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Options trading is booming. It’s also complicated — and if you don’t know what you are doing, you can lose big.
Options essentially allow you to bet on whether you think an asset is going up or going down. You can buy or sell option contracts and implement various strategies. In March alone, the Options Clearing Corporation cleared 1.1 billion contracts, up 12.2% year over year. It was the highest total volume month in the organization’s history and the first time cleared contract volume surpassed 1 billion contracts in a single month.
However, many people aren’t necessarily approaching options trading the right way.
“So many investors take a ‘ready, fire, aim’ approach, which is not the right way to do it,” said Randy Frederick, managing director of trading and derivatives for the Schwab Center for Financial Research.
In other words, they aren’t doing their homework before pulling the trigger on an options contract.
That said, done the right away options can complement your portfolio, especially during times of market volatility. They can be used to generate income when the market is moving sideways or as a hedge to reduce the risk on an existing stock position.
Getting started
Before you start buying options, understand the lingo and how the contracts work.
“Get educated. You need to know what you are doing with strikes, with how things expire,” said Scott Elisha, lead options strategist and wealth advisor at Perigon Wealth Management.
The good news is there are plenty of resources available. Brokerage firms, like Schwab, have explainers on their websites, as does the Securities and Exchange Commission. The Cboe’s Options Institute also has an options 101 course.
Understanding the basics
A call and a put are the most common types of options contracts.
A call option gives the buyer the right to buy shares of an underlying stock at a certain price — called a strike price — for a specified period of time. So if you think the price of a stock will move higher, you would buy a call option. If you sell a call option, you believe the price will go down or stay stable.
A put option gives the holder the right to sell shares of an underlying stock at a predetermined price before the contract expires. If you believe the stock will go down, buy a put option. You can also sell a call option if you think the price is headed lower. If you sell a put option, you are betting shares will rise.
While the buyer has a choice on whether to buy or sell the asset before the expiration date, the seller is obligated to sell or buy the asset if the buyer exercises his or her contractual right on or before the options expiration date.
“When you buy an option, you know the maximum amount of money you are putting to work and the maximum amount of money you could potentially lose,” explained Chris Murphy, co-head of derivative strategy at Susquehanna Financial Group.
“When you sell an option, you open yourself up to more risks,” he said. “For example, the risk to being short a call is, in theory, limitless because there is no actual limit on how high a stock can go.”
There are also costs involved. Investors pay to execute an options contract. The price, known as a premium, is determined by several factors, including the value of the stock, the strike price, volatility and expiration date. For instance, larger implied volatility translates to higher option prices.
Your first options trade
Your very first options trade should be a covered call, said Schwab’s Frederick.
A covered call is when the trader sells someone the right to purchase a stock that he or she already owns. If you have at least 300 to 500 shares of a company, have owned them for a while and they are worth more than what you paid for them, the strategy is a good way to “dip your toe into options,” he said.
Sell one call against 100 shares of that position, Frederick advised. Set the price a little bit higher than where it currently sits and have the contract expire in about a month or two, he said.
“Then you don’t have to do anything. Just sit tight. This is how you learn about how options work,” Federick added.
There is also minimum risk involved, he said. If the stock goes down, you’ll have lost the money anyway by owning the equity, he said. If the stock shoots higher, you may have given up a little bit of profit but will still make money on the rest of the shares you hold. If the stock goes sideways, you made no money on the stock but a little on the options, he said.
“The amount of downside is so little compared to the potential benefit,” Frederick said.
Perigon’s Elisha also likes covered calls for his portfolio, as well as his clients.
“The thing about selling covered calls is you do limit the upside,” he said. You also need to be comfortable with the strike price you select.
“If you bought a stock at $100 and sell a $110 call and stock goes to $120, you are missing out on that $10 of upside,” he explained.
Of course, there are other, more complex strategies available, including a multi-leg strategy that combines multiple options.
“Don’t assume that a more complex multi-leg strategy is better,” Frederick said. “It is different and it gives you potentially more flexibility.”
“Sometimes the simplest strategies are the best ones,” he added.
