Trading on the stock market can be a straightforward experience or a highly complicated practice involving timing and strategy. Options trading is a type of stock trading that requires understanding and application of various strategies for the best chance of positive outcomes. Learn how options trading functions, a few basic ways to trade options, and the risks and rewards associated with it.
What Is Options Trading?
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Options are also called “derivatives” since their value is derived from the stock with which the contract is associated. Options trading is the purchase and sale of options contracts tied to underlying assets. These contracts give the owner the option to sell or buy the stock associated with the contract — if they choose to — under a specific set of criteria, like date and price. Many investors perform options trading alongside traditional stock investing to increase their income, speculate, or hedge other investments.
Usually, options contracts represent 100 shares of a company’s stock, though the specific value can vary depending on the terms of the contract. In options tradings, the purchase of a contract is known as a “call” while the sale is called a “put.” Options trading is a popular style of stock investment since many of the strategies involved offer the possibility of substantial rewards.
Covered Calls and Covered Puts
The covered call strategy helps reduce the potential for money loss by purchasing stock and a call option at the same time. For example, the investor purchases 100 shares of stock from a company and simultaneously purchases a call contract for the same underlying asset. Once the investor sells the option, they’ll get the premium on the contract, which basically lowers the initial purchase price of the actual stock and protects them from downside losses on the total purchase.
Covered puts are the short-sell version of covered calls. With a covered put, the investor shorts a stock and then sells a put option for that stock. With this strategy, the investor gets some income upfront with the sale of the put option but runs the risk of losing an unlimited amount of money if the timing or pricing goes wrong.
Risks and Rewards
Options tradings presents the opportunity for substantial rewards but often at a higher risk than traditional trading. Consider these risks before you make any covered calls or covered puts:
- Covered puts and covered calls mitigate risk, but they don’t remove it. Some investors don’t realize the risk of losing money still exists in these strategies.
- Covering your calls and puts caps the amount of money you can make when and if the underlying asset’s value moves.
- There’s an unlimited downside in a covered put. That means there’s technically no limit to how much money you can lose if your covered put doesn’t work in the way you anticipated.
When options trading, covered calls and covered puts can help you manage the inherent risks, but they’re not all-powerful. Understand the risks and rewards of your contracts before making any sales or purchases.