Stock option trading has bubbled to the surface again. The global pandemic is keeping investors locked down, and that has led many to explore new investment styles. Options trading is often high on their list of things to try out.
According to a study from Benzinga, 37.1% of investors say they’ve traded options during the pandemic. Much of that volume is coming from younger investors, according to a recent E*TRADE study. The report shows that younger traders are getting more aggressive with their investments and that riskier options are a key component of that mindset. Two key points from that study:
- Risk tolerance has skyrocketed since the pandemic. 51% of Gen Z and Millennial investors say their risk tolerance has increased since the coronavirus outbreak. That’s 23% higher than all U.S. investors.
- Younger investors are trading more frequently – and are trading options. Over half of investors (51%) under the age of 34 are trading equities, compared to only 30% of all investors. 46% said they’re trading derivatives more frequently since the pandemic, compared to 22% of all U.S. investors.
“While young investors may gravitate to options to speculate on the future price of a stock in either direction, the reality is these derivatives are also used to leverage, hedge, and generate income,” said Chris Larkin, managing director of trading and investment product at E*TRADE Financial. “Leverage allows a trader to use less money to gain exposure to the movement of a stock’s price, while hedging is about reducing risk. Options can help protect trades—or an overall portfolio—in case things don’t work out quite as planned.”
Trading options presents both opportunities and risks, and you’ll need to consider both. Let’s take a closer look.
Key Option Terms
There are two basic types of stock options that options trading beginners need to know about: call options and put options.
- Call options give the buyer the right to buy 100 shares of an underlying stock at a specific price and during a specific time period.
- Put Options give the seller the right to sell 100 shares of an underlying stock at a specific price and during a specific time period.
New options traders also need to understand two additional key terms – the “strike price” and the “expiration date”.
The strike price is the price of a put or call options contract on execution of the contract. The strike price is tied to the underlying stock’s value at the time of the execution. It is a major component of any options contract.
To purchase a stock option at the strike price, the buyer pays the seller a premium for taking on the risk that comes with an options contract.
👉 The premium is based on the option’s strike price, the trading timetable, and the volatility of the option contract’s underlying stock.
A stock option’s expiration date is the date the options contract terminates. After that date, the option contract owner no longer owns the right to exercise the contract, making the stock option valueless. Expiration dates depend on the type of option bought or sold.
📆 Most option contracts expire at the end of trading on the third Friday of each month
Options Trading Defined
A stock option is a contract where the stock option buyer purchases the right, but not the obligation, to buy or sell shares (usually 100 shares per contract) of an underlying stock, bond, or commodity at a predetermined price from/to the option seller within a fixed period of time. The buyer is the “holder” of the option contract, and the seller is the “writer”.
“Like all investments, options are a means of speculation,” said Dave Sanderson, president of Red Jacket Capital, a hedge fund firm in Ontario, Canada. “Options are ‘conditional derivates contracts’ allowing holders to buy, or to sell, a security at a predetermined price. To trade options means to speculate an outcome, to place a kind of bet on the future of the chosen option.”
“One of the biggest reasons investors trade options is to produce income—some options strategies let an investor collect money on existing or future stock positions,” Larkin said. “Of course, investors of all ages should understand that the existing stock may have to be sold for less than the current market price. Options trading is not appropriate for everyone and there are risks associated—as with any investment vehicle. Know your long-term goals and risk tolerance before getting started.”
An Option is an Option
One of the key concepts of options trading is that you don’t have to exercise the contract. That’s why it’s an option. An options contract gives the holder the option to make a purchase at a set price within a set time, depending on the terms of the contract. You can exercise some options contracts at any point before the expiration date. Some can only be exercised on the expiration date.
If you don’t exercise the contract it will simply expire. You will still pay the premium, but you don’t have to buy or sell the underlying asset if the price is not favorable. That’s why options are useful for hedging.
💡 If you are holding a long position in a stock you can buy a put option on the same stock to cover your losses if the stock falls. If it rises as expected, you take your profit on the long position and let the put option expire. You’ll still pay the premium, which is effectively the cost of insurance.
