they believe the stock price will fall below the original strike price before the expiration.
- Long put. Buying a put while expecting the stock price to drop below the strike price before the expiration. This strategy is referred to as going long on a put.
- Short put. The polar opposite of the previous method, “going short” on a put is done when a trader expects the price of the stock to rise above the strike price before the expiration. When the trader sells a put, they receive a cash premium.
- Married put. In this strategy, the trader buys a put while owning the underlying stock at the same time when they expect the stock prices will rise but they use the put as insurance in case the stock falls. That way, they can offset the decline with the put.
Conclusion
Many forms of investment and trading are complicated and come with a learning curve, risks, and of course, potential gain. Trading options aren’t for everyone and only experienced investors usually dare to enter this trading market with the assurance they will come out on top.
But every experienced trader started from somewhere, and if they managed to succeed, so can you.
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