When looking at the benefits of trading options, traders should understand that options are a versatile tool for conquering the markets. In this beginner’s guide to trading options, we’ll review what it means to trade stock options, what’s an option in trading, and give you an overview of how to get started trading options. By the end of this article, you’ll understand exactly why you would buy an option and how options trading works.
How Does Options Trading Work?
To understand how options trading works, it’s important to ask what exactly does it mean to trade stock options? Put simply, an option is just a contract to buy or sell a stock by a certain date at an already agreed upon price, known as Strike Price.
An option allows you to bet on a stock without having to invest the full cost of the stock. You don’t have to buy or short anything in full. Instead, you’re buying a contract that lets you:
Buy or sell shares at a previously negotiated price
Sell the contract to another trader
Let the contract expire and walk away with no consequences (outside of your original investment)
Options are great because you have no obligation to do anything if you’re not happy with the direction your contract is moving. That lack of obligation allows traders to protect portfolios from volatility. If you own shares of NFLX and are concerned about earnings forcing shares down, a put (sell) option allows a trader to lock in a sell position at a certain price.
On the other hand, shares of AMZN can be too pricey for most traders. However, buying AMZN call (buy) options locks in the stock at a strike price, allowing you to then purchase the stock at that price even if it’s moved up significantly. Traders then cash in on the difference, or simply walk away. This lets traders take advantage of a symbol’s move without taking major risks.
One important note is that options all expire, generally within 30 days. If a trader doesn’t take advantage of their call (buy option) or put (sell option) within the allotted time, then the contract simply expires with no obligation for either involved party.
What Are the Benefits of Options Trading?
As mentioned above, trading options provide traders with numerous benefits. Perhaps the most important of those benefits is that options enable traders the ability to take advantage of a stock’s move without having to cover the cost of a stock itself. By buying the right to purchase or sell a stock at a specified price, traders are invested in the stock with limited risk.
And because of this lower capital requirement and no obligation to actually purchase the asset, options also allow for better diversification than simply buying stocks outright.
Additionally, options allow for a more conservative approach to trading thanks to the low capital investment. But they’re also more logical and safe than penny stocks and gambles such as IPOs.
However, there are numerous options trading strategies that traders can utilize to match their trading style. Options give traders leverage, letting you hedge your account to protect yourself.
Are There Any Risks in Trading Options?
As with any trading, options trading has risks. However, these risks are mitigated thanks to the lower cost of options. That being said, any time you invest money into a trade, you’re exposed. If you’re new to trading, make it a point to not invest more than 3% to 5% of your portfolio into any one trade. Additionally, options expire. That can present a risk if you’re not monitoring those exact expiration dates. Practicing with paper trading when starting off to prepare yourself is a good idea for new traders.
How to Get Started Trading Options
Just like trading any security, trading options requires a brokerage account. Fortunately, there are several platforms available online, such as TastyWorks. Once your account is set up and approved to trade options, you’ll want to make sure you understand the terms of your account. Brokerage firms set limits based upon your experience and funds. Each firm has its own requirements, so make sure you understand your brokerage’s terms. This ensures that traders understand the risks and setups involved in trading options.
You may want to start with paper trading to ensure you’ve got a handle on trading options before using real money. Additionally, invest in your trading education. Keep learning and keep yourself surrounded with a community of like-minded traders to keep you moving forward. For new traders, you can get a Simpler Trading Options Gold trial membership for just $7.