An Investor’s Guide to Options Trading | Investing

The popularity of stock options trading has soared in recent years, as retail stock traders have become more comfortable with managing their own investment portfolios and dipping their toes into the world of derivatives. There are now about 40 million options contracts traded every day, up from just 15 million contracts in 2010 and less than 2 million contracts in 1999, according to Nasdaq.

Trading option contracts is a bit more complicated than trading stocks, however, and investors can easily get themselves into big trouble if they don’t fully understand what stock options are, how options trading works and what risks are involved.

Here’s a look at what to consider before trading options:

An options contract is a financial contract that gives the buyer the right, but not the obligation, to buy or sell a specific quantity of an asset at a specific price – called the strike price – on or before a specific date. One options contract typically represents the right to buy or sell 100 shares of the specified stock.

An option contract holder can choose whether or not to execute the contract on or before its expiration date. If the option holder chooses not to execute the contract, it will simply expire without a transaction taking place.

Option contracts provide buyers with financial flexibility, but that flexibility isn’t free. Option buyers pay an upfront premium for the contract that is largely based on the amount of time left until the contract expires. As the expiration date approaches, the premium buyers pay for the contract decreases.

The value of options contracts typically fluctuates along with the prices of the underlying stocks, but the volatility of those price fluctuations can be extremely high as the expiration date approaches. Options contracts with strike prices at or near the current market price of the underlying stock can also be particularly volatile.

A stock represents a simple ownership stake in a company, while an options contract is a more complex product that gives you the right to buy or sell a stock. Options are a type of derivative because their value is derived from an underlying asset.

Call options give the buyer the right to buy shares of the underlying stock, while put options give the buyer the right to sell the stock.

Call option buyers want the price of the underlying stock to rise above the contract’s strike price so they can buy the underlying stock at a discount to its market value. Put option buyers want the price of the underlying stock to drop below the strike price so they can sell the underlying stock at a higher price than its current market value.

Options trading can be as simple or as complicated as you want to make it. For new options traders, there are several popular trading strategies for beginners:

To begin trading options, there are a handful of simple steps you must take:

There may be subtle differences between a brokerage account for trading stocks and an account for trading options. Option traders typically trade on margin, which involves borrowing money from a broker. Because of the risks involved in options trading, traders may be required to submit different information to their broker to be approved for options trading, including information about investment objectives, personal finances and options trading experience.

In addition to stock options, there are also option contracts for stock indexes, exchange-traded funds, fixed-income products, foreign currencies and commodities. Before making your first option trade, make sure you research the different types of options contracts and understand the terms and risks associated with your contract of choice.

Make sure you choose a strike price you anticipate will be “in the money” by the time the expiration date rolls around based on your trading thesis. Remember that call buyers want the underlying asset price to be above the strike price of their contracts, while put buyers want the underlying asset price to be below the strike price of their contracts.

Double check to make sure you choose the right order type, using a market order to fill the trade instantly at market price or a limit order to set a limit on the price you are willing to pay per contract. Make sure your trade will not violate the terms of your broker’s margin requirements, which could potentially cause the trade not to be executed or put you at risk of a margin call or forced selling of your options by your broker.

Basic rules of thumb for choosing an option contract are:

While options trading is often seen as extremely risky, there are plenty of conservative options trading strategies as well. Simon Curio, head trader at SimonSaysOptions.com, says the option market was once mostly about hedging risk rather than gambling in the market.

“Options provide the opportunity to hedge an investment or a portfolio against risk,” Curio says.

“That is what options were created to do, but somehow they became the weapon of the speculator and now they are mostly associated with get-rich-quick schemes where gurus claim to make millions with only a small amount of money.”

While many investors view options trading as a short-term strategy, it can also play an important role in a long-term investing portfolio. Michael Sincere, author of bestselling book “Understanding Options,” says long-term investors should consider selling options rather than buying them.

“Many long-term investors sell covered calls, a conservative option strategy that generates income from stocks that you already own. In a way, you are renting your stocks to option buyers and receiving compensation for doing so,” Sincere says.

Leav Graves, CEO and co-founder of Financial Samurai, says options traders often make the mistake of buying short-term options because of their lower price.

“Traders underestimate how long it will take their thesis to come into fruition. Because of it, they are buying short-term options, which are cheaper, and they don’t realize the full potential of the asset,” Graves says.

Options trading can be an excellent tool for informed investors, but it’s not right for everyone. Before trading options contracts, make sure you understand the basic pros and cons of options trading.

Let’s say shares of Amazon.com Inc. (AMZN) trade for $140 per share and you decide to buy 11 shares for $1,540 because you think the stock price will rise. Over the next month, Amazon’s share price increases by 10% to $154, and you get a $154 net return assuming no brokerage commission or transaction fees.

Suppose, however, that you instead buy call options that cost $5 per share, or $500 per contract, with a strike price of $140. With a $1,500 investment, you can buy three options contracts expiring in a month, meaning you’re making a deal on 300 shares. The stock price then rises by 10%, and your contracts expire in the money, leaving you with shares worth $14 apiece ($154 – $140). That’s a 180% return on your $1,500 investment, leaving you with a $2,700 net return.

This is only a basic example, as there are many ways to buy options for different scenarios.

Options can be fairly straightforward and offer many advantages, but they can get also get you into trouble if you’re a novice investor. Make sure you understand what type of option you’re buying, as there is a real danger of losing money quickly if your thesis turns sour.