You can also sell an options contract, which enables you to recover some of the premium. The closer the expiration is, the lower the contract premium will be. A contract that is “in the money” – meaning that the underlying asset is trending in the expected direction – is more valuable than a contract that is not.
Option Trading Examples
Stock option transactions come in many forms and lead to many outcomes. For the purposes of clarity, let’s look at how a basic stock option transaction could work.
A Call Option Example
For example, an options investor looks at ABC Co., a publicly-traded company whose stock is currently trading at $100 per share. The investor, who’s done the proper due diligence and researched the company, believes the stock should rise to $120.
That scenario represents an opportunity for an options investor. The investor buys a call option with a strike price less than $120. The investor winds up buying a stock option at a strike price no higher than $120. That covers the cost of executing the option and leaves plenty of room for the option to wind up “in the money” (i.e., where a profit is made on the options contract.)
The contract calls for an expiration date of three months and in that time, ABC’s stock price has risen to $125 per share within the 90 day period. The holder, who’s holding a call option at $120 or less, can go ahead and purchase the agreed number of shares at $120 or less, even as the underlying stock (worth 100 shares) is selling at $125 per share. That’s a profit for the call option buyer who has locked in a big gain.
A Put Option Example
The investor may believe that, at $100 per share, the price of ABC stock is way too high. The investors, having done the research, believes ABC stock will fall to $80 per share.
That investor purchases a put option to sell the contract at higher than $80 per share in the same 90 day time period. If ABC Co. slides down to $80 per share or lower in that 90-day span, the put option holder can sell the contract at the strike price (i.e., higher than $80 per share with the exact price depending on the contract and the underlying market conditions) and is in the money. Once again, a profit is locked in by betting correctly that the stock’s price will drop.
The options investor in the above scenario doesn’t get to choose the contract’s strike price. The market does that through a process called “option chains”. These chains, which move regularly based on market conditions, may include a healthy range of put and call option strike prices, based upon the underlying stock’s price and performance trends.
These examples represent the simplest forms of options trading. These trades are not that different from ordinary long or short trades. More sophisticated options traders may develop complex strategies involving multiple contracts. If you design and execute them effectively those strategies can drive gains and protect against losses.
⚠️ Complexity also increases the probability of error, and errors can be costly.
Pros and Cons of Options Trading
Stock options can be profitable. They also present risk, given that the contract represents 100, and not one, shares of underlying stock. That brings some complicated elements into play, which can work for or against the options investor.
“The most important advantage of options trading is complexity,” Sanderson said. “As the markets get more and more crowded, and as very smart people try to find an edge, complexity is a big value-add. Put simply, the obvious bets are taken. Complexity can take you places that aren’t obvious, which is where a lot of ground can be gained.”
Complexity cuts both ways. “It can be a barrier to entry for prospective options traders,” he added. “It’s often difficult to understand the language and methodologies of trading. That’s why options trading has a long learning curve, but the reward certainly justifies the time spent learning how to trade options.”
With that complexity in mind, let’s look at some other pros and cons of options investing.
✅ Pros of Options Trading
Options trading has some significant advantages. These are some of the most prominent.
- Limited losses: if the stock moves in a direction that you didn’t expect, you can decline to exercise the option. You can only lose the premium and the trading commission.
- Flexibility: you can exercise the option, sell the contract before it expires, or let it expire, depending on the movement of the underlying asset.
- Low up-front cost: buying an options contract requires only the premium cost and trading commission. That can be a much smaller commitment than buying shares in the underlying asset.
- Fixed prices: when you buy an options contract you lock in the right to buy a specific asset at a specific price in a specific time frame.
- Ability to make money in up and down markets: buying put options lets you make money on a falling market with less risk than shorting the stock would entail.
- Hedging: you can use options as insurance to protect or limit losses in a long position or short stock position.
