If you’re thinking about investing your hard-earned cash, you might feel overwhelmed by the different investment opportunities out there. Stocks, bonds, mutual funds—even experienced investors using a brokerage account (more on this below) need to conduct in-depth research (known as ‘due diligence’) to decide the best place to put their money.
Perhaps you’ve come across the term ‘options investing’ during your research. Also called ‘options trading,’ options investing is a little more complicated than merely investing in stocks or bonds. Getting into this type of trading requires research and a basic understanding of its popular strategies—otherwise, you risk wasting your money and could end up feeling like a fish out of water.
That’s why we’re here to give you the run-down on options investing.
So, what exactly is an option? And what are the best options trading strategies?
This article will guide you through these questions. I’ll explain:
- What options investing is
- What the best options trading strategies are
- Whether investing in options is a good idea for you
What Is An Option?
An option is a type of contract that enables investors to buy or sell an asset at a price, on or before a specific date. It might sound confusing but understanding the world of options investing—and options trading strategies—will give you more choices when making decisions about your own money.
The term ‘options’ refers to the contract you’re entering into, not the underlying asset you’re trading. Most options concern the trading of stocks.
What Is Options Investing?
Options investing is the act of buying (and selling) options to maximize your funds. When you buy an option, you’re buying the right to buy or sell a stock at a fixed price (the ‘strike price’) within a particular timeframe.
Options are also known as ‘derivatives.’ This is because they derive their value from the underlying stock or asset rather than having an intrinsic value of their own. Another example of a derivative is a mortgage-backed security or a currency exchange.
Let’s break this down: Say you’re interested in investing in a company whose stock price you expect to increase in the next six weeks. You’ll pay a premium for the right to have the option to buy or sell at the predetermined strike price. This premium will be multiplied by the number of shares you’re buying—usually 100.
In this example, pretend the premium is USD$5 per share, with a strike price of USD$90. You buy 100 shares for USD$500 and agree on a ‘maturity date’ set for six weeks. After this maturity date, your options will expire if the company stock price hasn’t increased, and you choose not to sell your shares.
- Outcome 1:
Congratulations! As you expected, the company stock price increases to $100 on or before the maturity date. That’s USD$10 higher than your original strike price, meaning your option is now ‘in the money’ (in profit) by USD$10 per share.
Because your shares are now worth more than you paid for them, you’ve made a profit of USD$500. That’s USD$10 profit per 100 shares ($1,000) minus your initial investment of USD$500.
- Outcome 2:
Unfortunately, you’ve misjudged it this time, and the company stock price has decreased. Fortunately, it doesn’t matter if the price has merely dropped a little or outright plummeted. Once your maturity date has arrived, your options will simply expire. That means you’ll lose the money you spent on them in the first place, but no more than that amount, even if the share price has declined.
It’s important to remember that an option is the right to buy or sell shares, not the obligation. Therefore, you’ll never lose more than your initial investment.
What Do Brokerages Have To Do With It?
Making sure you select the right brokerage is critical with options trading. I don’t recommend going with a broker that simply offers you the lowest cost either. You’ll want a broker who obviously offers options trading but does so with tools and resources that support you being successful.
A great example is E*TRADE. E*TRADE doesn’t necessarily have the lowest prices, but they were the first major online brokerage (so they have a lot of experience). They offer options trading, and they have a plethora of tools and resources (like advanced charting) to help you become successful with options trading.
So, in short, make sure you choose a well-rounded brokerage before you start buying and selling options.
What Types Of Options Are There?
To make matters more confusing, there are two different types of options: a call option and a put option. The type of option you’ll invest in will depend on whether you’re buying or selling an asset.
1. What Is A Call Option?
A call option allows an investor to buy assets (such as stocks, bonds, securities, or a commodity) within a settled timeframe. In the example we gave above, you were investing in a call option. This is because you were investing in your right to buy 100 shares at the predetermined strike price you originally paid, regardless of whether the company’s value increased or decreased in the six weeks before your maturity date.
