Trading Options can be an excellent method to producing returns in your investment portfolio. However, they can be tricky to new investors…and even experienced investors. The best place to learn to trade options is with the basics.
Trading Stock Options Explained
Trading stock options is an investing alternative to buying stocks at their full share price. Options are contracts that you can purchase that present you the option but not the obligation to buy or sell a specific amount of stock at an agreed upon date.
The price of an option is called a premium which is the price the buyer pays. The option premium is the maximum loss that the buyer of the contract can realize.
One option contract is worth 100 shares. So, if that option costs a $2 premium, it will cost $200. If the stock doesn’t go they way you want to and your option expires worthless, you lose the premium cost of $200.
Trading options can be exciting but very tricky. Option trading strategies range from simple calls and puts (which we’ll discuss below) to advanced strategies such as Iron Condors or Butterfly Spreads.
Options trading often feels a lot like gambling due to the intensity of the swings so people can get into serious trouble if they don’t educate themselves first.
And it doesn’t matter if you are new to trading or a “seasoned pro,” everyone can get burned on options if they don’t exercise caution.
In fact, here is an illustration of options trading in action:
That being said, let’s look at some of the basics of options trading and some of the top strategies that have the potential to make you money.
Buying and Selling Options
If you want to learn to trade options, the best place to start is with learning the basics; buying and selling options. When you purchase a Call Option, you buy the right to purchase a stock at a strike price for a specific period of time – usually a short amount of time. The Strike Price is the price at which the investor can buy (or sell) the security.
Here is an example of how a call option works.
Let’s say you wanted to buy 100 shares of a new biotech stock that was creating an anti-aging drug called 2x Pharmaceuticals. Biotech stocks are inherently risky due to a massive number of regulatory hurdles but buying a successful one can be very profitable.
Now, 2x Pharmaceuticals was selling at $20 a share and you purchase 100 shares for $2,000 in the hopes that 2x Pharmaceuticals clears all FDA hurdles and gets its product to market, sending their share price to $60 next year. This would net you a nice profit of $4,000.
However, let’s say that 2x Pharmaceuticals new product ends up going to stage 3 trials but ended up giving human trial patients Hammer toes and Banana Fingers. Most likely, that product is not going to get approved and it will send the share price tumbling.
Now, let’s say you wanted to trade options on 2x Pharmaceuticals. Tthis is where using a Call Option can be a great alternative to buying a stock.
Instead of shelling out $2,000 for 100 shares of stock, you can place a call option on a contract worth 100 shares for a period of 3 months and it will only cost you $200. Now, if that share price ends up going up to $60, you can exercise the right to buy those 100 shares of stock for just $20 in 3 months. You can then sell that stock right away at $60 for the same profit of $4,000.
When you buy a call option, you are betting that the stock will go up. However, when you buy a put option, you are betting on the stock to go down. Buying an option gives the buyer the right to sell a given stock at the agreed upon price and date. It is a good way to bet against the market and make money trading options.
Let’s go back to 2x Pharmaceuticals. You feel that $20 a share is too high for this company and you bet that it will see a decline. To bet on that decline, you buy one put option at $15. Your strike price is $15 and the premium was $2 so your breakeven price is $13. It cost you $200 for the option (100 shares x $2 premium) and you now have the right to sell this stock at $15 until the expiration date.
So, if 2x Pharmaceuticals gets FDA rejection and the stock tumbles, here is what can happen to your option contract:
- Stock falls to $17. Heading in the right direction but won’t be profitable for you since, your strike price was $15
- Stock falls to $10. The value of your option is now $500 giving you a profit of $300
- 2x Pharmaceuticals goes bankrupt, stock falls to $0. Your contract is now worth $1500 for a total profit of $1300
Top Option Trading Strategies
When you learn to trade options, you’ll soon realize there is a multitude of strategies out there. Here are a few of the top options strategies, investors use.
Buying Call Options – These are options where the buyer bets on a stock rising in price (bullish on the stock). A buyer purchases an option contract at a strike price and pays a premium cost for the contract.
For example, if a certain stock is $100, and an investor bets this stock will go to $110 in the next 2 months, he/she can purchase an option contract at a strike price of $100 and a premium price (let’s use $2). So, the buyer will purchase a call-option contract for $200. If the stock does rise to $110, the buyer will make a profit of $800 ($110*100 shares in a contract – $100*100 shares in the contract) – $200 initial investment.
Buying Put Options: Put Options are the opposite of Call Options. These are options when a buyer bets on a stock price decreasing instead of rising (bearish on this stock). Buying a put allows a buyer to put all the downside risk on the seller of the contract, so if the stock decreases from the strike price, the seller is obligated to buy the stock back from you at that pre-determined price.
Straddles: A Straddle Option Strategy is when a buyer purchases a put and call simultaneously of the same stock at the same strike price and expiration date. This approach allows the buyer to make money if the stock moves significantly up or down. The straddle writer makes money if there is little or no movement in the stock price by obtaining two premium prices
Spreads: A Spread Option Strategy is the purchase and sale of options on the same stock. The difference is that the options have either a different strike price with the same expiration date or the same strike price with different expiration dates.
There are a significant amount of variations of ways to trade options. They can become incredibly complex as you move into advanced strategies. However, educating yourselves and starting small can build a solid foundation of knowledge and can lead to successful trading.
The Best Investment Apps for Option Traders
At Wealthplicity, we have rated and ranked some of the top investment apps on the market. For our full list of reviews, please visit our “Best of Investing Resources Page“
As we discussed, there are a variety of investment apps and platforms, so to find the best investment site for you, it truly depends on what you are looking for. Don’t forget to learn to trade options before you actually start.
We took a close look at the best investment sites for option traders and judged their performance on critical criteria.
- Investor Fees -How much does it cost to use the platform and how complicated is the fee structure
- Research – Is there research that provides educational component?
- Investor Requirements – Does the investor need to be accredited? What is the account?
- Usability – How user friendly is the platform?
- Transparency – How hard is it to find critical information such as risk?
With this criteria in mind, some of the best investment sites for option traders are:
