An option is a financial contract that grants the holder the right, but not the obligation, to buy or sell an asset at a predetermined price before a specific expiration date. If the asset’s performance does not meet expectations, the option simply expires, and the holder loses only the premium paid for the option. Though considered a relatively low-risk investment, options trading involves certain costs and requires precise timing and keen market awareness to succeed.
Understanding Options
For investors seeking to lock in a price for a stock without immediate purchase, options provide a strategic solution. This approach allows traders to observe the stock’s performance before committing to a purchase. Options trading has gained popularity in recent years, not only among professional traders but also among ordinary investors. In 2020, options trading reached a record level, with 7.47 billion contracts traded, according to the Options Clearing Corporation.
Despite their growing popularity, options remain a complex concept for many investors. However, they are relatively straightforward once the terminology is understood. An option is a derivative contract between an investor and a brokerage, with its value based on an underlying financial asset, such as a stock. This contract provides the right to buy or sell the asset at a specific price on or before a specified date.
Types of Options
There are two main types of options: calls and puts. A call option gives the holder the right to buy an underlying asset within a certain period, while a put option grants the right to sell the asset within the same timeframe. The cost of the option, known as the premium, depends on several factors, including the strike price (the price at which the asset can be bought or sold) and the expiration date. Generally, options contracts are for 100 shares of the underlying security and typically run for no more than nine months.
Call Option Example
Suppose you purchase a call option for a tech company with a strike price of $500 and an expiration date one month from now. If the premium is $10 per share and the contract covers 100 shares, the total premium cost is $1,000. If the stock price rises to $600 before the option expires, you would profit $100 per share, or $10,000 in total, minus the $1,000 premium.
Put Option Example
Conversely, if you buy a put option with a $500 strike price, anticipating the stock will decline, and the stock price falls to $400, you would again profit $10,000 (minus the premium) since your strike price is higher than the market price at expiration.
If the stock does not move as hoped, the option expires, and the only loss is the premium paid. The main advantages of options trading include rights without obligations, the ability to hedge risk, and potential income generation through selling options.
Benefits of Options Trading
Rights Without Obligations
Options trading grants investors buying or selling rights over particular shares, without the cost that comes with actually buying those shares outright. This strategy allows investors to gain control over stock positions without immediate full investment, making it an attractive option for those looking to maximize leverage.
Hedging Risk
Options can be used to hedge against potential losses in other investments. For instance, if an investor owns a substantial amount of stock in a particular company, they can purchase put options to mitigate potential losses if the stock price falls. This strategy provides a safety net, as the put options can offset losses from the declining stock price.
Generating Income
Investors can generate income through options by selling puts and calls. Selling call options involves collecting premiums from buyers who wish to purchase the underlying asset at a specific price, while selling put options involves collecting premiums from buyers who wish to sell the underlying asset at a specific price. This income generation strategy can be particularly effective in a stable or slightly bullish market.
Risks of Options Trading
Premium Loss
The most straightforward risk in options trading is the potential loss of the premium if the asset does not move in the desired direction. This means that an investor could pay for multiple premiums without ever seeing a return, leading to cumulative losses.
Timing and Market Predictions
Options trading requires not just accurate predictions about the direction of the market but also the timing of these movements. For example, if an investor accurately predicts that a stock will rise but the option expires before the rise occurs, the opportunity is lost, and the premium is forfeited.
Transaction Costs
Options trading incurs costs such as premiums and commissions to brokers. These costs can add up and need to be carefully considered against potential profits. High transaction costs can eat into the profits from successful trades or exacerbate losses from unsuccessful ones.
Where to Trade Options
Options trading is most suitable for experienced retail investors who carefully research their trades and have a predefined strategy. A growing number of online brokerages offer platforms for options trading, including well-known names such as Fidelity, Charles Schwab, and TD Ameritrade. Other popular platforms for options trading include:
- InteractiveBrokers
- TradeStation
- E*TRADE
- tastyworks
- eOption
The Bottom Line
Options provide traders with the flexibility to buy or sell shares at a predetermined price without immediate purchase. They come in two main types — call (buy) or put (sell) options — and can apply to various assets, although they are most commonly used with stocks. The primary benefit of options trading is that it offers rights over stocks for a fraction of their market price, allowing investors to make strategic decisions based on market conditions without the obligation to buy or sell the underlying asset.
However, options trading carries inherent risks and is best suited to institutions and more experienced investors who employ rigorous research and predefined strategies. If used judiciously, options can be a powerful tool for profiting from market movements. Investors should set clear profit and loss targets for every options trade to manage risk effectively. As Edward Moya advises, “Investors should ideally have predefined profit and loss targets on every options trade.”
By understanding the mechanics and risks of options trading, investors can harness their potential to enhance their investment strategies, offering both flexibility and the opportunity for significant returns.