“There are several options trading strategies that offer flexibility to take advantage of different market environments,” said Katie Schaeffer, chief operating officer at Schaeffer’s Investment Research in Cincinnati, Oh. “For example, one can leverage anticipated volatility by simultaneously buying a call and put option with the ability to profit no matter the direction of the underlying. Plus, there are strategies to take advantage of time decay by selling, instead of buying, an option premium.”
❌ Cons of Options Trading
Options trading also presets significant potential disadvantages.
- Qualification: your broker will want you to demonstrate experience and knowledge before approving an options trading account.
- Commissions: options trades usually involve higher broker commissions than ordinary stock trades.
- Low liquidity: you may not always be able to buy or sell options contracts on the terms you want, especially if you’re trading less popular stocks.
- Minimum balance: Many options brokers require a minimum balance, often $2,000. That $2,000 could be making money in other investments.
- Time limits: “As an option buyer, you are required to be correct in the defined time period, defined by expiration of the option,” Schaeffer said.
- The spread: the spread between what a market maker is willing to pay for your shares and what they are willing to offer for your shares is larger than it is with a conventional stock purchase. That can cut into your profits.
- Tax consequences: if you hold a stock for over a year, any profit will be taxed as a capital gain. If you hold an option the year is counted from the time you exercise the option. That makes it more likely that your gains will be taxed as income, at a higher rate.
- Complexity: complex trades can lead to mistakes in planning or execution. They may require a margin account, potentially putting you in debt.
“The main ‘con’ with options trading is the risk that can be generated in their operations due to the high leverage,” said Santiago J. Andrade, CEO and founder of Finequities, a digitally-based all-in-one wealth management platform. “You can earn a lot of money, but you can also lose a lot of dollars along the way.”
Where to Start
First, educate yourself. Don’t make any trades until you fully comprehend the risks and realities of options trading.
“There is a wealth of information on the Internet, with websites, books, videos, and podcasts”, said Schaeffer. “Options are enticing and many want to jump right into it, but do your homework first.”
After studying options trading, start small and start simple.
“You’ll learn an enormous amount by having a hand in the game,” Sanderson said. “For example, try buying one long dated call option (a basic option trade). Then try selling it a week later. This simple trial run will teach you valuable lessons, and the first-hand experience that comes with being involved is irreplaceable. Research helps, but it’s hard to recreate the feeling you have as an active investor. Start with amounts you can definitely afford to lose and be as hands on as possible.”
Choose a Broker
Next, choose an options broker, with a special focus on transparency and reliability. “A regulated broker is subject to a series of rules that ensure the protection of investors, the solvency and security of funds, and the correct marketing, information, and transparency of the funds,” Andrade notes.
It’s also a good idea to thoroughly review the broker’s website before registering for an options trading account.
“A good options broker publishes detailed information on its trading conditions, provides documentation to answer your questions, has implemented contact and complaint procedures in case of an incident, and has a transparent website,” Andrade said.
You should ask questions before signing on the dotted line.
“A good options trading broker must help you answer the following questions,” said Michael Hammelburger, CEO at the Bottom Line Group, in Baltimore, Md.
- What advantage do you gain if you choose to invest your money in options trading?
- How is the expense that you want to fund going to be feasible?
- If you consider it as your primary income source, will it be better for you in the long term?
- Is this for your retirement savings? How can it help you?
BrokerChooser.com is a good place to find and vet qualified options brokers.
The Last Word on Options Trading for Beginners
As a new options investor, the watchword starting out is “caution” – in abundance.
“The first mistake new investors make is believing that investing in options is easy,” Andrade said. “Although its operation is simple, extensive education is necessary to be right with your predictions. Therefore, believing that trading options is easy and that you can make a lot of money overnight is a big mistake.”
“While options trading offers high profitability, it will not make you rich in a matter of hours,” he continued. “Maintain self-control and be disciplined as an options trader – especially as a new one.”
“Keep your feet on the ground and your head cool, because only then will you be able to negotiate with judgment and not get carried away by your emotions.”