Wisdom and Strategy

The Beginner’s Guide to Stock Options

We know how overwhelming it can be when you are just starting to learn about stock options. However, by understanding what they are and the basic concepts and strategies for trading them, you can quickly set yourself up for success.

What Are Stock Options?

A stock option is a contract that gives an investor the right, but not the obligation, to buy or sell a stock for a specific price by a particular date. There are two types of stock options: calls and puts. A call option gives the investor the right to buy the stock at the specified price, also called the strike or exercise price. In this case, the investor is betting that the stock will rise, and they are purchasing the option before the market price goes up. 

With a put option, the investor is buying the right to sell at a specific price on or before the date that the option expires. In this case, the investor is betting that the stock will fall, and they are protecting themselves against the downside risk.

Advantages of Trading Options

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Image via Flickr by Mike Cohen

There are several advantages of trading options, including:

  • Smaller upfront investment: The cost of buying an option is less than what you would pay to purchase the stock outright. Yet, if the trade goes the way you want it to, you will benefit in the same way as the investor who took the bigger risk.
  • Flexibility: An investor who purchases an options contract has several choices for how they can handle those options. They can purchase the shares and add them to their current portfolio, buy them and then immediately sell some or all of them, sell the “in the money” options contract to someone else, or sell the contract to another investor before it expires.
  • Lock in a price: Options contracts allow an investor to lock in a specific price for a stock for a certain period of time. They can then buy or sell at that price at any time before the market runs out.

Risks of Trading Options

There are some risks that you accept when you trade options. It’s important to note, though, that not all options carry the same risks, even if you’re new to stock options. If you’re the seller, for example, you carry a different risk than if you’re the buyer.

If you’re a put or call holder, the downside is limited to the premium of the option. If you’re the seller, though, the downside potential is unlimited, as you would be forced to sell if the option holder exercised that option. You could be forced to sell at a price higher than what the stock is worth. You could also be forced to sell at a low price when the market price is much higher.

Why You Should Consider Trading Options

While options trading can sound risky, it is no riskier than trading individual stocks and bonds. In actuality, if you do it correctly and go in with a strategy, it can be an incredibly lucrative investing opportunity. It all comes down to doing your research and understanding the factors that are impacting the market and a particular stock.

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