If you’re just getting into investing, the idea of trading stock options can be a bit intimidating. However, by better understanding what stock options are and learning a few strategies for trading them effectively, you can quickly set yourself up for success.
What Are Stock Options?
Stock options are contracts that give someone the right, but not the obligation, to purchase or sell stock at a specific price before the contract expires. Options are valuable because they can provide added income, leverage, and protection. An investor, for example, could use stock options to hedge against a stock market that’s declining in order to limit losses. Alternatively, stock options can be valuable for generating recurring income.
There are two types of stock options: call options and put options. A call option is where you have the right to purchase the stock, while the put option gives you the right to sell it.
Always Stick With Your Plan
Before you buy an option, you should have a plan in place, including what your target profit is. As soon as the option hits your target, make the trade, even if it’s early in the contract duration. Even if you are just close to the target, you may want to consider making the trade rather than waiting and potentially experiencing a loss.
Understand Factors That Affect a Stock
One of the best things you can do as an investor is to have a solid understanding of the stock market in general, including the current trends. Understanding the factors that affect a stock before you buy its options is the best way to mitigate your risk. If you want to make a profit, you need to know the history of that particular stock and the plans that the company has for the future.
Look for Dividends
Before you initiate any options trade, look to see whether the stock pays dividends. Looking for dividends is important because if the dividend is greater than the time value of the option, then the stock could be assigned. This means that the owner of the stock option could exercise the option to earn that dividend payment, forcing the owner of the stock to sell.
Married Put Options
The way this strategy works is that after purchasing stocks, you buy put options for an equivalent number of shares. This acts as an insurance policy against any short-term losses on your call options. You then simultaneously sell that same number of call options, but at a higher strike price.
Manage Risk Carefully
Never hold any position where, if the worst-case scenario occurs, you could lose more than you can afford. Always consider what the worst-case scenario could be before buying stock options, and evaluate whether you can afford that risk.
While trading options can be overwhelming in the beginning, they are relatively easy to understand once you grasp the basic concepts behind options trading. They can provide excellent opportunities for making money, and they can limit the risk of investing when used correctly.