When it comes to investing, some of the options can seem a bit scary to those who are just beginning. They want to make some good decisions with their investments, but the market may be too complicated, they may worry that they are taking on too much, or they don’t have the capital to spend when they want to. This can be especially true with the stock market, where things can go up and down pretty quickly and it is easy to lose a lot of money in a short amount of time. But when you work with options trading, you will find an investment choice that fits your needs and can help you earn money, no matter which way the market is going.
Options trading is a great place to start when you want to get into an investment no matter how the market is doing. As with any type of investment, there is a certain amount of risk involved and options trading is no different. This doesn’t mean that you will always fail until you become an expert, it just means that you need to learn how to avoid these risks.
What is Options Trading?
The first thing that we will take a look at is what are options and how you can start trading in them. While there are many different parts that are available with this kind of trading, it is important to understand how they will work on a basic level. They are complicated and understanding this from the beginning is so important, but for those who are interested in learning more, it can be a great way to make money in the market.
What are the options?
If you take a look through the profile of an investor, you will see there are a lot of different investments present including mutual funds, bonds, and stocks. In some portfolios, you will also see options, but this one is not as well defined as some of the others. An option is basically a contract that will give you the authority to buy or sell an asset or security, such as a bond or a stock. Think of it like getting a key where once you use that key to open up the front, the house becomes yours. You don’t technically own the house just because you have the key, but you do have the option to use the key any time that you want and even have the house.
Options are going to cost a fixed price for a certain length of time. This length can vary depending on the options that you are working with. Some will last for a whole day and others may last for years but you will know about this when you make the purchase. As the buyer of the option, you will not have an obligation to use it, but if you are the seller and you have someone who would like to purchase it, you have to sell the option.
There are several different types of assets that will fit under the category of options. Some of the most common types of options include:
Bond: a bond is a debt investment where the investor will loan out some of their money to a company or a government. Then this money can be used for many projects by the second party, but they will have to pay it back after a certain length of time with some interest on top. Government bonds are the most popular types and they are traded on the public exchange. These can give you the option to sell or buy a bond at a specific price by a certain date.
Commodity: another option is to work with commodities. This is going to be any basic good that is used in commerce like grain, oil, and beef. When they are traded, there is a minimum of quality that they will need to meet. This is a popular option to use because commodities are going to be tangible which means they will represent something real.
Currency: this would be any type of money that a government will issue like paper money and coins, although Bitcoin and cryptocurrencies are joining in the game as well. The exchange rate of these currencies, especially digital currencies, will change quite a bit in a short amount of time.
Future: This is similar to commodities, but there will be some specific guidelines concerning how the item will be delivered, the date, quality, quantity, and price. Both parties need to fulfill the contract to get it to work. A futures option is going to be a contract that will allow a person to sell or buy an asset at the futures price at a later time, but there won’t be an obligation.
Index: An index is going to be a group of securities that are imaginary and will symbolize the statistical measurement of how those will do in the market. These aren’t really tangible at all and it gives you the right to sell or by the value of the index at the exercise price before they expire.
Stock: stocks are going to represent a certain number of shares in a company. You can own a certain percentage of the shares, but instead of running that company, you will let other management do that while you make some profits each quarter when the company does well.
Working with your call and put options
When you are working with options, there are two things that you can do including a call and a put option. A call option is often used as a deposit for use in the future. For example, as a land developer, you may want to have the right to purchase a lot later in the future, but you only want to do this if the right zoning laws are in place. The developer would purchase a call option from the landowner of their choice for $250,000 (or whatever price they agree on) within the next three years.
Now, the landowner has to get something out of it too and they won’t provide the option for free. The developer in this situation would need to add a down payment to everything to keep their rights to the purchase. This is going to be known as the premium and it is basically the price of the options contract. Let’s say that in this example the premium is going to be $6000 that the developer would give to the landowner. Then a few years have passed and the right zoning laws are finally approved so the developer will exercise their option to purchase the land at the price agreed upon, even though the value of that plot may have doubled.
It can go the other way though as well. In the other example, the developer waited around for the zoning laws to change and they never did. After three years passed, if the developer still wants the land, they will need to pay the market price, whatever that may be. The landowner will get to keep the premium that the developer gave them in the beginning in this case.
You can also work with a put option, which we can compare to an insurance policy. Keeping with the land developer, let’s say that they own a big portfolio that contains a lot of stocks, but they are worried that the portfolio may lose value because of a recession that may happen in the next few years. The developer will want to make sure that they don’t lose too much value out of the portfolio no matter how bad the market gets during that time.
