Options trading is a lot different from trading stocks or mutual funds, but it can come with some real advantages for investors. But what is options trading? In this article, we'll take a look at what options trading is and how it might fit into your investment strategy.
The basics of options To trade options, you first have to know what they are. An option -- also known as a stock option or equity option -- is a contract between a buyer and a seller relating to a particular stock or other investment.
The buyer of the option has the right to force the seller of the option to do whatever the contract specifies within the period of time set by the option. Once the buyer exercises the option, the seller must follow the instructions set by the option.
What Is Options Trading? Examples and Strategies
For example, a call option on a stock gives the option buyer the right to buy a set number of shares at a predetermined price at any time before a specified expiration date.
The option seller must sell the stock to the option buyer if the buyer exercises the option. The most important aspect of an option is that as its name suggests, the buyer of the option has the right to exercise the contract, but is under no obligation to do so. Therefore, the option buyer will only exercise the option when it's smart to do so. There are many different ways to trade options.
In addition to call options as described above, put options give the option buyer the right to sell stock at a given price, protecting the option buyer from losses in a stock position or profiting from a stock moving down. You can also combine trading options like this call and put options to use more sophisticated options strategies that will turn a profit under a variety of situations.
You can also choose to become an option writer and sell options instead of simply buying them.
What Is Options Trading?
What are the benefits of options trading? There are many reasons why options trading can be a great complement to your existing investing strategy.
They include the following: Options give you leverage in trading options like this investing. An options contract can give an investor cheaper exposure to a stock than buying shares outright, magnifying both profits and losses if the stock price moves.
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Options can also reduce risk in your overall portfolio. For instance, you can use an option strategy that combines buying a put option to sell stock at a specified price with ownership of the shares themselves.
Mark Wolfinger Updated September 17, Whether you are a trader or an investor, your objective is to make money. Your secondary objective is to do so with the minimum acceptable level of risk. One of the major difficulties for new options traders arises from not understanding how to use options to accomplish their financial goals because options trade differently than stocks. But that is not good enough for option traders because option prices do not always behave as expected, and this knowledge gap could cause traders to leave money on the table or incur unexpected losses.
That trade, known as a protective put, gives you the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.
Options can offer a source of income.
How to Trade Options in 4 Steps
By selling options rather than buying them, you're the one to receive the payment for the option. Even if the option goes unexercised, you get to keep that payment as compensation for having assumed the obligation for the contract.
What are the risks of options trading?
Offsetting these benefits are some real risks to options. First and foremost, options often expire worthless, resulting in a total loss of whatever the buyer paid for the option. Second, there's a learning curve involved with options trading.
10 Options Strategies to Know
Many brokerage companies offer options trading, but you'll have to meet some added regulatory requirements before your broker will let you actually use options as part of your trading strategy. For instance, you'll have to read some educational material about the options market as well as learn how your broker handles accepting orders for options.
In addition, you'll need to know what you have to do to tell your broker that you want to exercise an option -- as well as what'll happen if you sell an option and the buyer decides to exercise it against you. Finally, there are some options strategies that only work well when you make multiple trades simultaneously.
Because options markets aren't always as liquid as the stock market, those simultaneous trades don't always work perfectly -- and that can introduce the risk that your strategy won't work the way you intended or hoped.
Picking the best options broker If you want to trade options, then finding a top stock broker is crucial. Here's what to look trading options like this Low commissions: Virtually all online brokers have eliminated commissions on stock trades.
Essential Options Trading Guide
But the same typically isn't true with options -- a few brokers offer free options trades, but the majority charge a modest per-contract position for options. Good research: Special tools for evaluating options can be very useful, but not all brokerage companies offer them.
Is it Easy to Make Weekly Income Through Options Trading? (the answer may surprise you)
Good trading platform: Any no-frills trading platform can be fine for buy-and-hold stock investors, but a feature-packed platform can be a major advantage for an options trader.