The Basics of Options Trading

Whether you’re new to trading on the stock market, or are looking to expand your existing portfolio of mutual funds, bonds and stocks, options trading can be a viable and profitable path. The versatile option can be as conservative or aggressive as you want it to be. However, even though options trading can be used to protect a position, realize that it is a risky venture, especially if you don’t know much about it. Options trading is generally left up to the professionals to handle—but that’s not a reason to not educate yourself on the possibility.

Start by learning about the basics before venturing any further into options trading.

What is an option? Unlike stock, options are not a physical thing—you don’t own a portion of the company when you trade in options. Instead, an option is a binding contract between two parties, giving the buyer the right—but not the obligation—to buy or sell the asset in question at a set price before a set expiration date. Each stock options contract usually refers to 100 shares of stock.

How does this contract work? The buyer gets to decide if they want to go through with the sale of an asset within a predetermined amount of time at a set price. If certain favorable facts about the asset are uncovered during that time period, and the value of the item increases, the option buyer still has the right to purchase the asset at the originally agreed upon price. However, if the asset is deemed worthless and no longer worth the agreed upon price, the buyer can decline to act on the option and let the option expire. This right to purchase or decline over a period of time, is the option, which comes at a price.

For example, you agree to purchase an aspiring artist’s piece during an art show, but you aren’t able to pay the full amount right now. Instead you pay $500 now for the option of buy the painting in a month for $5000—which means the contract expires in one month, at which point you pay either $5000, if you decide to buy it, or $0, if you don’t. You will not get your $500 back.

If in the interim, the artist the next big thing and the artist’s pieces start selling at $100,000, you still have the right to buy the painting for the previously agreed upon price of $5000, so long as it’s within the month. If close inspection of the painting reveals it to be a forgery, you’re out $500 for the option, but you won’t have to purchase the piece and can let the option expire.

What does “call” and “put” mean? Call options and put options are the two basic types of options. The difference between the two is simply whether the contract is to buy or sell the asset.

Call options gives you the right to buy a particular security at a set price within a certain amount of time.

Put options gives you the right to sell a particular security at a set price within a set amount of time.

What are the benefits of options trading? Option contracts can be a very lucrative addition to your investment portfolio, as you can get a higher percentage return through options trading versus buying the stock. There are options that provide returns of up to 85 percent of a stock’s actual performance, but cost a quarter the price of the security. You’ll be paying much less for nearly the same yield—that’s an investor’s dream come true.

Options trading can also be less risky than buying a security outright, and are sometimes used as part of a hedge to protect a position. Options don’t shut down after the stock market closes, so should something dramatic happen overnight or on a weekend to affect the company you’ve invested in, the right option strategy could save or net your portfolio a great deal of money.

What are the disadvantages? Options can be tricky to learn for beginners, and therefore a high-risk investment strategy. It’s also more difficult to get performance data and other analytical information on options compared to a tangible asset like stocks—and uneducated investments are high-risk as well.

Options trading also command higher commissions, up to nearly 30 percent of what you’ve invested.

One of the most cited disadvantages is that an option is considered a decaying asset, as the value of the price gradually diminishes as the contract approaches expiration. Upon expiration, the option is worthless.

Arming yourself with the basic information on options trading should help you decide whether or not you want to enter that arena. Options can be a worthwhile addition to an investment portfolio, but it’s best left up to experts who have the time and resources to do the necessary research, and have had the experience with trading. The last thing anyone wants to do is wind up in debt from poor management of money, but luckily there are services available such as National Debt Relief that can alleviate financial pressures during difficult times.

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