In this scenario, if the S&P 500 is trading at 2500, the developer would be able to choose a put option which gives them the option to sell their index at 2500 at any time during the following two years. If during the two years the market ends up crashing by twenty percent, which is 500 points inside the portfolio, which helps them to make 250 points since they could still sell at 2250 instead of at 2000 where the market is. This still results in a loss, but not as big as it could have been.
Just like with the other option, this one is going to have a cost or a premium for the investor. If the market doesn’t happen to drop during the period where it is estimated, the premium is going to be lost.
These examples are important for demonstrating a few points. The first one is when you purchase an option, you have the right, but no obligation, to do something with it. It is possible to just allow the expiration date to go by without doing anything. However, if you let this happen, you are going to lose the whole investment, or the amount that you paid as a premium. The second point is that an option is just a contract that will deal with the asset it is covering. Sometimes they work out well for you and other times they don’t but a smart investor can make it work for them more often than not.
How do the options work?
Options are going to work in a different manner than what you will see with some of the other investment choices out there. The options contracts are going to be price probabilities of events in the future. If something seems pretty likely to occur, the option is going to be more expensive if it profits from that particular event. Understanding how this works is going to help you to understand the value of the options that you pick.
Let’s take a look at an example of how this could work by using a call option with IBM. The strike price is going to be $200 with IBM currently trading at $127 and the options are going to expire in three months. Remember, the call option is going to give you the right (although you won’t be obligated), to purchase shares of IBM at $200 anytime during the next three months.
With this option, if the stock prices of IBM end up going above $200, you will win. It doesn’t matter that we aren’t sure of the price for this particular option right now. What we do know is that this option, if it expires in one month rather than three months, will end up costing less because the chances of anything occurring during this smaller interval of time are going to be smaller. On the other hand, if this same option lasts for the next year, it is going to cost you more because it is more likely the stock price will go up to $200 or higher sometime during that year.
Let’s bring it back to the three-month expiration that we started with. Another thing that will make it more likely that you will win in this option is if the price of this stock does get closer to $200. The closer that the stock price is at the beginning, the more likely it that the event you want will happen. As the price of your asset rises, the price of the call option premium is going to rise as well, but as the price goes down, the gap between the strike price and the asset price is going to widen and the option will start costing less.
For example, if you set the strike price at $190 instead of $200, your cost for the option will be higher because it is more likely that the stock will reach $190 instead of the higher price. If the strike price is $230, your options price will be worthless because it is less likely that the option will get that high.
Why Should You Trade in Options?
Some of the reasons that trading in options can be so beneficial to you as an investment include:
They are flexible: When it comes to working with options, there is a lot of flexibility. You can choose to sell or buy, you can pick out different expiration dates, use different assets and strategies, and even choose your strike prices. It is even possible to profit when the market goes down. Sometimes the flexibility will make options complicated, but if you are knowledgeable about what you are doing, this flexibility helps you to profit no matter how the market is doing.
You don’t need a lot of money: Some people have trouble getting into the stock market because they don’t have the right amount of money. Stocks can be expensive but stock options are cheap. It is possible to make quite a bit of money just by starting out with $1000, which is something that is hard inside the stock market. Plus, when you don’t have to put in as much money, you won’t be able to lose as much in the process.
Gain leverage: To keep it simple, having leverage is a big advantage. Inside of this type of trading, you will gain leverage because you will give yourself more options compared to what you would get in the stock market for the same cost. You can get a good amount of returns with options so this is a positive as well.
Low-risk: It is possible to work with options that are low-risk. First, these options are often affordable so that helps to limit the risk that you take and if you use the right strategies along the way, you can reduce your risk even more. You can even choose to go with some trades that aren’t considered too risky so you don’t have a chance to lose as much while you learn the ropes.
Lots of benefits compared to stock trading: If you have been thinking about whether to get into options trading or stock trading, there are a few benefits of going with the former. To start, options trading is considered more profitable. A small movement in the stock market can proportionally affect options way more. For example, sometimes the stock market will only move at 1 percent while the option is going to move at ten percent. If you make the right decisions and pick a good option, you could make a lot of money. In addition, while the stock has to go up for you to make money, it is possible to make a profit with options no matter what way they go; up, down, or not moving at all.
While working with options can be a little tricky when you first get started because they do work slightly differently compared to some of the other investment types that you are used to (which other investments allow you to make money even when the market goes down?), but there are so many benefits to getting to use them.
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