With the recent volatility in the stock market due to the COVID-19 pandemic, many investors are pretty nervous.
For some, though, they see a unique opportunity to benefit from the market’s wild swings.
If you’ve caught wind of the increased interest in options trading recently, you might be thinking about buying options yourself.
Let’s take a look at what options are, how options work, and when to buy options.
What Are Options?
Options are what are known as derivative securities. This is because the price of an option is dependent on something else’s price.
There are two kinds of options you can buy, known as calls and puts.
When you purchase an option, you are buying the right but not the obligation to buy or sell the underlying equity, index or ETF at a certain price before a certain date. The predetermined price is referred to as the strike price and the predetermined time period is known as the expiration date.
The difference between calls and puts is that calls give you the right to buy a security at the strike price by the expiration date, while puts give you the right to sell a security at the strike price by the expiration date.
If you’re just starting out, it’s important to know that it is also possible to write options versus purchasing them.
If you’re writing options without holding stock in the security you’re writing options for, this is called writing naked calls or puts. When you do this, you are potentially opening yourself up to unlimited risk. That’s just as scary as it sounds.
It is completely possible to purchase options in a smart way that manages your risks, but it’s just important to fully do your research before jumping in. This will help mitigate making incredibly costly mistakes.
When to Buy Options
Typically, one would purchase call options when they’re bullish regarding the market or the particular stock. Bullish means you’re expecting the price to go up. On the other hand, one would buy puts when they’re bearish, meaning they expect the price to go down.
Options contracts can also be purchased as a part of a hedging strategy. Hedging strategies are used to reduce your exposure to risk in the case that the price of an asset in your portfolio drops suddenly. When hedging is done properly, it can limit your losses, reduce uncertainty, and avoid reducing the potential rate of return.
Determining which strike price and expiration date you’re going to purchase your options for is an important consideration. It can take a lot of focused studying and practice to understand the way that price levels affect the movement of the market. There are a variety of tools you can use to help you to determine the appropriate options trading levels.
The Risks of Buying Options
Playing in the stock market in any manner is not without risk. It’s important to do your research before buying options so that you understand what’s at stake.
If you purchase an options contract and do not exercise it or sell it before the expiration date, it will expire worthless. This means that all of the money you put into buying the contract is gone.
It’s also worthwhile to spend time studying what they call the Greeks. This refers to the delta, gamma, vega, and theta that is assigned to each options contract.
The Greeks each tell you information individually, but together they also paint a picture that helps you understand how much risk you’re exposing yourself to. Before googling how to buy an option, it’s crucial to understand the Greeks when you’re learning how options work.
Options Strategies
There are a number of different options strategies that traders employ to minimize risk while maintaining a worthwhile return on investment.
As you get deeper into researching options, you’ll likely come across terms like long straddle, long strangle, butterfly spread, and an iron condor.
Depending on how seriously you intend to take your options investing, it could be worth your time to research these varying options strategies. When investing, no matter your strategy, you’re always looking to get the best returns while exposing yourself to the least amount of risk.
Are You Ready to Buy Options?
When you first encounter the world of options, it can feel overwhelming. Learning about the stock market and when to buy options can feel like learning an entirely different language. It’s actually not as complicated as it seems, though, and it’s possible for beginners to profit from the stock market in this manner.
It’s best to take your studying seriously and invest time into understanding as much as you can. Watch YouTube videos, read tutorials, and learn about both market fundamentals and technicals. This will give you a lot more confidence when you decide to put your money in the game.
Remember, though, you never want to risk more than you can stand to lose. It’s easy to feel confident that things will go your way such that you don’t consider at what point you’re going to get out of a trade.
While researching, do yourself a favor and learn as much as you can about trading psychology. Even the most level-headed person will get hot under the collar when a lot of money is at risk, and it’s important to not make rash or impulsive decisions.
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