One of the golden rules of the stock market is that diversity is key. Putting all your eggs in one basket, or just investing in one stock group, means that you’re at great risk of having your entire portfolio wiped out In the case of an unexpected crash. One way that many stock traders create diversity in their portfolios is by owning different asset classes, or via basket trading with tools like StockOdds. An asset class is a type of investment and include stocks, bonds and exchange traded funds (ETFs). Options are another asset class and learning how to trade options will help you develop your trading skills and generate further income.
What areoptions?
With regular stocks and securities, you buy and sell at whatever the market price is at whatever volume you feel is going to help you generate the most profit down the line. Options are a contract to buy or sell a set amount of a stock at a pre-determined price at any time during the length of the contract.
The key difference to know between owning options and owning stocks is that with an option, you don’t get an ownership stake in the company until you activate the option. Options are also considered one of the lowest level risk because you don’t have to take advantage of them if the market takes an unexpected turn; this makes them a useful for beginner stock traders with smaller portfolios that are more at risk from small market fluctuations.
What is options trading?
There’s no such as a free lunch on the stock market, and the way that options generate money for the seller of the option is that you’ll pay a fee for creating the contract. There are two classes of options contracts: call options, which give you the option to buy stocks at a set price, and put options, which give you the option to sell.
Call option basics
A good example to understand the call option process is to think of a housing development. As an investor, you might be offered a new house in a new development for $300,000 as long as you put a down payment of $20,000 right now. If the houses get built and the market value is $500,000, you’ll activate your option and flip the home for a $200,000 profit. However, if the market value comes out at $200,000, you choose not to activate it and only take a $20,000 hit. It’s also possible for the contract to expire before you make your decision, in which case you still lose your deposit and have to pay full market value.
Put option basics
While call options allow you to buy stocks at a pre-determined price, put options allow you to divest some of your portfolio in the same way. In this scenario, think about the put option as an insurance contract. You pay $1000 to take out an insurance payment on a $30,000 car for two years. After 18 months, your car has depreciated to $22,000 and you get into a crash, writing the car off. Your insurance pays out $30,000 as that is the pre-determined value of your car regardless of current market value. In the same way as call options, if your contract expires without you exercising the option, the contract dealer keeps your “insurance premium” in any case.
How to trade options
Learning how to option trade is a skill you will develop fairly quickly in your trading career. The mechanics of the trades will be handled through whatever brokerage system you use to make your trades in real time stocks. You’ll also find that you’ll be more in the market for buying call and put options as these have relatively little risk for buyers as you don’t have to exercise the option to buy or sell the shares. Selling options is an advanced technique for those with more capital to risk. You can see that there’s money to be made each time for creating the actual contract, but you are also committed to buy or selling at a detrimental price if the options purchases exercises their right.
How are options valued?
Given the basics outlined here, you may be wondering why everyone doesn’t buy options all the time as a low risk way of making money on the market. The answer is the way in which options are priced. You can strike an option with as long a contract as you like, and the golden rule is that the longer your contract, the more likely that the market is likely to shift in a way that benefits the buyer of the option. Therefore, longer term options increase exponentially in price, reducing your profit margins. However, a short term strike means you have to rely on significant short term shifts to make your option investment worth it.
Option trading techniques
As with everything in the stock market world, there are many ways to trade options. Some common combination methods include:
- Straddle – this one of the key swing trading strategies for options, and occurs when you buy a call and put option with the same stock and same expiration. It effectively protects you against a heavy loss and works well if you think the market will shift dramatically but you don’t know which way.
- Spread – this is where you’ll buy a call and put purchase in the same stock at different prices and different expirations. You make your money by exercising both at the point where the profit of selling outweighs the cost of buying.
- Butterflies – this is a series of three equally spaced strikes of the same type (call or put) with the same expiration. A successful butterfly sells the middle strike and buys the outer two (hence the name).
This information is intended as an introduction to options, but to learn trading strategies discussed here, you should take a trading course. This will allow you to further investigate the strategies and play with training data to see how you can use options as another technique in your trader toolbox.
