Whether you’re new to investing or hoping to grow your portfolio, you need a good understanding of how trading works. Most people start by purchasing stocks and bonds. However, options trading can be an excellent way to grow your wealth with less risk.
Options trading can be confusing at first. Here are some common questions about this form of investing and its advantages over traditional trading.
Are options riskier than stocks?
No. With proper education, options can actually be less risky than stocks. When you buy a stock, you often place a stop-loss order to minimize your loss if the value drops. The problem is, if this happens, you still sell at a loss.
By contrast, options do not create an obligation to sell or buy. Instead, they have pre-defined strikes and expiration dates. You pay for the option to call (buy at a predetermined price) or put (sell at a predetermined price). As long as you act before the contract expires, you can often minimize losses if the stock’s value plummets — or lock in a good price before it skyrockets.
In short, buying an option is only as risky as the price you pay for it. And often the cost of an options contract is less than a straightforward purchase of shares, as we’ll discuss in the next question.
Can you get more leverage trading options than trading stocks?
Yes. Each option you purchase controls 100 shares of the underlying stock. This means you can improve your trading position without tying up as much of your funds.
Let’s take an example: suppose you purchase 1 XYZ option for $5.00. In option-speak, this value is multiplied by $100 to come up with a total of $500. You’ve now created an opportunity to strike at that price, as long as you call before your contract expires.
Now, let’s say that XYZ stock is trading for $50 per share. Buying 100 shares of XYZ for $50 would cost you $5,000 — 10x more than the option price in this example. As you see, this gives you wiggle room in the market and allows you to gain a strategic advantage without putting up as much money.
Options seem difficult to learn. How do I learn how to trade options?
Options can seem overwhelming at first, but a little education goes a long way. Search the web for an options mentor or educator — there are many. Learn the basics first, and take time to research the stocks you’re interested in. Options trading requires you to do your homework.
Then, set yourself up with a paper trading account with TradeHawk by Tradier and practice, practice, practice!
What are the most important Greeks to learn and understand?
In options trading, Greeks are the variables used to describe the risk of an option or an entire portfolio based on the underlying stock price movement, time, volatility, interest rate changes, etc. Most options traders initially focus on deltas and theta.
Delta is the rate of change of the option based on a $1.00 move of the underlying stock. For example, if you owned a 50-delta call option in XYZ stock, and XYZ stock moved up $1.00, you would expect this call option to move up by $.50. (Option traders refer to deltas as whole numbers, but mathematically, a 50 delta is actually .50 or 50% of 1.00.)
Theta represents how much an option will “decay” over a day. Options are considered “wasting assets,” i.e., they inevitably get cheaper with time. Theta represents the diminishing value as the option nears its expiration.
For example, if you have a position that has -$200.00 theta, this value means that you can expect your position to lose $200 per day, assuming nothing happens to the underlying price action of the stock. A negative theta may sound scary, but some traders take advantage of this by waiting for the call option to decline in value. When this happens, they can sell their options and capture a profit.
What does assignment mean in options?
Assignment means that an option has converted (or assigned) to the underlying asset, and the stock now belongs to the options trader. Note that you’re never obligated to exercise an option. Instead, you can choose to either take action or let the option expire.
For call options, assignment happens when the contract expires and the stock price is greater than the strike price. This is called being “in the money.” By contrast, if the stock price is less than the strike price, the option expires worthless and the asset will not be assigned.
For put options, the opposite scenario applies. Assignment happens at expiration when the stock price is less than the strike price. If the stock price is more than the strike price, then the option expires worthless.
When options expire at least $.01 in the money, the exercise and assignment of the option is automatic. (Remember, each 1 lot of options represents 100 shares of the underlying asset.) Holders of call options will receive 100 shares of the underlying stock for every 1 option owned. Conversely, if you are short a call option that is assigned, you will receive 100 shares of short stock.
For puts, holders of long options that expire in the money will receive 100 shares of short stock. Those who placed short put options will receive 100 shares of long stock at expiration if the option is in the money.
The Bottom Line
Contrary to popular belief, options trading is no riskier than any other sort of investing. In fact, the flexibility it offers can help savvy investors reduce their risk. Options trading also provides an opportunity to trade with greater cost-efficiency and strategic advantage. If you are looking to gain profits from a growing stock, diversify your portfolio with less risk, or speculate on new stocks, options trading is a great choice.
Get started with Tradier’s TradeHawk, a powerful options trading platform designed by investing experts.