Options trading is a great way to diversify your stock portfolio and potentially increase the return on your investment. But what are options? How do you trade them? What’s an options broker, and how do you find the best one for your needs?
In this article we’ll answer these questions and many more, so that by the end of it all you’ll be ready to start investing in options.
What are options?
Options are a type of derivative security that provide the holder with the right but not obligation to buy or sell an underlying asset at a certain time for a certain price. Derivative securities are any securities whose value is derived, at least in part, from the price of another security or asset.
In other words, an option is the right to buy or sell a security at a specific price and on a certain date.
What is options trading?
Options trading is about buying and selling these options contracts. It’s what investors do when they want more control over their investments, such as using them to hedge against losses on other investments. When an investor buys a call option on shares of IBM, for example, he or she has the right to buy 100 shares at $100 per share by Sept. 21.
The best time to sell your options is when they are in-the-money (ITM). This means that if you sold one contract with a strike price of 110, you would have the right to buy 100 shares at $110 per share.
When your options are out-of-the money (OTM), you can exercise them if they become ITM before expiration day and sell them otherwise. With an OTM contract with a strike price of 120 like this one, for example, you would have the right to buy 100 shares at $120 per share but you would only want to exercise your options if they become ITM and sell them otherwise.
What are the different types of options
There are two types of options: call and put.
A call option gives you the right to buy shares at a specified price up until expiration day, or before if they become ITM. A put option is the opposite; it gives you the right to sell 100 shares on an exchange with usual trading hours (i.e., Monday through Friday) based on a specific price up until expiration day, or before if they become ITM.
Short-term options vs long-term options
Short-term options are used to speculate on a stock for an expected move in the near future. Long-term options cover periods of more than one month, and they are typically used by investors who want exposure to stocks without owning them outright.
An investor might use long-term call options when he or she expects that there will be a significant price increase for the underlying stock in a short period of time, and wants to have exposure to it without actually owning it.
An investor might use short-term put options when he or she expects a sudden drop in the price of an underlying security, and wants to have some downside protection without having to sell it at that time.
What are the benefits of using options?
Options can be a valuable tool for investors looking to diversify their stock portfolios. Options are also less expensive than many other investments, such as stocks and bonds.
- The risk of loss is limited because the maximum amount that you could lose in an option trade is equivalent to the price that was spent on the contract itself. For example, let’s say that you buy a $25 option for stock XYZ. If the price of this particular stock goes to 0, then your loss is limited to the amount spent on this contract – in this case only $25. In contrast, if you invest directly into stocks and there are any losses incurred because the company performs poorly, the entire investment is lost.
- There are more favorable tax implications: Options trades treat the gain or loss on each transaction as a separate event. This means that your profits are not taxed at higher rates and you’re also not subject to short-term capital gains, which is an additional tax imposed on investments held for less than 12 months.
- An investor can buy an option without ever owning any shares in the company or having to invest their own money if they are not comfortable with that.
- When an investor exercises the option, they can sell it for a gain and then offset their losses from stocks or other investments in order to reduce taxable income.
- If you exercise your call options before they expire (a few days after), all of the capital gains are tax free as long as you do not sell the shares before they are sold by your broker.
- When you exercise a put, all of the capital gains within that period are considered to be short term and therefore taxable at ordinary income tax rates.
What are the risks of trading options?
There are also risks involved in trading options:
- The risk of making a mistake in the timing as to when an option should be exercised.
- You can lose all your invested capital if you sell options with too little time left before expiration and they go against you.
- Selling naked options without buying them first is risky because it puts the investor at risk for unlimited loss.
- In the event of a stock split or dividend, an option’s price may be cut in half.
- A company can go bankrupt and not meet its obligations to purchase options from investors which could lead to unlimited losses for those who bought that option.
- There are no guarantees about how well stocks will do.
- The option writer has the obligation to sell shares of stock if an investor decides to exercise his or her options.
- An employee who sells company stock is prohibited from buying it back for six months, but this restriction doesn’t apply to selling their right on that same stock through a call option.
What are some strategies for options trading?
Options trading strategies are complicated. You should consult a professional before you make any decisions about investing in options, particularly if this is your first time investing.
What to know before trading options
Following are some of the things you should know before you start trading options:
- Because options are so complicated, it can be difficult to tell when an option is a good investment.
- Trading options may seem like the easiest way to make money from your investments, but you could also lose lots of money very quickly if things don’t go as planned.
- There are many different types of options available in the market. You may want to focus on a few of them, but it will help if you have an understanding of all the different types before you start trading options for real money.
- Options can be difficult to understand and work with because they are so highly specialized. It’s important that as soon as possible after purchasing an option, or any other security, that you work with a professional who can help you make sense of it.
What is an options broker?
Options brokers are people or organizations that act as middlemen between the trader and the exchange where they buy and sell options. Brokers provide an important service to traders because without them, they would not be able to trade on many different exchanges at once.
Some brokers specialize in certain types of trades like retirement accounts or penny stocks; others offer all kinds of services.
How to pick the best options broker
To pick the best options broker, you’ll need to understand what your own needs are. Do you want a full-service brokerage or just something basic? Will this be for investing in retirement accounts? Or do you need help trading penny stocks? Some brokers have special licenses and can only trade securities like bonds while others will offer services specific to retirement accounts like mutual funds and 401ks.
A good way to find a reputable broker is by looking at which ones the exchange recommends and checking if they are US regulated brokers with specific licenses in order to trade securities (which most likely means that their customers won’t get ripped off).
The exchanges also have a website that lists their recommended brokerages, so it’s easy to find one and start trading.
Where to learn more about options trading
Several online training programs are available for options trading, including websites like Investopedia that teach you the basics of how an option works, what a call is and more.
One such program is Raging Bull, a company co-founded by Jeff Bishop in 2014. Bishop claims the program will teach customers how they can become millionaires through stock trading, including options trading. Bishop and other founders face legal problems. Federal regulators say the company operators have defrauded consumers out of more than $137 million over the past three years.
Check out I Buy I Review’s look at Jeff Bishop and Raging Bull here.