Understanding how the stock market works can be a tricky business, particularly for anyone who has no previous experience in the sector.
There are numerous opportunities for people to get involved, with options trading one of the popular ways that people choose to dabble in the stock market.
Options are amongst a wide range of ‘derivatives’ found in the stock market, with the profit or loss associated with them coming from the value of the underlying asset or stock.
Read on as we take a closer look at options trading in the United States and find out what some experts have to say about this element of the stock market.
What are options?
In simple terms, an option is a contract that provides the holder with the buying or selling rights of 100 underlying shares.
There are two types of options – puts – which is a bet that a stock will fall – or calls – which is a bet that a stock will rise.
The contract specifies the amount at which the shares can be bought or sold, along with establishing a timeframe during which the transactions can happen.
As explained by finance expert Matt Frankel, the buyer of the option is under no obligation to exercise the contract and fully controls the decision-making process in this regard.
“Let’s say that the call option let the option holder pay $100 per share for a given stock – known as the strike price or exercise price,” he said.
“If the underlying stock traded in the market for $50 per share, the option buyer would never exercise the option, because it would be silly to pay $100 for shares the buyer could purchase for $50 on the open market.
“However, if the share price in the market were $175, then the buyer would exercise the option contract, since $100 would be a bargain compared to the prevailing share price.”
Why trade options?
Options trading has numerous advantages, with the smaller initial outlay required to get involved perhaps the most attractive.
An option buys an investor time to see how things play out and protects them from risk by locking in the price without any obligation to purchase.
The nature of trading options bears some similarities to sports betting, but with the added benefit that you can hedge against short-term volatility in the market.
Steve Sosnick, the Chief Strategist at Interactive Brokers, says that the psychology of wagering on sports is very similar to options trading.
“With sports gambling, I stand to make some percentage of the money,” he said.
“It’s the same thing with stocks and options, but with stocks and options there are thousands of bets you can make every day.
“When you are in an up market like we have been experiencing, you can come to believe that the odds really are in your favour.”
What is the expiration date?
All options have an expiration date that is determined when the trader is placed. The options contract must be exercised before this date.
The trader’s broker will automatically close the contract at the market price ahead of the market close on the day of the expiration.
Traders can choose different lengths of expiration dates which can be as little as one day or away or as long as a few years away.
Trading educator, James Ramelli, says that the expiration date gives you breathing space to choose the optimum time to decide what to do with you options.
“Always be aware of potential catalyst events that might be near,” he said.
“You want to know if paper is playing the overall direction of the stock or if they are playing a near-term catalyst event like earnings, drug announcements, or new product launches.
“This might factor into your decision to take the trade or not. Once you have your time horizon set, you want to pick a profit target.
“Are you leaving this trade on to expiration? Taking off half at a double and letting the rest ride? Knowing the answers to these questions at the onset of the trade make it easier to manage going forward.”
How do I make a profit?
Determining whether you make a profit or loss in options trading is determined by the quality of the options in your portfolio.
Sticking to a single options strategy is fraught with danger, as you are effectively placing all your chips on one number on a roulette wheel.
A drastic move in a negative direction can leave you ruthlessly exposed, meaning you are well-advised to take a more diverse approach to building your options portfolio.
Jacob Mintz, the Chief Analyst for Cabot Options Trader Pro, advocates spreading the risk in options trading to maximise returns.
“My fundamental philosophy of options trading is to understand the risk and reward of every trade,” he said.
“When buying or selling options, I break down the best and worst case scenarios, and determine if the odds are in our favour, and if the trade fits our objectives.
“What makes options so potentially lucrative is that you can make tremendous profits with little capital at risk. When I buy options, I risk pennies to make dollars.
When I recommend selling options, I will always do so in a way that has defined risk, often by using spreads. This way, we’re never exposed to catastrophic risk.”
Options trading – the final word
Now you are armed with a basic understanding of options trading, you are ready to seek out the services of a broker.
It is advisable to find a broker that offers resources to further your knowledge of options, to ensure that you make informed decisions in the future.
Test out your prospective broker’s customer service by firing questions at them through a couple of different routes to make sure that you are happy with their support.
Spend time on their trading platform to get a feel for how things function – make sure it is user-friendly and easy to place a trade.
Check out whether there any commissions to pay – many brokers now offer free commissions, while others can be as little as $0.50 per contract.
Always remember that trading options can be risky, and there is no guarantee that you will make a profit, but doing some basic groundwork will improve your chances in the long-run.