Dennis Hammer is a writer and finance nerd with six years of investing experience. He writes about personal finance for Wealthsimple. Dennis also manages his own investment portfolio and has funded several businesses in the past. Dennis holds a Bachelor's degree from the University of Connecticut.
When it comes to trading securities, you have a lot of choices. The market offers plenty of financial products to help you customize your investment strategy. While we typically advocate for passive investments we can’t ignore that options are one type of investment you could choose to buy. While all investing carries a certain level of risk—stock options are particularly risky investments and highly speculative. If you really want to trade options it’s probably wise to only invest what you can afford to lose.
What is options trading?
An option is a contract that gives you the right (but not the obligation) to purchase or sell the underlying asset at a specific price by a certain date. A call option gives you the right to buy a stock. A put option gives you the right to sell a stock. You can buy and sell calls and puts on the open market.
Options are known as derivatives because their prices are derived from the price of something else. Their value depends on the price of that other thing. A stock option, for example, is a derivative of a stock, and the option’s price will change as the stock’s price changes.
An option contract typically represents 100 shares of the underlying stock, but they can be written on any sort or size of the underlying asset. Like other asset classes, you buy options through a brokerage account.
Why trade options?
There are two reasons to trade options: speculation and hedging. Speculation is when you wage on the future price of an asset. Let’s say you think the price of a stock will go up. You could buy the stock, but that would require spending money today. Or you could buy a call option on the stock. In this case, you wouldn’t have to buy the stock until a later date. If the price of the stock rises higher than the price of the option, you make money.
Hedging is a way to reduce your overall risk for a small cost. It’s like purchasing an insurance policy to protect your other investments. For instance, let’s say you want to buy airline stocks but you’re worried about an industry downturn. You could buy puts for the same stocks so you’ll always get something for those stocks, even if they fall in value dramatically.
How do options work in trading?
Buying and selling options is about determining the probabilities of future price changes. If the value of an underlying asset is more likely to change, the price of the option goes up. If the value of an underlying asset is less likely to occur, the price of the option goes down.
Time is a factor as well. Option prices fall as they come closer to their expiration date. This is because there’s less chance of the underlying asset’s price changing. For this reason, options are also called wasting assets.
Volatility is another factor that determines auction prices. If the price of an underlying asset is volatile, larger price swings increase the probability of price changes up and down. Greater volatility, therefore, means higher option prices.
There are four ways to trade options:
If you buy an option, you’re a holder. If you sell an option, you’re a writer. Call holders and put holders (buyers) aren’t obligated to buy or sell, but they have the choice to exercise those rights. This means all they risk are the premiums they spend on the options. Call writers and put writers (sellers) are obligated to buy or sell if the option expires. This means a seller has a greater exposure to risk than a buyer and can lose much more than the price of the option’s premium.
An example of options trading
Let’s say that on April 1, the stock price of Acme Inc. is $62. The premium (cost) of a 70 call that expires on May 31st is $3. You have to buy 100 shares, so the total price of the options contract is $300 ($3 x 100 = $300). The price of the stock must rise above $70 before the call option is worth anything, but it actually has to reach $73 before you make any money (because the option contract costs $3/share).
Two weeks later, the stock shoots up to $81. The stock is up $16, which means the value of the options contract increased too. Let’s say the contract jumped from $3 to $6.50, so it’s now worth $650. Subtract your original $300 investment and you profit $350. You could close your position (sell your option) and take the money, or you could hold the option longer.
Let’s say you decide to hold the option until the expiration date. Sadly, the stock’s price falls to $65, which is beneath the $70 strike price, so the option is worthless. In this case, all you lose is the cost of the contract, which is $300.
Here’s what happened to your investment over time:
(For the sake of simplicity, our example didn’t take commissions into account. Your broker will charge a fee for performing the transaction, so make sure you calculate that cost before you make any trade.)
Risks of options trading
Options are no different than any other security in that they come with risk, which is why we typically don’t recommend them for the average investor who just wants income or passive growth. If you decide to get into options trading, here’s what you’re up against.
Options make you vulnerable to amplified losses
When you write a put or a call, you become obligated to buy or sell shares at a specified price before the contract’s expiration date, even if the price means you lose money.
For example, let’s say Acme Inc. is $5/share, but you think it will rise. You write a call option to buy 100 shares of the stock at $5/share within a month, but Acme Inc.’s stock price actually falls to $3/share. Unless you walk away from the contract before the expiration date, you’re obligated to buy Acme Inc at $5/share, even though it’s only worth $3/share. You just lost $200.
There’s limited time for your predictions to come true
Buying or selling an option is making a bet on a future price change, but options are short-term investments, which means there isn’t much time for your predictions to bear out. In order to make money, you have to buy the option contract at the right time and choose the right moment to exercise the contract, sell it, or walk away before it expires. Which brings up a key truth about investing: Timing is challenging.
The brokerage can liquidate your account if you can’t pay
If you make a bad bet and can’t pay what you owe (or if your margin account dips below a certain percentage), your brokerage can issue a margin call and liquidate your investment account. This means they’ll sell everything you own on your behalf to raise enough funds to pay your balance.
Additional costs may affect your profit and loss
In some cases, options trading requires you to open a margin account, which is essentially a line of credit from a brokerage. The brokerage will charge you interest and fees on any money you borrow. Interest rates can reach up to 10%, which may make some of your options trading unprofitable or further amplify losses.
1. Decide how much money you want to risk
Your first step is to decide how much you’re willing to lose on options trading. Do not invest your entire retirement portfolio as options (like other derivatives) come with significant risk.
2. Choose a broker that trades options
Find a broker or trading platform that trades options. Choose one with lots of choices, low commission fees, and a solid reputation. Like, maybe... Wealthsimple?
3. Select an options trading strategy
When it comes to options, you shouldn’t just buy whatever “looks good.” You need a clear strategy in place that not only plans what you’ll buy or sell, but also plans when you’ll buy or sell it. Focus on options whose price movements you understand well. Educate yourself as much as possible about trading options and study price movements on Bloomberg or Reuters.
4. Practice with a demo account
A demo account is just like a real trading account, but the money isn’t real. You can make “trades,” but you won’t really own the securities you buy. This is a useful way to practice with options trading without losing money. If your broker offers this service, use it.
5. Start trading with a live account
When you’re ready to dive in, start small. Make a few minimal purchases to ensure you know what you’re doing. Make informed, emotionless decisions. The best traders don’t gamble.
Is options trading right for you?
Options trading is one way to invest but it comes with serious risks. One of those risks is that you could lose everything you’ve invested. Make sure you have a clear understanding of how options work before making trades. If you’re trying to build your retirement fund, we recommend enrolling in automated investing to passively grow your wealth.
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