CNBC is calling becoming an options trader “the new sports betting.” And if you’ve seen how many ads there are for sports betting on television today, you know the rising popularity of options trading is serious.
So, why is it becoming so popular?
It seems that people took a keen interest in the financial markets and began embracing the concept of options trading during the pandemic lockdown. One trader that CNBC spoke with said, “People were stuck at home … and no sports to watch or bet on. So they went to the stock market, then realized that options have similar payoff structures to sports bets.”
These new investors realize that in the options market, there is money to be made on volatility, or the price increases and decreases happening in the stock market.
Another reason options trading is becoming popular is that investors realize that you can trade stock options with much less money and less risk (if you know what you’re doing) than with stock trading, where investors are purchasing the actual stocks themselves.
With the significant rise in the number of options traders out there, we’ve written this article to provide an introduction to options trading. Inside, you’ll learn what an option is, what options trading strategies look like, and some next steps you can take to get started.
What Is Options Trading?
At first glance, options trading can seem complicated. But trading options, especially after you’ve educated yourself, can be one of the most reliable ways to generate extra income for retirement.
First, you need to understand what an option is and then layer on some foundational strategies.
The Basics of Options
The easiest way to define an option is to think of it as a mini-contract.
Options contracts give the purchaser the right, but not the obligation, to buy or sell an underlying asset — usually a stock — at a predetermined stock price until a predetermined date in the future.
Just like other derivatives, an option derives its value from the underlying security. Some investors who use options are trying to harness the power of the underlying stock’s price fluctuations. And others are leveraging the risk management power within options trading.
The type of option an investor uses will be determined based upon an investor’s predictions about the future of the underlying asset’s market price.
Two Types of Options
The two most common types of options are call options and put options. Both types can be bought and sold.
Which types you buy is all about what you anticipate the market price of the underlying stock will do.
Expecting the current price to go up? Buy a call option.
With call options, the option buyer purchases the right (no obligation here) to buy a specific number of shares at a preset strike price any time before the expiration date. Purchasing a call option essentially locks in a buy price if the underlying stock should ever reach that market price.
The person who sold the call option must sell the stock to the option buyer if the buyer exercises the option.
Expecting the price to go down? Buy a put option.
On the flip side, the buyer of a put option obtains the right (again, no obligation on the buyer’s side) to sell a certain number of shares at the predetermined strike price in the time frame before the expiration date.
The options buyer becomes protected from a loss should the price of the stock decrease.
Again, the person who sold the put option must buy the stock if the option buyer exercises the option.
Example: The Hunch
Let’s break it down using an example.
Imagine that you have a hunch about Tesla (NASDAQ:TSLA) stock when it is trading around $700 per share. Your hunch tells you that the market price of Tesla is about to shoot even higher.
In this case, you would buy a call option to purchase 100 shares of Tesla stock for the strike price of $700 up until some point in the future, also known as the expiration date of the option.
You pay a fee, called the premium, to have this option.
If Tesla shoots up to $730 before the option expires, you can exercise your option and purchase the stock for $700 per share. You have the opportunity now to turn around and sell those shares at the market price of $730. With 100 shares in play, that’s a profit of $3,000 ($30 per share on 100 shares), less the premium paid, of course.
If Tesla stays at $700 or the price declines, you only lose the premium.
Example: The Hedge
Another way investors can use options is to manage downside risk in the stock market. When used correctly, buying a put option can reduce uncertainty and cap losses without any significant impact to your rate of return.
If you own a stock with a market price that is declining or is expected to decline, you might use options to limit your risk.
For example, if you own Tesla and you expect that the price might dip in the near future, you can purchase an option to sell a portion (or all) of your shares at a certain price so that you limit your losses.
Is Becoming an Options Trader Right for You?
Now that we’ve outlined some of the basics of options trading, it’s time to think about whether this sometimes complicated trading strategy is right for you.
There are a few things you’ve got to possess if you’re thinking of becoming an options trader.
First, a general understanding of financial markets is a must. This involves a commitment to educating yourself about new strategies like condors, straddles, and bull call spreads. The more you know the better able you will be to lower your risk and improve your return on investment.
Next, knowing your own risk tolerance as a trader is critical. This ultimately determines the types of trades you’ll be comfortable executing. Is your risk tolerance aggressive, moderate, or conservative?
For many investors saving for retirement, trading options is more marathon than race. Why? Because at the end of the day, the goal is to accumulate as much money for retirement as possible. So keeping this in mind helps those types of investors to make better decisions within every trade.
One more really important skill to have in your options trading arsenal is knowing when to seek the right advice. While it’s very important to feel confident about selecting the right options contracts on your own, knowledge is power. And unless you are the best trader on the New York Stock Exchange, you can likely use some extra knowledge when entering into new options trades. When investors perform their own due diligence and combine that with professional seasoned advice, that’s when the real magic can happen with options trading.
Take the First Step Toward Becoming an Options Trader Today
So now you’ve got a basic understanding of what an option is, what options trading looks like, and some tangible next steps to get started. With that foundational understanding – even if you’ve never traded anything other than stocks — you should feel more confident that being an options trader is within your reach.
Continue building on this foundation by subscribing to Investors Alley’s “Options Floor Trader PRO” newsletter. You’ll find actionable advice to get started as an options trader today.