As with any investment opportunity, there are several factors you should consider when deciding whether to buy a call option. These are the terms you’re likely to encounter when negotiating one:
- Trade amount. This is the maximum amount of money you’re happy to spend on your call option.
- The number of contracts you want to buy. Each share technically constitutes a separate contract, so this is another way of asking how many shares you want to buy. Many investors choose to purchase 100 shares at a time.
- Strike price (also known as an exercise price). The owner of the call option can decide on the strike price, which is probably the most critical decision you’ll have to make. Whether you choose a strike price above or below the current value of the stock price will depend on your tolerance for risk.
- Call options price. This is the overall cost of the premium x the number of shares you buy. For example, if you buy 100 shares at a premium of $5, your call options price will be $500.
- Maturity date (also known as the expiration date). Along with the strike price, this is one of the most important decisions you’ll have to make. Investors can choose their maturity date, so think carefully about the timeframe you want.
2. What Is A Put Option?
A put option is the opposite of a call option. Although the basic principle is the same, this option gives you the right to sell assets rather than buy them. You’ll pay a premium for this right, which means you can ask the person or company that sold you the put option (known in investing terms as ‘the writer’) to repurchase it at the fixed strike price before an agreed maturity date. In this respect, it’s more of an insurance policy than an investment opportunity.
As with a call option, you’re not obliged to ask the writer to pay you the strike price. Doing so is simply a way of protecting yourself should the share price of your portfolio drop.
To give another example, let’s pretend you have 100 shares, at USD$100 per share, in your investment portfolio. The company has recently hit some stumbling blocks, and you’re worried that the share price will decrease in as little as a month.
An excellent way to mitigate against the dropping share price is to purchase a put option. There are two choices available to you: a covered put option and an uncovered put option.
- Covered Put Option
You choose to buy a put option that will give you the right to sell your 100 shares at USD$100 (their current value) at any point in the next four weeks. You negotiate a strike price of USD$3 per share, which means your overall option price is USD$300.
Again, there are now two possible outcomes:
- The first outcome is that you were right, and the stock price does drop. No matter how much its value decreases, you’ve guaranteed that you can sell your shares for their original value of USD$100. This means you’ll only lose the $300 you paid for your put option.
- The other outcome is that your shares retain their value. Here, you can choose not to sell your shares. You’ll have lost your $300, but you knew you would anyway—it’s the price you paid for peace of mind that you wouldn’t lose more than USD$300.
As you already own the shares you’d be selling, this is an example of a covered put option.
- Uncovered Put Option
An uncovered put option, on the other hand, is one that covers assets you don’t already own. When you purchase this type of put option, you must buy the shares before exercising your right to sell them. But while you’ll be able to buy them for their current value, you’ve purchased the right to sell them for their initial value.
In other words: if you bought an uncovered put option for the shares we mentioned in the example above, you would buy the 100 shares at the price to which their value had dropped. The writer would then have to repurchase them off you for the USD$100 you initially spent on them. The lower the share price drops, the higher your profit.
What Is The Best Strategy For Options Trading?
Now that we’ve explained how options investing works, let’s look at some of the most popular options trading strategies.
As with any investment opportunity, the most suitable options trading strategies for you will depend on various factors, including:
- How risk-averse you are
- The funds that you’re planning to invest
No investment is entirely free from risk. By law, investment opportunities are bound by the regulations of the Securities and Exchange Commission. These regulations state that investors must be given clear and accurate information about the opportunity, with regular reminders that their capital is at risk when they invest.
Before we look at the most popular options trading strategies in more detail, the most critical strategy is to steer clear of any opportunity that promises ‘guaranteed returns.’ Returns are never guaranteed when investing, so this is likely a scam.
1. Covered Call
A covered call strategy is a popular choice for investors and is generally considered conservative.
To follow this options trading strategy, you would buy an underlying asset (for example, 100 shares) while selling call options on that asset. This creates additional revenue for you without increasing the risk.
