Advantages, disadvantages, risks and benefits to options trading
Five things to know if you are considering options trading
If you're looking to go beyond stocks, mutual funds or bonds in your portfolio, options could be a good fit.
Options give you, well, options for diversification. And while the risks can be high, so can the rewards. You may have heard that getting started with options trading is difficult, or it's only for the most advanced investors. The reality is options are something virtually any investor can try — with the right know-how.
Interested in getting on the options trading bandwagon? Here’s an overview of options trading that cuts through the jargon and gets right to the core of this versatile way to invest.
What is options trading?
Options trading can seem more complicated than it is. If you're looking for a simple options trading definition, it goes something like this:
Options trading is the trading of instruments that give you the right to buy or sell a specific security on a specific date at a specific price.
An option is a contract that's linked to an underlying asset, e.g., a stock or another security. Options contracts are good for a set time period, which could be as short as a day or as long as a couple of years.
When you buy an option, you have the right to trade the underlying asset but you're not obligated to. If you decide to do so, that's called exercising the option.
If you’re a DIY investor diving into options with a self-directed account, you're in full control of your trading decisions and transactions. But that doesn’t mean you're alone either.
Plenty of communities bring traders together to discuss things like current market outlook and options trading strategies.
Listen to the latest episode of the Options Playbook Radio or watch our free, weekly YouTube show covering stock market moves and options strategies.
The different types of options
To form your knowledge base in options trading, start by getting familiar with the different types of options you can trade. The two basic categories of options to choose from are calls and puts.
What is a call option in stocks?
A call option gives you the right to buy an underlying security at a designated price within a certain time period (think of it as calling the underlying security to you.) The price you pay is called the strike price. The end date for exercising a call option is called the expiration date.
Call options can be American-style or European-style. With American-style options you can buy the underlying asset any time up to the expiration date. European-style options only allow you to buy the asset on the expiration date.
What is a put option in stocks?
A put option is the opposite of a call option. Instead of having the right to buy an underlying security, a put option gives you the right to sell it at a set strike price (think of this as putting the underlying security away from you.)
Put options also have expiration dates. The same style rules (i.e., American or European) apply for when you can exercise them.
How does options trading work?
Options trading is something you can do via an online brokerage account that allows self-directed trading. In terms of the mechanics of how to trade options, here are a few key points to know.
What is buying a put?
When you buy a put, you're buying a contract that gives you an option to sell a security by a certain expiration date at a certain price. Before buying a put, a few things to consider include:
How much you want to invest
What kind of time frame you want to invest for
Anticipated price movements for the underlying asset
Buying put options can make sense if you think the price of the underlying asset is going to go down before the expiration date. If you buy put options at one strike price, then the asset's price drops, you can exercise your option at the original strike price.
For example, say you buy a put option for 100 shares of ABC stock at $50 per share. Prior to the option's expiration date, the stock's price drops to $25 per share. If you choose to exercise your option, you could still sell the 100 shares of stock at the higher $50 per share price.
What is buying a call?
Buying a call means you're buying a contract to purchase a particular stock or asset by a set expiration date. When buying call options, it's important to consider the same factors that you would when buying put options.
Buying call options can make sense if you think the price of the underlying asset is going to rise before the expiration date. For example, say you buy a call option for 100 shares of ABC stock, only this time you're hoping for a price increase.
Your call option contract gives you the right to buy shares at $50 each. Meanwhile, the stock's price climbs to $100 apiece. You could effectively use a call option contract to buy that stock at a discount.
How to read a stock option quote
Options based on equities, more commonly known as “stock options,” typically are a natural lead for traders new to options. Stock options are listed on exchanges like the New York Stock Exchange in the form of a quote. It is important to understand the details of a stock option quote before you make a move.
There are five parts of a standard stock options quote:
Stock symbol refers to what's used to identify the underlying asset attached to an options contract.
Expiration date is the date on which the option will expire.
Strike price is the price at which you're able to exercise the option.
Type refers to the type of option involved, i.e., call or put.
Premium is the cost to buy the option's contract itself.
How options pricing is determined
Options pricing can be calculated using different models. But at its core, options trading prices are based on two things: intrinsic value and time value.
An option's intrinsic value represents its profit potential, based on the difference between the strike price and the asset's current price. Time value is used to measure how volatility may affect an underlying asset's price up until the expiration date.
The stock price, strike price and expiration date can all factor into options pricing. The stock price and strike price affect intrinsic value, while the expiration date can affect time value.
