Options Trading
Options trading, once a highly specialized niche reserved for Wall Street experts, has exploded into the mainstream with the rise of online trading.
Now, regular investors can take advantage of the leverage afforded by using call and put contracts, spreads and straddles to hedge risk and amplify their gains. But before you can start, you need to understand the fundamentals of the options market.
A long option is a contract giving you the right, but not the obligation, to buy or sell a specific security at a specific price over a specific period of time. After that period of time has elapsed (the option’s “expiration”), the option ceases to exist.
A short option contract (where you sell a call or a put) is more akin to selling insurance, where you collect premium in exchange for taking on the obligation to buy or sell shares at the strike price for a fixed period of time.
A long call option gives you the right to buy the security.
A long put option gives you the right to sell the security.
There are numerous types of options trades. Depending on which method you choose, options trading can be used to hedge a portfolio, create yield or gain significant market exposure and returns with little capital risk.
Options contracts typically represent 100 shares of the underlying stock or ETF. So, if you exercise a call, you’re buying 100 shares of the underlying stock; if you exercise a put, you are selling the underlying 100 shares at a stated price—known as the “strike price.”
However, most options contracts are never exercised, with traders generally preferring to sell the contract prior to expiration at either a gain or a loss depending on the performance of the underlying asset.
While there are a variety of option trading terms that are unique to this type of investment, here are a few that can help you learn more:
Options Premium: This is also known as the options “price.” The potential loss for the holder of an option is limited to the premium paid for the contract. On the other hand, the initial premium can offset potential losses or generate income for the seller of the option.
Time Decay: All options are wasting assets whose time value erodes by expiration—and that erosion is called “time decay.” The more time remaining until expiration day, the higher the premium will be. That’s because the longer an option’s life, the greater the possibility that the underlying share price will move to make the option in the money.
Implied Volatility: If the market becomes volatile, or if volatility is expected, implied volatility will rise, thereby increasing options prices. Conversely, low market volatility lowers options prices. The Chicago Board of Options Exchange Volatility Index (VIX)—a.k.a. the investor “fear gauge”—is the best way to measure near-term volatility in the S&P 500. It represents the market’s volatility expectations over the next 30 days.
Want to learn more? Let our options expert Jacob Mintz explain more about options basics, and his own personal options strategies. Jacob runs three options services for Cabot Wealth Network: Cabot Options Trader, catered to options beginners; Cabot Options Trader Pro, for more experienced options traders; and Cabot Profit Booster, which trades covered calls on one momentum stock each weed recommended by our resident growth investing expert Mike Cintolo in his Cabot Top Ten Trader advisory.
Jacob carefully assesses the risk and reward of each one of his options trades. When he buys options, he risks pennies to make dollars. When he sells options, he does so with defined risk to avoid big losses. Sometimes Jacob uses conservative options strategies to hit singles; other times he uses more aggressive strategies to try to hit home runs.
Despite its growing popularity, options trading remains widely misunderstood by the investing public. We encourage you to read and learn more, and, if you’re ready, to take advantage of the expert guidance of Cabot’s options services.