2. Naked Call
A naked call strategy is an alternative to the covered call (and is sometimes known as the ‘uncovered call’). With this strategy, you would sell call options on an underlying stock without owning that stock. Your investment returns come in the form of the premiums that your buyers pay upfront for your options.
This is a much riskier strategy than the covered call. While your profit caps at the cost of your premiums, your losses are potentially unlimited. That’s because you only make money if the option expires on its maturity date. If the value of the shares increases and your buyer purchases them for their original price, you’ll lose the same amount of money by which the price has increased—land this is potentially unlimited.
3. Married Put
A married put is like a covered call. Instead of buying underlying assets while selling call options, you would purchase underlying assets while also buying put options.
This is an excellent strategy to mitigate the risks associated with holding stocks, as you’re protected from any dramatic drops in value. It’s one of the safest options trading strategies as it doubles as an insurance policy.
4. Bull Call Spread
When following the bull call spread strategy, you would buy call options at a fixed strike price while selling the same number of call options at a higher strike price.
The call options should have the same maturity date and be tied to the same underlying asset. This is a good strategy to take if you anticipate a modest increase in the asset value.
A bull call spread is one of the most attractive options trading strategies for many investors. Although it caps your potential gains, it also caps your potential losses. You can calculate your max losses by multiplying your net premium by the number of contracts or options that are issued.
Is Options Trading A Good Idea?
Whatever your options trading strategies, options investing is often considered more complicated than merely trading in stocks. While it may be a little more challenging to understand, numerous benefits to options investing can make it a great alternative—if you understand the process.
You may have to apply to become an options investor to a regulatory body before you start. This is to prevent people with little to no investing experience getting in over their heads.
What Are The Advantages Of Options Investing?
- You don’t need large funds. Options investing doesn’t require high capital, and the amount of money at stake can be relatively low (at around USD$1,000). This is because many investors are speculating about marginal increases and decreases in share price.
- The risk-to-reward payoff is attractive. Depending on which options trading strategies you choose, it’s possible to minimize losses while enjoying potentially uncapped profits.
- Options contracts are a great leverage tool and allow investors to speculate while minimizing risk. In investing, leverage refers to using borrowed capital to fund future investments and (hopefully) increase returns. Options contracts are cheaper than buying the underlying asset. However, by purchasing options, you can still benefit when the price of the underlying asset fluctuates.
What Are The Disadvantages Of Options Investing?
- Low liquidity. At any one time, an individual stock will have multiple options trading at different premiums and with different maturity dates. This means your option will have a low level of liquidity (the extent to which an asset or stock can be bought or sold without affecting the underlying value of the asset).
- Potentially uncapped losses. Although your payoff can be attractive, this entirely depends on which options trading strategies you choose. Because options are derivatives, it’s difficult to predict profits and losses accurately. With some options trading strategies, your losses could be unlimited, as there’s potentially no limit to the percentage increase of a stock’s value.
- Time decay. Every option, whether it’s a call or put option, is subject to time decay. This means you lose the time value of your stocks while you hold them.
- High commissions. Per every dollar you invest, you’ll pay more in commission fees than other investment opportunities. These indirect costs come from the high spreads seen in options trading. A spread is created when investors purchase options while selling them, like in the bull call spread strategy.
Options investing is notoriously complicated. It’s crucial that you feel comfortable with the terminology, options trading strategies, and potential outcomes before starting. However, it’s possible to trade in options with smaller sums of money than what is typically required by other investment opportunities, such as equity.
Whether you’re already a savvy investor or just starting, hopefully this article has given you an understanding of the world of options investing. Like any investment opportunity, options trading strategies aren’t for everyone—but if you have some experience, it could be worth discussing your strategy with a broker or financial advisor.
Author: Chris Muller
Chris Muller is a professional personal finance writer who has written for some of the largest financial publications in the world. Chris brings a BBA and MBA in Finance, along with a decade of experience in the field, to help break down complex financial topics into easily digestible pieces through his written content in an effort to assist others in better managing their finances. Chris is currently in pursuit of FI/RE, is an aspiring minimalist, loves craft beer, and is a dad two to kids.