Advantages and risks of trading options
As with any other investment strategy, options trading has its benefits and drawbacks, and it's important to understand these potential advantages and risks to avoid making costly mistakes.
In terms of advantages, options trading can offer flexibility as well as liquidity. Compared to other investment options, you may be able to invest with smaller amounts of capital. Options can be used to create downside risk protection and diversify your portfolio. And a savvy options trader could generate substantial returns.
On the other hand, options trading can be much riskier than buying individual stocks, ETFs or bonds. Predicting stock price movements can be difficult and if your guess about a particular security turns out to be wrong, options trading could expose you to serious losses. For that reason, it's important to consider how options trading aligns with your overall goals and risk tolerance.
Options trading strategies to know
Once you've mastered options trading basic concepts, you may be interested in more advanced options trading strategies. As you become more comfortable with options trading, your investing efforts may include some of these commonly used techniques.
A covered call strategy has two parts: You purchase an underlying asset. Then you sell call options for the same asset. As long as the stock doesn't move above the strike price, you can realize profits by selling call options for the assets you own.
A married put strategy involves purchasing an asset and then purchasing put options for the same number of shares. This approach gives you a measure of downside protection by allowing you the right to sell at the strike price.
A long straddle strategy involves buying a call and put option for the same asset with the same strike price and expiration date at the same time. This approach may be used when an investor is unsure which way prices for the underlying asset are likely to move.
5 things to know before you start options trading
If you're interested in beginner options trading, keep these factors in mind as you get started.
1. Options trade on different underlying securities.
It's worth noting that while this discussion references calls and puts in relation to stocks, options can be attached to other types of securities. The most common underlying securities are equities, indexes or ETFs.
Quite a few differences separate options based on indexes versus those based on equities and ETFs. It’s important to know the differences before you start trading.
2. Options trading is all about calculated risk.
If statistics and probability are in your wheelhouse, chances are volatility and trading options will be too. As an individual trader, you really only need to concern yourself with two forms of volatility: historical volatility and implied volatility.
Historical volatility represents the past and how much the stock price fluctuated on a day-to-day basis over a one-year period.
Implied volatility is based on what the marketplace is “implying” the volatility of the stock will be in the future, over the life of the option contract.
Implied volatility is one of the most important concepts for options traders to understand because it can help you determine the likelihood of a stock reaching a specific price by a certain time. It can also help show how volatile the market might be in the future.
3. Options trading lingo
When trading options, you can buy or sell calls or puts. You can be long or short —and neither has anything to do with your height. Consequently, you can also be in-the, at-the, or out-the-money. Those are just a few of the many commonly used words you’ll hear in a room full of option traders.
Simply put, it pays to get your terminology straight. That’s why we decided to create an options trading glossary to help you keep track of it all.
4. Options traders borrow from the Greeks.
We’re not talking about Aphrodite and Zeus. Options traders use the Greek alphabet to reference how options prices are expected to change in the market, which is critical to success when trading options. The most common ones referenced are Delta, Gamma, and Theta.
Although these handy Greek references can help explain the various factors driving movement in options pricing and can collectively indicate how the marketplace expects an option’s price to change, the values are theoretical in nature. In other words, there is never a 100% guarantee that these forecasts will be correct.
5. Options trading starts with your financial goals.
Just like many successful investors, options traders have a clear understanding of their financial goals and desired position in the market. The way you approach and think about money, in general, will have a direct impact on how you trade options. The best thing you can do before you fund your account and start trading is to clearly define your investing goals.
Take the next steps to start options trading.
Trading options can add diversification to your portfolio along with the potential for higher returns. While you should be aware of the risks, it’s important to understand the benefits that this type of trading can add as well. By easing into options trading, you can quickly expand your knowledge and leave your novice status behind.
As senior options analyst for Ally Invest, Brian Overby is a widely sought-after resource for his option trading knowledge and market insights. He has contributed to numerous articles for the Wall Street Journal, Reuters, and Bloomberg, and has had frequent appearances on CNBC Fast Money and Fox Business News. A veteran of the financial industry since 1992, Brian continually seeks to improve the understanding of the retail investor. He has given thousands of option trading seminars worldwide, written hundreds of articles on investing, and is the author of the popular trading resource The Options Playbook and its free, acclaimed companion site OptionsPlaybook.com. Prior to Ally, Brian was a senior staff instructor for the Chicago Board Options Exchange (CBOE) and managed the training department for one of the world’s largest market makers, Knight Trading Group.