How to Get Started with Options
Options are more accessible than ever, thanks to the explosion in popularity that's occurred during the past decade. With a wealth of educational and trading services available online, it's never been easier to add these versatile assets to your portfolio -- so there's no excuse to keep sitting on the sidelines. With a little education, and our five top tips below, you can ease yourself toward options-trading success.
Study the lingo. Even for those who have a strong background in stock trading, options jargon can be a culture shock. In order to succeed as an options trader, it's crucial that you understand phrases and concepts such as sell to open, delta, time decay -- and many more. Fortunately, the widespread popularity of options means that there are many free online resources where you can research the terminology you'll be using as you begin to trade calls and puts.
Learn how options pricing works. When you're dealing with stocks, the pricing aspect is pretty straightforward. If you're long a stock and it moves higher, you've made money! However, due to the multi-faceted nature of options pricing, the underlying stock's performance is only one component that factors into the overall value of the asset.
Essentially, there are three main variables that determine how much your option is worth: the price of the underlying security; the amount of time until expiration; and implied volatility. (Under the Black-Scholes pricing model, interest rates and dividends also factor in, albeit in a much more predictable and less dramatic fashion than the other three components.)
Implied volatility is the wild card that is most likely to trip up rookies. When market participants are expecting a major price swing from the underlying asset prior to expiration, implied volatility rises -- and so do option premiums. For this reason, it's critical that option traders consider implied volatility levels and how they relate to the stock's historical volatility. When implied volatility is higher than its historical counterpart, it means options are relatively more expensive to buy -- which can ultimately impact your bottom line on a trade.
Stick with basic strategies. A major benefit of options is the ability to buy and sell calls and puts in a wide variety of combinations, allowing you to tailor a specific strategy to just about any forecast you might have for the underlying security. From ratio call spreads to iron condors and long butterflies, there's an endless diversity of trades you can construct.
That said, it's a reasonable idea to stick with basic call- and put-buying strategies when you're first starting out. Managing these straightforward positions will help you get a handle on the dynamics of option trades and the different variables that affect pricing.
And on an even more practical level, many brokerage firms will restrict your ability to trade more complex strategies at first, depending upon your expertise and the size of your account. After you've mastered these fundamental option strategies -- and ramped up your investing capital with a few big winners -- then you should feel comfortable branching out into more sophisticated spreads and combinations.
Check your motives. Simply put, you should never buy an option just because you can afford it. Instead, make sure it's the right choice for your investing purposes. Let us explain: When you're trading options, both the strike price and the expiration date you select will play a role in determining what kind of premium you pay to play. Broadly speaking, short-term, out-of-the-money options will be less expensive, while longer-term, in-the-money bets will carry higher prices.
That's because a front-month call with a strike price 10% above the stock price doesn't allow much time for the underlying security to make the drastic move needed for an in-the-money finish, so the market price for that option is relatively low. While the upfront cost may be lower, bear in mind that the odds of taking a 100% loss are that much higher.
On the other hand, a call option with six months of shelf life and a strike price that's 10% below the stock's current perch has decent odds of expiring with some value, and therefore it commands a higher premium. It's a mirror image trade-off here, as your upfront cost is greater, but the odds of retaining some intrinsic value at expiration are better.
Since there are pros and cons to each approach, be sure that you let your forecast for the underlying stock -- and not your available capital -- dictate which option you choose. While it pays to invest judiciously and follow basic money management rules, you never want to buy an option simply because it's the "cheapest" one available.
Understand that options expire. While you're free to hold a stock position for as long as the company remains in business, an option has a predetermined shelf-life. Not only does the stock need to move as you expected, but it needs to do so within the time frame dictated by your option's expiration date. An easy way to remember this is the acronym FAR -- you need the stock to make a Fast, Aggressive move in the Right direction in order to profit from your option play. To help yourself out on this front, buy a sufficient amount of time for the expected stock move to develop, and look out for catalysts (such as an upcoming earnings report, or a high amount of short interest) that could push the shares in the right direction.
Advantages of Stock Options
It's no mystery why so many traders have flocked to options in recent years. Calls and puts offer plenty of advantages over traditional stock-trading strategies, and easily complement just about any investing approach. Here are a few compelling reasons why options are in such high demand.
Low cost of entry. A call option contract based on 100 shares of stock is far cheaper to buy than the shares themselves. So if you're bullish on a particular security, but don't want to tie up a lot of capital in the trade, buying a call would be a more economical choice than purchasing the stock outright.
Leverage. Due to the comparatively low cost of entry on an options position, buyers get to enjoy the benefit of leverage. Specifically, this means that traders stand to collect profits many times greater than their initial investment if the shares make a move in the right direction.
Limited risk. In a straightforward call- or put-buying strategy, the maximum potential loss is limited to the initial premium paid. Since it's less expensive to buy options than an equivalent amount of stock, speculating with options typically carries a lower possible risk than a comparable stock play.
Flexibility. There are many different ways calls and puts can be combined to create different strategies for every type of situation -- whether your forecast for the underlying security is bullish, bearish, or anywhere in between. In addition to speculating on direction, you can also use put options to hedge your long stock positions. Meanwhile, buying puts on select stocks or sectors is an easy way to ramp up your bearish exposure during periods of market turmoil, without taking on the high risk of a traditional short-selling strategy.
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