Historically, many investors — especially beginner investors — have avoided trading options because of their complexity. However, when you take the time to understand options trading, you’ll realize that when done carefully, this practice can actually pose less financial risk to you and maximize your potential profits.
How Options Trading Works
Here’s a quick overview of options and how they work:
- Options are “derivative contracts,” meaning option holders buy the right to buy or sell a security in the future.
- They are divided into “call” (right to buy) and “put” (right to sell) contracts.
- Buyers pay a premium (often pennies on the dollar) to control options.
- Although holders can purchase the right to buy or sell securities, they are not obligated to do so.
- If buying or selling would be favorable at any point in the contract, the holder may execute the trade.
- If buying or selling would not be favorable, a holder can let the contract expire.
- Options ensure that potential losses do not exceed the value of the premium paid.
- However, potential profits are unlimited.
While options trading is not something to rush into, this strategy is a great way to safely use leverage.
7 Reasons to Consider Options Trading
While you should never limit your portfolio to a single strategy, there are several reasons to expand your investment strategy to include options.
1. Flexibility and Versatility
Trading options is a great way to make money in volatile markets. You can profit from a stock moving up or down by paying a fraction of the cost of owning that stock outright.
Are you looking to protect your portfolio from a downside disaster, bet on a stock soaring or sinking, or turbocharge returns on stocks you already own? If any of those avenues sound appealing, look no further than the options markets.
2. You Can Profit by Correctly Anticipating the Market
Before venturing into options trading, make sure you have a solid understanding of market dynamics. You can profit from correctly anticipating a rising or falling market. The availability of index and exchange-traded fund (ETF) options allows you to make money whether a stock, sector or the market as a whole makes a move.
3. Make Money in a Sideways, Non-Trending Market
Options traders make some of their biggest returns when markets are volatile. However, you can use options to liven up even the most boring market conditions.
How? Become an option seller. This allows you to collect a premium (cash) upfront on the next business day (the transaction would be a “sell to open”). You can sell options against stocks you already own or options you hold long in your trading account.
4. Profit From the Passing of Time
It’s a fact that time is the enemy of the option buyer. You can hold a stock forever, but time starts ticking on options from the moment you enter a position. However, you can hop over to the other side and become an option “writer” (seller) and profit from the passing of time!
5. Gain Leverage and Financial Muscle
With options, you can control tens of thousands of dollars worth of stock for pennies on the dollar. Each option contract controls 100 shares, and you can’t lose more than the premium you pay.
Options can cost anywhere from a few cents to the price of a share of stock. But remember that you’re only paying a fraction of what the stock is actually worth to control the same size position as someone who actually owns the shares.
6. Using Leverage Means Minimal Capital Outlay
The magic of leverage allows you to participate with minimal capital outlay. Since options cost so little, you can control the stock with a small amount of money and keep the rest in interest-earning accounts.
7. More Selective Trading
With options, you can tailor-make strategies with their own risk/reward scenarios before entering into a single contract. Knowing your risk beforehand is a major advantage over other traders.
You might have a substantial amount of money in stocks that you plan to hold for a significant amount of time — maybe some blue-chip names that are achieving stable or even incremental gains. In the meantime, you could make some fast gains on stocks you already hold long.
Alternatively, you might want to dabble in some new names, like up-and-coming “hot” stocks, but you’re not ready to invest the serious dollars that go along with stock ownership. Because your losses are limited, you have the freedom to be a little more creative in your investing.
Are Options Right for You?
Options trading has unlimited upside and minimal downsides, but it’s not for everyone. However, for investors who understand market dynamics and have a great sense of timing, it can be an outstanding way to grow your portfolio and diversify your investment strategy.
On the date of publication, Sarah Edwards did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
