By Daniel Bustamante, Co-Founder and Lead Coach
We like options and we think you should too. In this short article, we are going to do a mini introduction lesson about them to get your options knowledge going.
Options are conditional derivative-based contracts that allow buyers of the contracts (option holders) to buy or sell a security at a chosen price. Option buyers are charged an amount called premium the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless, thus ensuring the losses are not higher than the premium. In contrast, option sellers (option writers) assume greater risk than the option buyers, which is why they demand this premium.
Options are divided into “call” and “put” options. With call options, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price. This is called strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price. Whether it is a call or a put, when you buy an option you have the right to do something, but not the obligation.
Why Use Options Over Stocks
So the next question should be why use options over stocks? Investors use options for a variety of reasons, but the main advantages are:
- Buying an option requires a smaller initial outlay than buying the stock.
- An option buys an investor time to see how things play out.
- An option protects investors from downside risk by locking in the price without the obligation to buy.
Let’s say there is a company you’ve had your eye on and you believe the stock price is going to rise. A “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out, you get to buy the stock for less than it is selling for on the open market. If it does not, then your financial losses are limited to the price of the contract.
It is important to remember that options can be risky. However, so are all investments to some degree, be it stocks, forex, or futures. What is more important, is how you handle the risk. That is what makes all of this either work for you or against you in the long run.
You also can limit your exposure to risk on stock positions you already have. Let’s say you own stock in a company but are worried about short-term volatility wiping out your investment gains. To hedge against losses, you can buy a “put” option that gives you the right to sell a number of shares at a predetermined price. If the share price does trade lower, the option limits your losses and the gains from selling help offset losses.
So really, when you buy a call (speculating that the price of a stock goes higher) or buy a put (speculating that the price of the stock goes lower), your risk is limited to the amount you pay for the options.
If you are a beginner and want to learn to trade options, then let’s understand some basics first. Click here to watch the StockAbility StartUp Lesson 5, which covers the fundamentals of leverage.
The video you just watched is one strategy of trading options. In our opinion, it is usually an easier strategy for beginners to learn how to trade options. Now the thing to remember when you’re learning about options trading is that you’ll hear the term ‘advanced options’ thrown around all the time.
Keeping It Simple To Start
Names like Iron Condor, Verticals, Butterflies….you’d almost think you were in a science class hearing it. The key here is to not confuse this with them being ‘better’ strategies. They are more complicated to trade and the upside is limited on what you can gain. In fact, in this article, we are not even going to dive into those because it’s too much. As a beginner options trader learning to make money with one strategy is the key to start. Once you can do that consistently, then maybe consider other strategies. Although, if you are making money with one strategy why would you switch?
We discuss some of the best strategies in our OptionsAbilities course. When you expand your options knowledge, the strategies also expand so it takes a little longer than just buying or selling stocks. However, the rewards from options trading can be phenomenal.
See you next time,