People often say that it takes a great deal of capital to make any real money in the stock market. While this is not entirely false, it is not entirely true, either. Options trading allows people with modest amounts of investment capital to reduce their risk while still retaining the potential of healthy profits.
What are options
Put as simply as possible, options are contracts between two parties: the writer and the buyer. An interesting part of this is that you do not actually have to own the stock to sell somebody an option. There are two main types of options: “call” options and “put” options.
Assume you are interested in a stock because you think it is on the rise, and assume said stock is currently trading for $35 per share; this price is known as the “market price.” When you buy a call option, what you are actually buying is the right to purchase 100 shares of a stock at a “strike price” for a predetermined amount of time, which is called the “expiry date.” Strike prices vary but are often pretty close to the market price. It is important to understand that when you buy an option, you have the right, but not the obligation, to buy the stock at the strike price any time prior to the expiry date. This is called “exercising” the option.
An option’s premium is the money charged by the option’s writer (the holder of the stock) to the buyer of the option. The amount of premiums is based on a given stock’s “volatility.” That is, it is based on the stock’s likelihood of increasing or decreasing in value. Going back to the example stock, whose market price is $35 per share, assume, just for the sake of round numbers, that the premium is 10% of the market price, or $3.50 per share. The total premium to buy the option, then, is $350. Also assume that the strike price of the call option is $36.
Once you have paid $350 and secured the option, you can exercise it any time before the expiry date. Assume that the stock rises to $35.50 per share. Exercising the call option will still net you a loss, but the value of your option to buy at the strike price of $36 has increased. It is incredibly important to understand that many traders buy call options with absolutely no intention of exercising them; they merely seek to sell the option for more than they paid for it. Depending on how much time remains before the expiry date, your call option may net you a profit if the stock has closed the gap between the market and strike prices.
Put options can be simply thought of as the opposite of call options; instead of making money through a stock increasing in value, the buyer profits when a stock declines. For example, if you buy a put for a stock at a strike price of $32, and its market price is $35, your put option increases in value the more the stock declines. It is important to note that selling put options takes considerably more capital than buying them; if the buyer chooses to exercise the option upon you, you have a legal obligation to sell them the stock at the strike price, which can wind up being quite expensive should the stock rise unexpectedly.
Pros and cons of options trading
Options trading is a great way to build a portfolio and get your foot in the door, but like anything stock-market related, there is always some risk. It is entirely possible that the stock for which you purchase a call option will decline and expire worthless. Likewise, there is a chance a stock for which you sell a put option will increase in value. There is also a pretty big learning curve, but there are a ton of sources where you can find information on simple options trading for beginners, so it is by no means over your head.
People net profits in the stock market every day, and you can be one of them. All you need to do is get started.