Options trading enables traders to essentially place a timed bet on whether or not the price of the underlying asset, be it shares in a company, a commodity or other asset, will rise or fall in value. Since the 21st century, the options industry has evolved, presenting investors with massive trading opportunities. However, most investors have avoided trading options, mainly due to the initial learning curve. Thus, the lack of knowledge and expertise in options trading can act as a detriment. In this article, you will learn about how to trade stock options.
What is a Stock Option?
An option refers to a security or contract that gives the holder the privilege to buy or sell an underlying asset at a given price for a specified timeframe. Typically, each contract comprises of 100 shares of the company stock. Just like stocks, options are traded on exchanges through brokerage investment accounts. Some corporations also issue employee stock options as part of compensation, allowing employees to buy shares at a specified amount for a fixed duration. The price of stock options can be lower or higher than the value in which the underlying asset was first publicly traded.
Types of Stock Options
Stock options are categorised into two common classes, which differ by when and how the options are taxed. The two categories include the following;
Incentive Stock Options (ISOs) – In this class of options, taxes are not paid at the time when the option is exercised. Instead, capital gains tax is paid once a sale has been achieved. An ISO holder often opts to have their shares sold in the future.
Non-qualified Stock Options (NSOs) – In this category, employees are given an offer to buy company shares at a price below the prevailing market value. Holders of NSOs are typically not eligible for a tax break like in the case of ISOs. On the contrary, the difference in the price at which an option is exercised, and the grant price is subject to income tax.
Common Terms Used in Options Trading
Most traders find options trading to be overwhelming, especially when they cannot understand the investment jargon. This section highlights the common terms that you will encounter when trading options.
Spread – This refers to the difference in the grant price and the market value at the time when an option is exercised.
Exercise – Exercise is the sale or purchase of an option at a strike price.
Strike Price – The strike price, also known as the grant price, is the value at which an option is exercised.
Vesting – This refers to the process followed by a company before it can avail options to employees or investors. This involves an obligation for employees to fulfil performance or tenure criteria before the options are vested.
Option Term – This is the duration within which employees can hold options before they reach their maturation.
Call Option – This is the right of an option holder to buy stocks at the strike price, and before the expiry of the option.
Put Option – This is the opposite of a call option, referring to the right of an investor to sell company stocks at the strike price, and before the option expiry.
How to Trade Options
The process of trading options is simple and straightforward. This guide highlights the most fundamental steps that investors can follow to trade options.
Open an Options Trading Account
You will have to open a brokerage account to trade stock options. The only difference with option trading accounts is that a broker will have to assess your financial preparedness, knowledge of the associated risks, and your trading experience. This is because of the complexity of speculation and the large amounts of capital required to get started.
Consequently, a broker will need you to provide the following information;
- Type of options you intend to trade.
- Financial information, such as personal employment status, annual net income, and net worth.
- Trading experience.
- Your investment objectives, such as speculation and capital preservation.
Speculate the Movement of Stocks
This step is critical as it influences the type of options you trade. For example, if you speculate a rise in the value of stocks, then you will purchase a call option. On the other hand, if you speculate a decline in the stocks, a put option contract will be the ideal choice.
Specify your Speculation
This involves speculating how low or high the value of stocks will move from the current market price. Your option will only remain valuable when your specified stock price closes below or above the strike price. This means that if you decide on a call option contract, then your speculation must be above the strike price, while put options require you to specify a value below the strike price.
For example, if you speculate a rise in stocks from $100 to $120 in the foreseeable future, then you will go for a call option with a grant price below $120. This means that your option will generate substantial profits if the stocks rise above your speculated value.
Determine the Time-frame for Stock Movement
This is where you specify the duration around which you speculate a movement in the stock. If you are anticipating a short-term movement, then you can use daily or weekly options. For long-term stock movement, however, you will need to go for the monthly or quarterly options. Keep in mind that every options contract you purchase comes with a specified expiration date, which is why the decision you make at this step influences your investment. Once you decide on the timeframe of the stock movement, you can open a position and place a trade.
Monitor Your Position
With your position opened, you will need to monitor movement of the stock to assess the potential profit or loss of your position. You might want to close your position when your option gets “in the money”. This is to maximise your profits before the options contract expires. However, if your options trade is not yet in money, then you might want to leave your position open for the expiration of the contract.
What are the Benefits of Trading Stock Options?
Although stock options are a risky investment, options investors enjoy an extensive scope of benefits that come with these securities.
When stocks move in the direction that investors speculate, there is the potential of earning high returns. For example, if you speculate an 80% change in stock prices, then your option would gain 80% of that movement, which is relatively a high yield. However, if stocks move against your speculation, then you might be exposed to a loss of up to 100% of your investment.
