What Is Stock Options Trading?

Stock options are a riskier type of investments but have the ability to produce outsized gains for investors without the need for margin, though some strategies require it. An investor might lose their entire investment, and some strategies may expose you to theoretically unlimited losses. A stock option is a derivative that gives the option holder the right to buy or sell 100 shares of the underlying security at the designated strike price, if exercised before expiration. You have to pay a premium, or the option price, to purchase a contract. The premiums can rise or fall substantially within a short time frame. The derivatives can help hedge your portfolio or provide more exposure to a stock without needing to put as much money down. This article explores several stock options trading strategies and how to manage risk. 

What Are Stock Options?

Stock options are derivatives that give you exposure to 100 shares of an underlying asset. Instead of saving enough money to accumulate 100 shares, you can trade stock options, which gives you exposure to 100 shares. Unlike stocks, options have expiration dates. Out-of-the-money options expire worthless if they stay out of the money, but options that go from out of the money to in the money can produce quality returns. With good timing, it’s possible to see your investment generate positive returns.

Stock Options Types

You can trade put or call options, and there are variations to how you can trade these options. For any stock option, you must assess the underlying stock and do your due diligence to predict its short-term price movements. 

1. Stock Put Options

Stock put options gives the holder the right but not the obligation to sell 100 shares at a strike price within a specific time frame. This contract limits help to your downside if you own 100 shares, You can select the strike price and the expiration date before trading a put. Put Options contracts are more expensive if you select a strike price that is equal to or higher than the underlying stock’s price. Put options contracts get cheaper if you buy contracts with strike prices below the current stock price or seek a closer expiration date. 

Assuming expiration dates were the same for a stock valued at $100 per share, and other factors were equal a put option with an $80 strike price would cost less than an option with a $100 strike price. The option contract with a $100 strike price would cost less than the option with a $120 strike price.

2. Stock Call Options

Stock call options give the buyer the right but not the obligation to buy 100 shares at the strike price within a specific time frame. Both call options and put options are used as a way to speculate on the future price movement of a stock, or as a way to hedge an existing position.. Calls are similar to puts, but buying calls is a bullish trade instead of a bearish one. Call options with strike prices well above the current stock price cost less than call option contracts with strike prices near or below the current stock price.

Assuming expiration dates were the same for a stock valued at $50 per share, and other factors were equal a call option with a $40 strike price would cost more than a call option with a $50 strike price. The call option with a $50 strike price would cost more than a call option with a $60 strike price.

How to Trade Options

Options traders have several ways to potentially profit from stock price fluctuations. Understanding how to trade options will help you manage risk and may increase the odds of making profitable trades.

1. Figure Out Your Objectives

Stock options trading can aid in your goals, but if you don’t set clear objectives, you can get greedy and take on too much risk. You should always ensure options trading aligns with your stock trading, income, expenses and other factors.

2. Research and Assess Options Ideas

Stock options trading is not for passive investors. You have to research several stocks and assess options ideas based on news, earnings, economic reports and other details. You can narrow your focus to a single industry or expand your horizons and look for more opportunities.

3. Choose Which Options to Buy or Sell

After doing your research, it’s time to analyze potential trades. You will have to decide which options to buy and sell depending on your individual goals, circumstances, portfolio, etc. Investors must consider the underlying stock, strike price, expiration date, implied volatility and other factors. Implied volatility is a dynamic figure that can significantly drive options prices right before earnings or other significant events that can impact the activity in the options marketplace. Even if the underlying asset moves in the right direction for your option, it may not move sharply enough to compensate for a sudden decrease in implied volatility. This is part of the reason it’s typically riskier to trade options right before earnings.

4. Execute Your Options Trade

Once you select your options, it’s time to execute your options trades. You will see several ways to open and close options positions:

• Buy to open: Starting a new position by purchasing a call or put
• Sell to open: Starting a new position by selling a call or put
• Buy to close: Purchasing a call or put to close your open position
• Sell to close: Selling a call or put to close a long position

5. Monitor Your Position

It’s good for any investor to monitor their portfolio, but with expiration dates and stock price movements significantly impacting an option’s value over a short time frame, you should pay extra attention to your options positions. It’s not uncommon for options traders to monitor their positions throughout the day and stay in tune with after-hours developments. 

Stock Option Strategies

Knowing how to monitor stock options positions, analyzing charts and conducting due diligence can increase the likelihood of success. Understanding various stock option strategies will help determine how you could make money and how much risk you want to take on.

