If you are new to trading options there are a few things that you should be aware of. Before we discuss these here is a tip. Don’t listen to people who have never traded options. Options are a viable mechanism in the financial world. They are used by the largest institutions in the world and have dedicated exchanges where they can be traded. There are differences between stocks, futures, and options. To become more knowledgeable about options you should seek out a good source of education. Whether a newbie or not to options, here are 5 things you should know before getting started.
- There are two different types of options. Put and Call
The first part of learning about options is to understand there are two types of options. One is a call and one is a put. You can buy or sell a call or put. However, for this post, we will focus on the “buying of the put and call. When you buy a put or call you to want the market to go a specific direction.
Buy a Call: You are wanting the stock to go up, you would buy the call for a premium (amount to buy the call) which would give you the right to buy the shares at a fixed price by a certain date in the future. You could use these two ways. If you are wanting to own the stock but do not want to pay for an amount of the share unless you are sure it is going higher, you buy the calls and if the price is higher than your purchase price (strike), then you can exercise the “right” to shares and own the shares outright. The other way to use them is to close out the call after the price rises thus increasing the amount of premium. If you paid $5.00 (Premium) to buy the call and sell the call later at $6.50 (Premium) then you have made $1.50 or 30% on your money invested. Not bad.
Buy a Put: Buying a put is the opposite of buying a call. You are wanting the stock to go down, you would buy the put for a premium (amount to buy the put) which would give you the right to sell the shares at a fixed price by a certain date in the future. A way to use them is to buy a put if you feel the stock will fall by a certain time in the future. You could close out the put after the price falls thus increasing the amount of premium. If you paid $5.00 (Premium) to buy the put and sell the put later at $6.50 (Premium) then you have made $1.50 or 30% on your money invested.
- Options are a derivative
A derivative is a fancy word meaning based on another source. In other words, options are based on other trading instruments in the financial world. The most common instruments are Stocks and Futures. It’s important to understand that you can use options to trade some of your favorite stocks and futures. Also, you will need an underlying instrument to be able to have an option to trade.
- They do not trade like a stock
In the example of buying a put and call trading options is not like trading a stock. If you were to buy 100 shares of XYZ stock that are trading at a price of $100 it would cost you $10,000 to own the 100 shares. The only way you could make money is if the stock increased in price. In options, you can have the right (Call Option) to buy the shares at a fraction of the cost. This is a way to stick your toe in the water without laying down $10,000. There are also ways to take advantage of a sideways market with options, but we will save that for another blog post.
- Options are leveraged
In the example of buying a call if you paid $5.00 (Premium) to buy the call and sold the call later at $6.50 (Premium) then you have made $1.50 or 30% on your money invested. The stock value would not need to rise very much to realize a nice gain in the option value. If you were to buy 100 shares of XYZ stock trading a $100, you would need to see the stock rise $30 to realize the same 30% gain. That is called leverage.
- Learning Options is a skill
Once you have learned options you have learned a skill for a lifetime. Options are based on simple principles that have not changed since their inception. Options price is what changes and that is based on the stock price and volatility. Buy learning options and applying your skills you can take advantage of the change of price and volatility to gain.Bonus: You don’t have to start at a screen all day to trade options
You may have a job or other obligations in life that doesn’t allow you to sit in front of the computer screen all day to trade options. The good news is you don’t have to do that. Options use time periods (expiration dates) and these time frames allow you to take the trade and let time help you with the trade. Checking the trades are important but don’t take a lot of time.