When you think of Wall Street, you probably think of stock brokers buying and selling stocks. But as it turns out, there is a secondary marketplace called the derivatives market, where stock options are traded. But what are options, exactly? And are they a good idea to invest in for the everyday retail investor?
Pros and Cons of Options Trading
- Lower Margins
- High ROI
- Less Risk
- Less Liquid
- Not Available for All Stocks
As you probably know, when you purchase a share of stock in a company, you are essentially purchasing a share of ownership in the company that has issued those stocks. These stocks have a purchase price for which they can be bought or sold on the stock market. Some of these stocks produce dividends, which are shares of company profits paid out to individual stockholders.
What is Options Trading?
An option gives you the right—but not the obligation—to buy or sell a certain security (that is, a stock) at a particular price, called the strike price. If you go ahead and buy or sell the stock using your option, that is called executing the option. However, you can also sell the option contract itself on the derivatives market, which until recently was not available to everyday retail investors.
A put option gives you the right to sell a stock at a certain price, while a call option gives you the right to buy it at a certain price. Options contracts need to be purchased in bundles of one hundred. They also have an expiration date, after which they are no longer valid. American options can be exercised any time before that date. European options can only be exercised on that date. It’s important to note, however, that these terms have less to do with geography and more to do with the type of options contract.
How Does Options Trading Work
Call Option Example
Let’s say there is a certain stock priced at $10 per share. However, based on reports you’ve read, you firmly believe the stock price will rise to $30 per share by the end of the month. That’s when you would purchase a call option that gives you the right to buy shares of this stock at $15 per share (this is the strike price). In this example, thankfully, the stock price does indeed rise to $30 within a few days, which means your option gives you the ability to purchase the stock at $15 per share. Your options contract is valuable because the stock price is above the strike price, so it is said to be “in the money.” You could sell the options contract or exercise it yourself by purchasing one hundred shares of said stock to either hold or sell, having obtained them at a 50 percent discount. That’s how a call option works.
Put Option Example
Now let’s look at a slightly different scenario. Say the same stock was priced at $30 per share, but you are convinced that it’s going to fall to $10 per share. You could purchase a put option that gives you the right to sell one hundred shares of this stock at $15 per share. If the price falls to $10, your option is “in the money,” and you can either sell the contract or do something similar to short selling stock—that is, you could purchase one hundred shares of said stock at $10 per share, and then exercise your option to sell them for $15 per share, pocketing $5 on every share sold. That’s how a put option works.
Of course, in either scenario the stock price could have deviated from your plan, making your option worthless.
We should also mention that in addition to the put option and call option, there is another type of option—binary options. This type of trade involves making a bet that the market price of an underlying asset will be above a certain price by a certain date. Binary options are named because if the answer is true, you get paid; if it is not, you lose your money.
Typical underlying assets traded on the binary options market include stock market indices (such as the NASDAQ or Dow Jones), global currencies, and natural resources like gold, oil, gas, and agricultural products.
Pros and Cons of Options Trading
To clarify, pros and cons discussed in this article will relate to the standardized options available to retail investors with an options trading approved account through their brokerage. Such an exchange traded option is set up by an option writer to have a specific strike price and expiration date, attracting a larger number of traders and providing the options market with greater liquidity.
Options Trading Pros
Margin is a complex term that can have a lot of different meanings when it comes to trading vs investing, but in this case we are referring to the cost of the initial investment.
Recall the examples we outlined, where buying a put or call option gives you the right to buy (or sell) a certain stock. Instead of having to shell out the money for one hundred shares of said security, you can purchase an options contract giving you the right to purchase it. These options contracts will always be less expensive than the price of the actual security itself. For many investors, options contracts are a way to dip their feet in the pool before diving all in.
If an options contract turns out to be in the money, the return on investment is huge. Oftentimes, options contracts are just pennies on the dollar compared to the actual stock price itself.
Imagine, for instance, in our example to purchase a $30 call option for $15 per share, if each option was priced at one cent. For just $10, you could increase your stock portfolio by $3k at a 50 percent discount—or sell it and pocket $1500. The option contract itself can also increase dramatically in price, sometimes by thousands of percentage points, making the sale of the contract another profitable alternative.
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Options can be less risky than buying and selling actual securities up front. It sounds counterintuitive because options seem complicated. However (to cite the example used in the previous section), paying $10 for a profitable investment opportunity beats investing $1k up front.
If things don’t go as planned with the stock price, losing $10 hurts a lot less than losing several hundred. This is why many investors use options contracts (particularly put options) as a sort of insurance for their portfolio. If the market dips, they can exercise their option or sell the option contract and recoup their losses.
Options Trading Cons
Of course, like anything else, options have their downsides. While stocks are a fairly liquid asset (meaning, they can easily be sold and converted to cash), the derivatives market is significantly less busy and it can be harder to buy or sell the options you’re looking to ditch.
Of course, this only applies if you are looking to sell your options contract. If your contract ends up being in the money, you’ll want to exercise the option and purchase the stock to hold it long term or sell for profit.
Not Available for All Stocks
Options contracts are not available for all stocks. If you are using a trading app, like Robinhood or WeBull, you can look and see if options are available for the security in question. Sometimes you will need to purchase an options contract through a stock broker, though.
While we’re on the topic of buying options for a particular stock, we should mention that typically a trading platform does not provide the ability for option trading for all users. You will often have to answer a few questions or go through a vetting process that indicates you understand what options are and how they work before participating in the options market.
We hope that options contracts seem a little simpler now that we’ve explained how they work. That said, options contracts can be complicated to understand for novice investors, especially once you start looking at how the options contracts themselves are priced.
Even though options contracts are certainly within the ability of a retail inverter to buy, sell, or exercise, most retail investors are better off with an investing strategy like micro investing—that is, saving little bits of money on a regular basis until they snowball into a serious nest egg. At the end of the day, only 10 percent of day traders make money, 10 percent break even, and 80 percent lose money. Considering that the stock market has yielded an average return of 10 percent per year over the last century, investing in mutual funds or a managed 401(k) is probably the best option for most individuals.
Can You Make Money as an Options Trader?
Typically, an investor engaged in day trading will use a variety of strategies to realize a profit, and an options trading strategy is one of them.
Buying and selling stocks based on their market price can certainly yield a profit, but as you’ve seen from the above examples, an option holder can significantly amplify their gains with an option strategy.
Trading options can allow investors to realize greater profits, whether the market price of an underlying asset goes up or down. In fact, many of the biggest names on Wall Street have used an option strategy to build a portfolio by acquiring stocks at a discount (namely because the predetermined price is lower than the market price) or by capitalizing on a bear market by selling off shares of stock that they purchased for far less. These days, though, an option buyer does not have to be a stock broker. Platforms like TD Ameritrade allow retail investors make options part of their trading strategy, provided they pass the vetting process.
At the same time, as you can see from the cons in our list, there are some downsides to trading options, including the implied volatility. You really need to monitor the stock market in order to truly benefit from betting on the rise and fall of the market price of an underlying security. Otherwise, you’re shooting in the dark, and playing with options will likely cost more money than you make.
Options Trading Can Be Very Profitable if You’re Comfortable with the Stock Market
If you’re familiar with the stock market, then adding options trading to your investment strategy can not only be a very profitable endeavor, it can also help you manage the risks of investing in certain stocks. However, it is not a strategy for novice stock investors. The pricing itself can get complicated, and you have to have a solid understanding of stock market trends in order to make a return on investment.
Thankfully, there are resources available to those wanting to learn more about investing in the stock market and options trading. Our Infinity Investing basic level membership is free, and includes access to investing workshops, stock trading tips, and more.
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