What is Option Trading? A Beginner’s Guide

Key Takeaways

• With options trading, investors possess the right to purchase or sell a specific security on a specific date for a specific amount.

• The buyer in a put option gains the right to sell the underlying asset at the pre-established price in the future.

• The expiration date, strike price, and stock price are all considerations when it comes to options pricing.

Once viewed as too fraught and complicated for retail investors or those just starting out, options trading has become increasingly accessible and popular. In 2013, for example, about 4.2 billion options were traded, according to the Options Clearing Corporation. That number rose to 5.2 billion five years later, and last year, some 10.2 billion options were traded.

But exactly what is options trading? Here is a beginner’s guide.

What is Options Trading?

With options trading, investors possess the right to buy or sell a specific security on a specific date for a specific amount. They are not obliged to, however.

In other words, an option is a form of derivative contract for an underlying asset such as a stock or another security. The contract is effective for an established period, be it a day, a few years, or somewhere in between.

If the holder opts to trade the underlying asset, they are exercising the option. For this right, they are charged what is called a premium. The holder could also allow the option to expire if market prices are undesirable. 

Essentially, options permits the use of smaller sums than they would have to if they were trading the underlying asset. For example, a trader could spend $2,000 on a call contract that is priced 10 percent greater than the market price. That is as opposed to paying $10,000 to purchase 100 shares of a $100 stock.

Say a $5,000 investment is sought in Apple, currently trading at about $165 per share. So, the trader can buy 30 shares for $4,950. Next, say the stock price rises over the next month by 10 percent to $181.50. Consequently, the trader’s holdings will increase to $5,445, and the trader has a $495 net dollar return.

Different Types of Options 

Generally, options are either “call” or “put.” With the former, the contract buyer buys the right to purchase the underlying asset at a later date. The price, also called the strike price or exercise price, is predetermined.

By contrast, the buyer in a put option gains the right to sell the underlying asset at the pre-established price in the future.

The Difference Between Calls and Puts

As explained above, call, and put options are opposites. Rather than possessing the right to purchase an underlying security, a put option provides the right to sell the security at a preset strike price. 

In an example, a put option for 100 shares of XYZ stock is bought at $50 per share with a $1 per share premium. The stock’s price falls to $25 per share before the option expires. If the option is exercised, the 100 shares could be sold at the higher $50 price per share. That would mean a profit of $25 x 100 minus the $1 share premium, which comes to $2,400.

On the other hand, the trader will lose their premium if the stock’s price goes up.

Meanwhile, a call option provides the right to purchase an underlying security at a set price within a certain period. 

To illustrate, say a trader purchases a call option for 100 shares of XYZ stock with a $3 per-share premium. This time, the trader wishes for a price increase.

The call option permits the purchase of $50 shares. The stock’s price, meanwhile, increases to $100 each. The call option could be employed to purchase that stock at a discount. Savings would total $4,700 ($50 x $100, less the $3 per-share premium.

Note that had the stock price fallen and the contract expired, the loss would be the premium cost.

How Options Pricing is Determined 

The expiration date, strike price, and stock price are all considerations when it comes to options pricing. But at its essence, options pricing is determined by two types of value: intrinsic and time.

An option’s intrinsic value is its profit prospects based on the difference between the asset’s current price and its strike price. Time value, meanwhile, gauges the effect of volatility on an underlying asset’s price before it expires.

Note that intrinsic value can be affected by stock and strike price, while time value can be impacted by expiration date.

Potential Benefits and Risks of Trading Options

Electronic trading, better pricing models, and digital analysis instruments have helped heighten the popularity of options trading in recent years. But there are also potential risks when it comes to such trading, as with any other investment approach.

On the positive side are liquidity and flexibility, and the possibility that comparably smaller sums of capital can be invested. Also, options could diversify one’s portfolio and produce downside risk protection.

However, risk could be a major consideration. Participation in options trading could be markedly riskier than purchasing individual stocks, bonds, or exchange-traded funds. It is difficult to forecast stock prices, and an incorrect guess could expose the trader to substantial losses.

How to Trade Options in Five Steps

If one has weighed the benefits and risks and still wishes to get started trading, here are steps one can take to get started.

1. Determine one’s risk threshold. Whether it is a percentage of funds or specific dollar amount, this determination can help produce the best personal investment strategy. Do consider how an options trade could impact one’s portfolio.
2. Focus on a specific investment. Identify what to trade. Resources such as market commentaries and company financial statements can help here. How a stock performs can be affected by a number of factors, dividends, and earnings reports.
3. Choose an approach. Be sure to factor in strike price and expiration date. Strategies can include buy call options for implementation of a bullish outlook. With another approach, called a bull spread, risk can be lessened along with any gains. Explore all possible strategies.
4. Know the impact of volatility and probability on options. It can be challenging to match the right contract with one’s approach. Also, situations can change during an options contract’s life, affecting success probability. Volatility changes can also be impactful, which should be kept in mind. The Profit/Loss Calculator and Options Trade Builder can help with finding the right contract.
5. Establish an exit strategy. Options contracts expire, so some decisions may be required at some point. Options include holding, closing out one’s existing position to an entirely different one, or closing the trade.

For investors who wish to go beyond stocks and bonds to lower portfolio volatility and generate secondary income, private-market “alternatives” are an option.

Increasingly, investors are turning to alternative assets such as art and real estate to add variety to their portfolio, protect it from inflation, and potentially increase returns. The private market has performed better than stocks in every economic downturn of almost the last 20 years.

One of the leading alternative investment platforms, Yieldstreet, on which $4 billion has been invested to date, offers the broadest selection of alternative asset classes available. While every investment carries some degree of risk, each Yieldstreet opportunity is highly vetted before becoming available.

A crucial benefit of such investments is diversification — crafting a portfolio composed of a mix of asset types. Diversified holdings can go a long way toward mitigating overall risk. In fact, diversification is a cornerstone of long-term investing success.

Alternative Investments and Portfolio Diversification 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary 

Options trading can potentially provide steady income as well as portfolio protection. But while trading options is more accessible than ever, the activity can still be complex. Investors would do well to understand the risks, as well as the rewards, before participating.

Remember, too, that there are other ways to diversify one’s portfolio outside the stock market.