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Have you ever wanted to venture into the exciting world of options trading? Many dream about it but never get around to taking action. Often, it’s because they’re unsure of how risky the practice is or have heard some negative myths about it. Luckily, options transactions are only as risky as you want them to be and can be an excellent way to play the market without buying or selling physical shares of stock. How does it work, and what are the most common techniques for earning a profit? Because option-based trading can be a bit tricky at first, it’s essential to study the steps for succeeding, learn about the pros and cons, and review a typical transaction to get a feel for the process and lose any fear or misgivings you have about this style of investing.

What is Options Trading?

Unlike the traditional method of buying and selling securities, options traders deal in contracts. Technically, when you purchase an option, you own no stock but only the right to buy or sell at a designated strike price. If you want options trading explained in-depth, consider taking an online tutorial in your broker’s educational section to learn more.

Tips for Making Smart, Safe Trades

It’s best to begin by nurturing an attitude of viewing options as if they were a different kind of stock share. In other words, you’ll need to do the same research on the underlying stock before committing to a transaction. Always do the math before buying a contract, so you know every possible result scenario. Option trading can be complex, which means you need to use software to calculate all the potential outcomes. Start small. Spend at least a month using single contracts to learn the ins and outs of the process. Keep in mind that you’re dealing with the legal potential to purchase or sell 100 shares for every contract you hold.

Pros

There is a large cost-efficiency advantage when you leverage 100 shares of a company’s stock. Returns can be much higher than with traditional stock share buying and selling. For short selling, there’s no easier way to capitalize on expected price declines. Contract holders often purchase puts when they believe that a particular company’s shares are about to suffer. In addition to the fact that an option’s risk is considerably lower, there are dozens more strategies you can use to protect yourself from losses and make outsized gains in volatile markets. 

For those who have experience in the options markets, it’s possible to lower a portfolio’s overall risk by using the contracts to hedge against losses of other assets. Many people discover that buying and selling contracts is a much safer, more exciting, and potentially more profitable way to trade. It’s a fact that while anyone can dabble in numerous markets, many folks discover that they want to specialize in option-based trading and enjoy the leverage, potential returns, and excitement they derive from the practice.

Cons

Of course, any asset that suffers from time decay carries an inherent disadvantage. The longer you hold your contract before selling it, the more you stand to lose to time-related decay. Few other assets come with this kind of downside. Note that you can’t always buy contracts on every stock. Plus, depending on which brokerage firm you use, there’s a high probability that you’ll pay a higher commission on each trade. Finally, compared to other asset classes, an option’s liquidity is usually lower.

Anatomy of a Transaction

Here’s a simple example of how a person might make a typical options trade. Research leads you to believe that XYZ Corp. stock is about to fall in price, but you don’t want to sell it short. Instead, you choose to use an option contract to make a profit on the coming decline in the value of the security. You purchase a put option, which gives you the power to sell 100 shares of XYZ at a locked in price of $50 per share one month from today. The current cost of XYZ shares is $49, but you think it is about to suffer a fall in value. Assume the put contract costs $100. As you predicted, XYZ falls to $46 within two weeks, and you choose to exercise your put contract, selling 100 units for $50 each, or $5,000. To fulfill the contract, you purchase 100 units on the open market at $46 apiece, and after fees, you pay $4,650. Your net profit on the deal is $350 because you correctly predicted that the price would fall.