Looking to expand your trading portfolio? Look no further than options, a versatile way to diversify and earn great profits. An option is essentially a contract that allows a buyer the right, not the obligation, to buy or sell an asset at a certain price within a certain time frame. It can be used with a variety of assets ranging from equity and stocks to real estate.
Reasons to Trade Options
For experienced investors, options open a world of versatility and allow you to quickly adjust your trading position as situations change. Options can produce strong profits with a smaller amount of cash outlay. You can either trade a single option or combine multiple options into a more complicated, but potentially more lucrative, trade. It all boils down to options allowing investors more freedom to create the deals they want.
Risks to Options
Because options are so versatile, the risks differ according to the situation. Each investor can decide how speculative or conservative they wish their options to be. After all, an option doesn’t include the obligation to purchase something, but rather just the right to do so. However, in general, options tend to be a more advanced trade and have an overall higher degree of risk, often coming with a disclaimer that trading options is not for everyone because of the risk involved. Trading options is especially risky if you are inexperienced or don’t fully understand what you are doing.
Steps to Trade Options
Option trades are broken into two categories: calls and puts. A call is for you buy the option, and a put is when you sell the option at the agreed upon price. Within calls and puts, there are four main trading strategies:
- Long call. This option involves buying calls and is good for investors who are bullish on a certain stock but who don’t want to take much risk, or for those wanting to take leveraged profit in a bearish market. One option is equal in size to 100 equity shares, which means that buying calls allows for greater net profit. For example, you could purchase 500 shares of a stock or the equivalent of five options, allowing for a greater reward when the stock grows. The risk of a long call is equal to the premium the investor paid, but the profit potential is essentially limitless.
- Long put. This option involves buying puts and is good for investors wanting to take advantage of a leveraged position or who don’t want to risk a short-sell strategy. If you are bearish on the market, a put option allows you to make a profit if the stock price falls. If the stock price goes up, simply let the option expire with your only loss being the premium. The most an investor would lose in this scenario is the premium paid, but earnings are limited depending on how much the stock is worth.
- Covered call. This option is good for investors who don’t expect the underlying price of a stock to change. The strategy combines a short position for a call option and a long position in the asset, which ensures the purchaser can deliver on the predetermined price. If the share price increases or decreases too much, the investor faces a risk of losing the stock entirely or the option becoming worthless.
- Protective put. This strategy works well for investors who own the underlying asset and who want downside protection. It works similarly to simply selling the asset, but it allows the investor to access potential gains over the long term instead of liquidating the portfolio; it is essentially an insurance agreement. A protective put includes a long position on the asset and a long put option strategy. If the price increases at maturity, the investor loses the premium but gains the increased price. If the underlying price decreases, the portfolio’s value drops but the investor gains from the put option position. Potential losses for this strategy are relatively minimal.
There are an infinite number of possibilities when it comes to trading options. The four strategies listed above are the basics, but they can be expanded upon and customized as you gain more experience in the options world. With patience and research, you could create a lucrative and diverse options portfolio.