Option trading is a viable option for any investor with the time and interest to learn the basics and understand the guidelines. Getting smart about what options can bring to your portfolio can go a long way toward helping you reach your full investment potential.
Although investors of all stripes trade options, it’s not something you’d want to dive into without a clear understanding of what options are and how they work. Knowing the upside as well as the downside can help you decide if they belong in your portfolio.
What are options anyway?
In simple terms, a stock option is a contract that gives an investor the right to buy or sell stock shares at a set price for a certain period of time. The right to buy is a call option; the right to sell is a put option.
Typically, option traders are self-directed investors, meaning they don’t work directly with a financial advisor to help manage their options trading portfolio. As a do-it-yourself (DIY) investor, you are in full control of your trading decisions and transactions.
Why invest in options?
Trading options is one of those investment strategies that sounds like it’s only for the pros, but in reality, a wide variety of traders with varying degrees of experience regularly incorporate options in their investing portfolios. Why? Because option trading can be used to help boost portfolio performance or, alternatively, as an effective hedge (i.e. protection) against risk associated with other investments.
The technical jargon associated with options can often make them seem intimidating. That’s why we decided to create an option trading terminology cheat sheet to help you keep track of it all. But underneath all the complicated terms, they offer some great benefits:
Options can be a more cost-efficient way to invest. Buying individual stock shares outright typically means a larger outlay of cash. It’s possible to invest in a call option at a fraction of what you’d pay to invest in stock shares.
They also offer a level of risk reduction. When investing in the stock market, there’s always a degree of risk, but options can help insulate you against some of it. Let’s say you buy $5,000 worth of call contracts for a stock and your friend purchases $15,000 worth of shares of the same stock. If the stock fizzles, you’ll both lose but you carry the smaller loss by choosing options, since you have less money invested.
The lower buy-in associated with options gives you the ability to invest in specific stocks that you otherwise might not be able to afford. A more affordable price also means you can spread your cash around to other assets, helping to hedge against risk by diversifying your portfolio in the process.
Return ratios increase with options. If you had a chance to invest a fraction of what someone else is investing in a stock and make the same return, would you say no? That’s what option trading can offer. The smaller initial investment to buy means you can reap more of the rewards when a stock performs well.
And don’t forget about the flexibility. When you invest in individual stock shares, you typically have two choices: hold or sell. With options, there are multiple strategies — including short and long calls and puts — you can use to leverage their potential in your portfolio. That’s important if you don’t want to feel boxed in to a particular investment, especially when the market becomes more volatile.
What are some of the risks?
It’s true options offer investors many benefits — if they didn’t, they’d have gone away long ago — but it’s important to be clear that they involve risk and are not a fit for every investor.
Option trading involves many moving parts. If you are not careful and prepared to stay on top of your option trades, you could lose the entire amount of your options investment in a relatively short period of time.
Because the very nature of options requires you to pick the direction of a stock’s movement within a specific timeframe, if you don’t sell your option or “exercise” it by that date of expiration, then the option becomes worthless and you’ve lost your investment.
There are differing degrees of risk. Certain option trading strategies can expose you to higher losses than others, so you need to know your limits when it comes to trying your hand at various options strategies.
There are plenty of communities that bring traders together to discuss things like option trading strategies. Here are some communities and resources to help you get started:
• Listen to the latest episode of the Options Playbook Radio
• Get a hardcopy of The Options Playbook to help you cut through the jargon
• Ask Brian Overby, our “options guy,” anything by emailing him directly.
Whether you’re a beginner, expert trader, or somewhere in between, take the time to learn all about options and find the best strategy that fits your experience, risk tolerance and goals.
Options have several potential influences. A number of factors can impact the outcome of an options trade. Everything from the condition of the underlying stock to the state of the economy, the supply and demand factors in the options market, and the volatility in the overall market – all of these things and more can affect the pricing of options contracts and therefore the overall performance of your trades.
Using tools to look at the probability of these outcomes in any given market environment is important in helping you fully appreciate the potential upside and downside of an options trade.
At Ally Invest, our trading platform is designed to help you make informed investing decisions from wherever you happen to be. You can explore opportunities, gain insight, or take action whenever the mood strikes:
• Profit loss graph
• Probability calculator
• Option chains
• Research and market data
• Connect to the market from any device
You can include options in your investment portfolio by working with a financial adviser or you can do it yourself. Often option traders are self-directed investors, meaning they don’t work directly with a financial adviser to help manage their options trading portfolio. As a do-it-yourself investor, you are in full control of your trading decisions and transactions. This could be a viable option for any investor with the time and interest to learn the basics and understand the guidelines.