Stock options are a type of financial contract that give the holder the right, but not the obligation, to buy or sell a stock at a specified price on or before a certain date. Trading stock options can be a great way to make money, but it’s important to understand the basics before getting started.
Understand the Basics of Options Trading
Before you start trading stock options, it’s important to understand the basics of how they work. Options are a type of derivative, which means they derive their value from an underlying asset (in this case, a stock). There are two types of options: call options and put options. A call option gives the holder the right to buy a stock at a certain price (the strike price) on or before a certain date (the expiration date). A put option gives the holder the right to sell a stock at a certain price on or before a certain date.
Different types of options
There are many different types of options, each with its own set of risks and rewards. Some common types of options include:
-American options: These can be exercised at any time before the expiration date. This means that American options offer more flexibility, but also usually carry a higher price.
-European options: These can only be exercised on the expiration date.
-Index options: These are options on a stock market index. Index options can be either American or European, and provide exposure to the overall performance of the stock market, rather than the performance of a single company.
Choose a Broker
Once you have a basic understanding of how options trading works, you’ll need to choose a broker. A broker is a person or firm that executes trades on your behalf. Be sure to research different brokers and compare their fees, platforms, and services before making a decision. Be sure to compare different online brokers to determine the best platform for your needs.
Traders that tend to be more active should ideally look for a broker that is designed for bulk trading. Conversely, occasional options dabblers could prefer a broker that provides the lowest costs and commissions structure. Either way, it is important to understand your style and approach before searching for a broker.
Develop a Strategy
Before you start trading, it’s important to develop a strategy. This will help you make informed decisions and minimize risk. Some common options trading strategies include:
-Buying call options: This strategy allows you to profit from a stock that you believe will go up in value.
-Selling call options: This strategy allows you to earn income from a stock that you believe will stay the same or go down in value. An investor can hedge against their stock positions by selling calls for each 100 shares owned. This is called a “covered call” and allows an investor to collect payments from the buyer of the call option. However, they risk the shares being “called” away at the strike price, should the underlying asset price rise above the strike.
-Buying put options: This strategy allows you to profit from a stock that you believe will go down in value.
Examples of Common Stock Option Trades
Buying a Call Option:
Imagine a stock trader named John who believes that the stock price of XYZ Inc. will rise in the near future. He buys a call option for XYZ Inc. stock with a strike price of $100 and an expiration date of 3 months. The option allows John to buy 100 shares of XYZ Inc. stock at $100 per share, regardless of the current market price.
After three months, the stock price of XYZ Inc. has indeed increased to $120. John exercises his option to buy 100 shares of the stock at $100 per share, and immediately sells the shares at the current market price of $120. He has made a profit of $2,000 ($120 per share – $100 per share) x 100 shares = $2,000.
Selling a Covered Call Option:
Consider a stock investor named Sarah who holds 1,000 shares of XYZ Inc. stock, which she purchased at $60 per share. The current market price of XYZ Inc. stock is $70. Sarah is optimistic about the stock’s future but realizes that the market may be volatile, and she wants to generate some additional income while she holds the stock.
Sarah decides to sell 10 call options with a strike price of $75 and an expiration date of 1 month. Each option allows the buyer to purchase 100 shares of XYZ Inc. stock at $75 per share. Sarah receives $2 per option, or $20 total, for selling the call options.
At expiration, the stock price of XYZ Inc. is still $70. The call options will not be exercised, and Sarah will keep the $20 she received for selling the options. If the stock price had risen to $75 or higher, the call options would have been exercised, and Sarah would have been required to sell her 1,000 shares of XYZ Inc. stock at $75 per share. Despite the potential loss from selling the stock, Sarah would still benefit from the additional income she received from selling the call options.
Buying a Put Option:
Now consider a stock trader named Jane who believes that the stock price of ABC Inc. will decrease in the near future. She buys a put option for ABC Inc. stock with a strike price of $50 and an expiration date of 2 months. The option allows Jane to sell 100 shares of ABC Inc. stock at $50 per share, regardless of the current market price.
After two months, the stock price of ABC Inc. has indeed decreased to $40. Jane exercises her option to sell 100 shares of the stock at $50 per share, even though the current market price is only $40. She has made a profit of $1,000 ($50 per share – $40 per share) x 100 shares = $1,000.
Monitor Your Trades
Once you’ve placed a trade, it’s important to monitor it closely. This will help you make adjustments if the stock’s value changes. It’s also important to have a plan in place for when things go wrong. Be sure to take things slow when starting off with options. A good way to initially begin options trading is through a paper trading account. This allows you to understand the mechanics and process for placing an options trade, its price action, and the potential gains & losses that can be realized once you begin live trading.
In conclusion, trading stock options can be a great way to make money, but it’s important to understand the basics and develop a strategy before getting started. It’s also important to choose a reputable broker and monitor your trades closely. Remember, options trading is a risky endeavor, so it’s important to be aware of the risks and to never invest more than you can afford to lose.