Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
Trading options means you're trading an asset that's based on a stock's trading price. With options, you're predicting whether a stock's price will rise or fall within a certain time period.
How to trade options
If you’ve spent any amount of time on this website, you probably already have a pretty good understanding of the things you can invest in: stocks, mutual funds, real estate, bonds, etc. Well, now’s the time to add options to that list. And by options we mean an asset that functions as a derivative of a stock. It’s basically like a contract that stipulates that the owner of the option has the right to buy or sell the stock the option is based on at an agreed-upon price, at an agreed-upon date or throughout a certain period of time. An option allows you to buy or sell shares—usually a set amount of 100 shares—at a specific time, but an option is not a stock itself, meaning it doesn’t represent ownership of a company and the owner of an option is not entitled to benefits like dividend payouts. Think of it more as a prediction you’re making on what direction the stock’s price will move in.
Because of this, an option’s value depends on the price of the stock it’s based on. The most common use of options is probably something you’ve already heard of, if not benefit from it yourself: companies giving their employees stock options. Yep, employees aren’t given options—as in choices—but options, as in assets. Depending on how that particular company is doing, this could be a useful perk.
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As is the case with stocks, you’ll need to go through a brokerage before you can start buying and trading options. Since trading options is usually riskier and more complex than trading stocks, the requirements for opening a brokerage account are a bit stricter. Usually a brokerage will ask for your trading experience, your income, and what your financial goals are. Nonetheless, the process is still pretty similar to trading stocks. Once you’re set up and you’ve chosen what assets you want to trade, it’s time to get into the nitty-gritty: are you agreeing to buy or sell a stock once it hits a certain price? And what amount are you investing in? What’s your time frame? You need to have all these things worked out before you start trading options.
Predicting factors like price, rises, and falls
The main reason why options are considered quite risky and only really advisable for very experienced stock traders is that a lot of the methodology around trading options hinges on speculation. You’re essentially speculating on whether a stock’s price will rise or fall, which will determine what kind of option you choose. Will you pick a call option, which indicates you’re counting on the stock’s price to rise and are therefore choosing to buy the stock at an elevated price at a determined future date, or will you pick a put option, where you’re speculating that a stock’s price will decline and are therefore choosing to sell shares at a specific price during a certain time period.
Keeping the “strike price” in mind
An option needs to fall above or below a certain price (depending on what kind of option you’re trading) within a certain time period or by a certain date. So for call options, you want the stock price rising above your strike price before the time period of your contract is over, and for put options you want the stock price below the strike. This is how option traders make a profit.
So let’s say you have your eye on a stock on the S&P 500 that’s currently trading at $100 per share. You think that the stock might rise to $150 a share by some future date, so you’d buy a call option at a strike price below $150, so let’s say $120 a share. Your option is valid for six months, so you can buy shares at $120 a piece if the stock rises, even if the price goes above $120, meaning you’ve bought the share under market price and can then sell it for a profit. That’s how option traders make their money.
As you can probably see, it’s also extremely risky; if the stock doesn’t actually rise above your strike price, you will have lost money. That’s why options trading is really only advisable to experienced traders who have the time and energy to keep abreast of the market and its developments. Another thing to keep in mind is that the fees for option trading can be pretty steep as well because you’ll usually want to work with a brokerage that offers tools and market research for making the best option trades. Plus, you also have to pay commission and buy the option, which is kind of like a down-payment on the contract.
So if it’s so risky, why buy options? Well, it can be a great way to maximize profits if you’re an experienced trader, but it’s also a good way to test out the strength of new companies. Say there’s a hot new Company X on the market, and you think they’ll probably grow quite quickly but you’re not 100% sure. So you buy a call option that’s valid for a six-month period: If the stock price rises above your strike price during that time, then congratulations, you’ve acquired some hot stock below market price. But if it doesn’t and the company is a bust, your losses are limited to what you paid for the option contract.
Options trading in Canada
In Canada, in order for a stock to be available as an option, it needs to be listed on a Canadian stock exchange such as the Toronto Stock Exchange and the stock’s market capitalization needs to be within the top 25th percentile of securities listed on Canadian exchanges. More information on the eligibility of stock options can be found here.
How to trade binary options
We’ve already mentioned that when you’re trading options, you need to decide whether you’re predicting that the price of a stock will rise or fall. Among options you can trade there are also binary options, which basically take the philosophy of an option one step further and settle on a fixed outcome—hence the term “binary,” because there are only two options, either the desired outcome occurs or it doesn’t.
Trading a binary option means answering the question: “Will this stock be above this price at this time?” If you think the answer is yes, then you buy the option. If you think it’ll be below, then you sell. Binary option trading has often been compared to gambling, and that’s not a totally incorrect metaphor. After all, you’re putting down an investment as a bet that the market will turn according to your prediction. You set your strike price and your expiration date and time, and hope that the market reflects your prediction. So if you paid $500 for a binary option for a stock that’s trading at $100 a share and set the strike price at $150, thinking that the stock will rise above that price on June 5th at 9:30am, then you’ll receive a payout if you’re correct. If you’re not, you lost $500.
The silver lining with binary options is that you never lose more than what you invested. So if your prediction was wrong, you lose a flat fee, namely the amount you invested, but not more. So there’s a cap on the risk you’re taking on. Still, as you can probably tell, binary options start veering very closely into gambling territory and are not for the part-time or newbie investor.
Resources for learning to trade options
Despite the risks, options can be attractive, well, options, for investors looking to add new assets to their portfolio or branch out in their investing strategies. Options do have the potential to deliver high returns, and can be a cost-effective strategy to acquire new stock in a growing business (or to mitigate losses if a stock’s price starts dropping). But entering an options trade is not for the unprepared, and it pays to do your homework.
Companies like Charles Schwab have options trading resources available to their clients, and Fidelity has an options strategy guide that helps you learn about different options trading strategies. There are also online resources such as Option Alpha or TastyTrade, which offer (mostly free) courses and podcasts on the basics of option trading. If you’re working with a brokerage specializing in option trading, they’ll also usually be able to give you resources and direct you to educational tools.
If you think options trading might be a little too much for you, and you’d rather stick to good old-fashioned stock trading, then Wealthsimple Trade offers you a low-cost platform with commission-free trading across Canadian and U.S. exchanges. And if you’re looking for a more hands-off, less time-intensive way to get into the investment game without having to pay exorbitant brokerage fees and keeping constant track of the market, then Wealthsimple’s “investing on autopilot” method will create a personalized portfolio calibrated to your financial goals and risk tolerance. Get started today.