While trading options come with potential risks, investors can have these risks minimised significantly when used in the right way. Compared to equities, stock options are less risky, as they require less financial commitment. Buying a call or put option would expose you to minimal risks than when trading the same stocks directly.
One notable attribute of stock options is their cost-efficiency. Investors can open an option position at higher cost savings compared to opening a typical stock position. For example, if each share of stock was trading at $100, then it would cost you $10,000 to purchase 100 shares. On the other hand, it might only cost you $200 to be in control of 100 shares in a call option. However, this must be accompanied by the purchase of the right call contracts.
Stock options are generally known to be leveraged instruments. This is because options allow investors to sell or buy stocks at their own selected prices. Again, the fact that investors can buy options at a significantly lower price than equivalent amounts of stocks means that one can earn high percentage gains relative to minimal investment.
Websites Where Stock Options Can Be Traded
There are various websites which stock options can be traded, including spread betting websites or through online brokers. In this section, you will find a few websites where you can trade stock options.
E-Trade is a popular broker for options trading. Traders also do not need a minimum deposit to get started on E-Trade. The E-Trade platform is one of the low-cost trading websites, with each options contract trading at $0.50 to $0.65. In addition to the E-Trade mobile and desktop applications, the broker features visually appealing tools for enhanced trading.
Known for its user-friendly and low-cost brokerage platform, Ally Invest is another leading stock options broker. There is no minimum deposit requirement to trade in Ally Invest, with all options trades going for zero commission.
TD Ameritrade is a global brokerage firm, featuring a wide range of securities. The platform charges $0.65 for every options contract. TD Ameritrade is also popular for educational, research, and risk assessment tools. These tools are helpful when dealing with complex spreads and basic trading guidelines. Many TD Ameritrade investors use the Thinkorswim platform suite for options trading rather than the standard TD Ameritrade trading view.
If you are looking for an all-round options trading site with advanced tools, then Charles Schwab is another good choice. The platform charges a $0.65 base fee for every options contract. Charles Schwab is also not left behind when it comes to options courses, trading tools, and zero-fee commission trades.
For active traders interested in advanced features for high-quality trades, then Tastyworks is the ideal platform. Tastyworks has been in the trading business since 2017, with experienced investors finding their niche here. You can trade options in Tastyworks via its mobile application, website, or desktop application.
Risks Associated with Stock Options Trading
Trading stock options can earn you significant returns in a given period. However, you should be cautious of the associated risks when trading any type of options.
Liquidity of Options – Stock options are considered to be generally liquid. However, it is possible that a given type of stock option might be trading in very low volumes, resulting in liquidity risk. This means that it might become quite difficult for you to buy or sell options at ideal prices.
Time Value Risk – Every options contract has a timeframe attached to them. The further the contract is from expiration, the higher the value of the options. This means that your investment will be declining in value as time lapses, exposing you to what is popularly known as the time decay risk.
Trading Complexity – Although it is not that difficult to comprehend the basics of options trading, some aspects of these securities can be quite complex. Traders, especially beginners, who do not take time to understand the basics and strategies of options trading might incur significant losses in a short duration of the trade. It is therefore important to learn more about this type of security before you can make that investment decision.
What are the Metrics to Use When Trading Stock Options?
Despite the risks associated with trading stock options, it is still a lucrative making money online. You only need to analyse the risks and find a way to mitigate them. To lessen the risks associated with stock options, as well as monitor the performance of these securities, traders should consider using metrics designed for stock options trading. These metrics will not only help you counter the associated risks, but they will help you identify the right time sell or hold your stock options. Here is a closer look at each of the metrics linked to stock option trading;
Relative Strength Index
This metric measures the speed and change in movement of stock prices. The metric ranges from 0 to 100, with a 70-plus measure indicating overbought security. A measure below 30, on the other hand, reflects oversold security.
Money Flow Index
The Money Flow Index is used to calculate the outflow and inflow of money into a stock option over a given period. The index applies both volume and price datasets to establish whether an asset is oversold or overbought relative to money flow.
Options investors rely on this metric to determine the overall change in what is known as market sentiment. This is used as an indicator to determine investor attitudes towards the options market. The metric establishes the volume of trade using put options relative to call options.
This metric shows the unsettled options contracts. Open Interest reflects the strength of both upward and downward trends in stock movements.
This article has provided an overview of how to trade stock options. Whether you receive the securities as employment-related compensation or buy them for portfolio diversification, understanding the basics of stock options trading is fundamental to the success of your investment. This includes knowing the different types of options, risks involved, and the best metrics to use for options trading. Depending on your strategy, trading stock options can be more profitable and less risky than typical trading. It would be wise to undertake extensive research on options trading to make informed investment decisions.