1. Buying Puts (Long Puts)

Buying protective puts can help shield you from a significant downturn for the long positions paired with the protective put. These puts will expire worthless if that downturn never happens, just like an insurance policy. An investor may buy a protective put for a growth stock to limit their downside. For example, If the investor bought a protective put with an $80 strike price for a $100 stock, the downside is limited to $2,000 plus the cost of the put contract. If the growth stock sinks to $40 per share, the investor does not lose $60 per share. The investor would only lose the difference between $100 and the strike price plus the cost of the contract.

2. Straddles

A long straddle is an options trading strategy where you buy a call and put, which have the same strike price and expiration date. These investors hope the stock will move sharply in either direction, regardless of whether it is bullish or bearish. Straddle traders lose their total premium paid if the stock price stays close to the strike price by expiration.

For example, If you buy a call and put with a $95 strike price and the same expiration date when a stock is valued at $100 per share, you would benefit if the stock went to $80 or $120 per share. However, if the stock price drops to $95 per share and stays in that range, both of your options will quickly lose value by expiration .

3. Cash-Secured Puts

Cash-secured puts are a less risky options trading strategy when compared to some others. However, there is potential for significant loss if the stock goes to zero and you’re assigned. For example,  If you want to buy 100 shares of a company at $90, but it is currently valued at $100 per share, you can sell a cash-secured put at a $90 strike price. You will receive the premium because you are the seller, but you will need $9,000 to secure the put. This money becomes inaccessible until you close the put position, get assigned or if the contract expires worthless. If the stock price is below $90 at expiration, and you’re assigned, you will purchase the 100 shares at $90 per share, regardless of how much the stock falls. 

If the stock is above $90 per share when the put contract expires worthless, you get to keep the premium and regain access to your $9,000. You won’t have 100 shares, but you can sell another cash-secured put to get additional premiums and wait for the stock to reach a more desirable entry price.

4. Covered Calls

Covered calls are another options trading strategy that does not incur as much risk. You must first own 100 shares of the underlying stock to sell a covered call. A covered call limits your upside but can lower your cost basis which can help if the stock experiences a price drop. A bearish investor may buy 100 shares of a growth stock at $50 per share. The investor can sell a covered call with a strike price of $60 to secure a premium. The investor must sell 100 shares at $60 if the stock price is above $60 at expiration, even if the investment doubles. But the investor will hold onto the shares if the stock price is below $60 at expiration. This covered call can provide additional cash flow and lower your cost basis.

5. Option Debit Vertical Spreads

Options spreads involve purchasing two options contracts for the same stock, typically with the same expiration date. The trader minimizes their max losses and also limits their upside. A trader may find a stock valued at $70 and believes it can fall to $60 per share. For example, A trader in this scenario could consider buying a put with a $70 strike price, allowing them to benefit from a declining stock price. The trader could also sell a put with a $60 strike price. The premium from this put would reduce the total cost of the options position. 

For this example, it’s optimal for the underlying stock to trade at $60 per share or lower when the contracts expire. You won’t make extra money if the stock drops to $50, but if the stock stays flat or rises, your loss is limited to the net debit paid to open the spread.

Options Trading Pros

Options trading is risky but can provide several advantages that could make sense for certain investors 

• Hedge your portfolio: Options trading can help limit the damage of a recession, bad earnings report or another unfavorable event for one of your core holdings.
• Potential to increase your returns: When you get an options trade right, it can have a substantial impact on your portfolio, even if you allocate a small percentage of your funds.
• Learn more about the market: Options traders immerse themselves with their picks, current events and other news. These traders tend to be more alert and learn a lot about the stock market.

Options Trading Cons

While options trading has several benefits, it’s also important to consider the risks:

• You can lose money with options: Every investment has a risk-reward ratio. You can lose money with options, just like any other asset. It’s important to do proper planning and due diligence to minimize your losses and avoid putting too much of your portfolio into options. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.
• Prices fluctuate quickly: Options prices have several underlying factors that result in fluctuating prices. It’s normal to see an options contract go up 20% and give up all of those gains by midday.

Fitting Stock Options into a Portfolio Strategy

Stock options can be a useful tool for suitable investors. These assets can generate substantial returns, but come with significant risk and are not appropriate for everyone. It’s important to do your due diligence before trading options, but they can be a useful investing tool when used optimally.

Frequently Asked Questions