We’ve been riding a bull market long enough that the talking heads on CNBC and actual economists are starting to talk about pullbacks, softening, and lowered expectations–the language that makes smart investors take notice. Current conditions are all over the place–one day the Dow is down 800, the next week it’s up 1200–so figuring out how to keep your portfolio in the black and even growing into 2019 is top of mind for many independent investors.
Now might be a good time to explore options trading–it’s like the next level up from stocks and takes a little more research, experience, and, some would say, nerve than basic buying and selling equities. Here is a quick guide to getting started in options trading; you can determine whether options trading is the right fit for your investment strategies.
Finding The Right Options Broker
Do you know the licenses your current broker holds? If you’re trading online, you’re probably working with a broker holding a Series 7 license–the General Securities Representative license–that allows them to buy and sell stocks on your behalf. Options trading requires another license, the Series 4–the Registered Options Principal license–so the first thing to do is to ensure your broker can trade options, and if not, help you find one who can.
When you’re choosing an options broker, it’s a lot like online dating–you both need to swipe right to determine if you’re a good match. There are a few more hoops to jump through with options–you’ll need to provide detailed financial information–income, liquid assets, and net worth–along with your investment goals and trading experience to open an options account. Your options account is separate from your equities account.
You’re interviewing a broker for the job, too. Ask prospective brokers what tools they have–research sources, support, and guidance–as well as their own experience–failures and successes–in options trading.
Options Trading For Beginners
Options are a fundamentally simple concept–you purchase a contract to buy or sell a given stock at a predetermined price by a certain date. There is some strategy involved with options–short of a crystal ball, you’ve got to trust your broker’s advice on whether a stock is going up or down, and when.
Put or Call
You buy options contracts in 100 share increments. If you think a stock is going up, you buy a call option. This gives you the option–but not the obligation–to buy within a time range at your strike price. If you bet a stock is going to drop, you’ll buy a put option–you can sell shares at your contract price. The contract specifies whether it’s a put or call, the strike price, and the expiration date.
Here’s where it does get a little more complicated–picking your strike price. Options trading isn’t like buying a lottery ticket; you can’t just pick a random number and hope the ball rolls out before the contract expires. It’s more like roulette, with magical algorithms creating option quotes–a range of strike prices, in standard small increments–for a given stock that are based on the stock price, so that’s always a moving target.
Remember the basic finance calculation–the time value of money? In other words, how much does something actually cost over time? With options, you have to factor in two values–time and intrinsic. Intrinsic value is easy–the difference between the strike price and the share price. Time value would be easier to calculate with that crystal ball–combine the time on the contract, the stock’s volatility, and interest rates to get that number. When you’re figuring out your strike price, you’ve got to add in the premium on the contract, too, so you make a profit on the call or put.
The final component of the contract is the expiration date. Again, it’s like roulette–there are predetermined expiration dates for contracts, and you’ve got to pick one that’s offered in the option’s range. The range is wide–from the next day to years out. Short options are riskiest, and when you’re a novice options trader, your broker may well start you out in longer contracts. A longer contract lets you see how the stock moves, and how your investment strategy works in reality. Longer contracts also are a hedge against a dip in price, and as the expiration date gets close you can still sell the option, although the time value has decreased.
If you’ve been paying attention, you’ve noticed that options trading is not for day traders–if your investment strategy is one that relies on extremely short-term trades, clearly extended options contracts are not going to work for you. Really experienced options traders do day trade, but for beginners, you’ll need the guidance of your broker to teach you the ropes. After you’ve had some success with options trading (made more than you’ve lost) you can move into that higher level of trading. If an options broker says they’ll allow you to day trade right away, run like the wind–they see nothing but short-term commissions and do not have your best interests at heart.
Advantages Of Options Trading
Here are three good reasons for adding options to your trading strategies.
With good guidance, you can get into strong stock positions at a fraction of the cost. Here’s an example: suppose a stock is trading at $50 and you want to buy 500 shares–in a straight equities purchase, that would cost you $25,000 right off the bat. If you had bought five call options (500 shares) at $20, your total outlay is only $10,000–leaving you the balance to invest elsewhere.
Higher Return Potential
Obviously, if you bought your 500 shares for $10,000 instead of $25,000, your net profit is $15,000 if you sell at $50–on top of the $15,000 you didn’t spend on the initial trade.
More Strategic Opportunities
Options trading is the doorway to more sophisticated investment strategies–with an experienced trader guiding you, the market’s “third dimension” opens to you. This lets you trade not only in equity prices, but strategically invest in time and market volatility. Options also let you play the downside of the market with put contracts–an alternative approach when an equities broker will not let you short your positions.