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There are many different ways you can invest your money, and investing in options is one of the more complicated ones. While options can make a great addition to an investment strategy, it's a good idea to wait until you have some trading experience under your belt and that you understand how the process works.
Here's what you need to know about options trading, including pros and cons, along with some more straightforward alternatives.
What Are Options?
Options are contracts that give an investor the right to buy or sell a stock at a specific price if they choose to do so at any time before the expiration date. Options are made in increments of 100, so if you purchase one option contract for the right to buy Apple stock at a specific price, it's for 100 shares of the company.
Note that these contracts are different from stock options that an employee may receive from their employer.
Buying options is a more advanced investment method compared with stocks and mutual funds. Traders can develop many different strategies to take advantage of options and limit their risk with a specific stock, increase their income (if they're the seller) and plan for the future.
How Do Options Work?
There are two types of options that you'll come across: call options and put options. Here's a quick summary of how each type works.
If you're buying a call option, you're purchasing the right (but not the obligation) to buy at a specific price, called the strike price, by the contract's expiration date. If you're selling a call option, also referred to as a "covered call," you agree to sell the stock at that price to the buyer if they choose to exercise their option.
If you're the buyer, you're hoping that the price of the stock will increase. For example, let's say you buy a call option for a $20 premium, giving you the right to purchase 100 shares of Apple stock at $160 per share. If the price of the stock increases to $200, you can exercise the option and essentially get a discount of $40 per share—that's a profit of $4,000. If the stock price goes below $160, though, and your option expires, you're only out the cost of the options contract (which isn't much).
In contrast, if you're the seller, you're hoping that the price of the stock will either go down or stay the same. If you're the seller in the previous scenario and the price goes up to $200, you're obligated to sell at a $40 discount per share, which means a loss of $4,000. But if the stock price goes down or stays the same and the buyer doesn't exercise the option to buy, you walk away with the $20 premium.
Opposite a call option, a put option gives the buyer the right, but not the obligation, to sell a stock at a specific price within a set timeframe. If you're selling a put option, you agree to buy the underlying stock at the agreed-upon price if the investor who purchased the option exercises it.
If you're buying a put option, you're hoping that the price of the stock will go down. Taking the original example, let's say you buy a put option for $25 that gives you the right to sell 100 shares of Apple stock at a strike price of $160 per share.
If the price of Apple stock drops to $140 and you exercise your option, you get to sell 100 shares to the seller of the put option at the strike price, giving you a profit of $20 per share, or $2,000 in total.
In contrast, if you're selling a put option, you're expecting the price of the stock to increase. If Apple's stock stays at or above $160, the put option buyer won't exercise the contract, which means you get to keep the $25 premium.
Pros and Cons of Investing in Options
There are many benefits and drawbacks to using options as part of your investment strategy. It's crucial to understand both before you make any decisions about including options in your portfolio.
- Lower financial commitment: If you're hoping to take advantage of the price movement of a stock, options make it so you don't have to fork over the cash to purchase actual shares. As a result, your potential return can be much higher compared with your initial investment.
- Less downside for buyers: Whether you're buying call or put options, you're not obligated to make the decision to buy or sell the underlying stock in the contract. If things don't go your way, you're only out the contract premium.
- More flexibility with trading: Depending on the type of option and your position as the buyer or the seller, you could use options to hedge your current investments, get some extra income from stock you already own or use other strategies to achieve your investment goals.
- They're complicated: Options come with their own set of jargon and rules that you need to understand. As such, it's best to avoid them until you have a good amount of trading experience under your belt and have spent the time learning about how they work.
- Loss potential is high for sellers: Whether you're selling a call or a put option, you can incur a loss that's far greater than the income you receive from the contract's premium.
- Not just anyone can do it: Before you can trade options, you need to receive approval from your brokerage firm. You'll need to answer several questions and agree to keep at least $2,000 in your brokerage account as cash reserves.
Consider Your Investment Strategy Before Trading Options
Before you think about investing in options, it's crucial that you understand what you're getting yourself into. There are many other potential investments available that are a bit more straightforward and beginner-friendly. These alternatives include:
- Mutual funds and exchange-traded funds (ETFs)
- Real estate investment trusts (REITs)
You may also consider consulting with an investment advisor or a financial planner before proceeding with options to get expert advice about whether options are right for you and how to incorporate them into your investment strategy.