Some investors or traders don’t buy or sell company stock. Instead, they trade stock options to take advantage of the stock markets. A stock option is a derivative that offers the holder or buyer the right (without obligation) to purchase or sell an asset at a specific price on or within a specified period.
However, stock options trading is more confusing than stock trading, especially if you are a newbie. You must understand the ins and outs of stock options if you are to profit from the trading – beyond just getting lucky. It’s similar to taking part in casino games on platforms like VulkanVegas, where if you know what you are doing, you have a high chance of winning big.
Likewise, if you can grasp the concept behind trading stock options, you will definitely make better moves and, of course, enjoy significant proceeds. So, if you’ve ever thought about venturing into this type of trading, stick around to learn the basics.
Types of Stock Option
In stock options trading, there are two styles of options that you can exercise. They are:
- American style: Can be traded any time between the day of purchase and expiration.
- European style: Can only be traded on the expiration date.
Additionally, stock options are divided into two forms of contracts, namely:
- Call Option: This gives the option holder the right but not the requirement to purchase an underlying security at the exercise price on or before a set date. A call option’s value increases if the price of the asset goes up.
- Put Option: Here, the option holder is accorded the right (without obligation) to sell an underlying security at the exercise price before or at the given expiry date. Accordingly, a put option gains value when the price of the underlying security decreases.
How to Trade Stock Options
As an investor, you must determine your objectives before adding stock options to your portfolio. That is, are you trading in options to hedge, speculate or generate income? With that in mind, here are ways you can trade stock options:
Buying Calls
If a trader or investor thinks the price of a security will rise, they can buy an asset using less cash than what the asset is worth. The upside to longing calls is the potential profit is boundless because the payoff increases as the price of the underlying asset increases. However, if the asset price drops, they lose the premium they paid.
Traders or investors who prefer this strategy either want to apply leverage to take advantage of the increase in prices or are confident about an EFT or company stock and want to mitigate risk.
Buying Puts
If you are bearish about a stock, you can exercise your right to buy a put option and profit from its price decline. When you buy a put, you pay a premium which is the maximum amount you can lose in the trade.
In this case, you should consider a put option as insurance against the price drop of an underlying asset. So, if the stock prices tank, you get paid the premium. However, the profit you get from buying a put is limited because a stock price cannot go below zero.
Cover Calls
If a trader expects no or minimal changes in the price of a stock, they can exercise a covered call to create income using options premium. A trader or investor who owns an underlying security will sell call options of the same security to exercise the covered call.
Protective Puts
Protective puts work best for investors who own an underlying security and want to protect it against loss and profit from the downside move. To do so, a trader buys a downside put by paying a premium, creating a lower floor below which you cannot make further losses even as the underlying security price continues to drop.
In the event the price of the underlying security increases and registers above the put option’s strike price at the maturity date, then the contract expires worthless. Conversely, when the price of the underlying asset decreases below the strike price of the put, the trader’s portfolio takes a hit. However, the loss is primarily covered by the increase in the put position.
Long Straddles
It’s a strategy where an investor buys both a long call and a long put of the same underlying security with similar maturity dates and strike price. This options strategy is used to profit from a strong move mainly triggered by significant events in either direction of the underlying security.
Play Your Cards Right!
Stock options are risky; however, if traded correctly, they can minimize risk as you make some moolah from the upward or downward movement in the price of a stock. It’s all about understanding the market and then making the right moves to emerge ahead!
