Investing and trading stocks is a sound idea for those looking to build their wealth portfolio? From stocks to bonds to exchange-traded funds (ETFs) to options, investors have myriad choices for strategizing where and when to put their money. For the adventurous investor, options trading is worth considering. This type of investing requires some important background knowledge, but with a little information, options traders can see the possibility of huge returns in a short amount of time.
What Is Options Trading?
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Options trading is the sale and purchase of contracts. Options contracts give investors the option of buying or selling the asset associated with the contract under a specific set of parameters, like date and price. Investors can use stock options for income, to hedge other investments, or to speculate. Some people call options “derivatives” since they don’t have any value themselves but instead derive their value from the asset to which they’re tied.
Most stock option contracts represent 100 shares of the underlying asset’s stock, but investors can write up any type of contract they’d like, so it’s important to look closely at the details of each and every options contract. Additionally, since some options contracts are speculative, they carry a higher risk than traditional stock investing.
Covered Calls and Covered Puts
Options are divided into calls and puts — calls, essentially, are purchases, while puts are sales. Unlike traditional stock investing or trading where there’s some strategizing, but sales are often straightforward, options trading is predicated on strategy. Two of the most popular options trading strategies are covered calls and covered puts.
A covered call is a strategy that helps reduce the investment loss potential through a dual purchase strategy. The investor purchases 100 shares of a company’s stock. At the same time, the investor purchases an options contract against the same company. Once the investor sells the options contract, they’ll collect the premium on the contract, essentially lowering the purchase price of the original stock and adding some downside protection to the overall exchange.
Covered puts, then, are the inverse of covered calls. With a covered put, investors follow the same process, but with a short. The investor first decides to short-sell a stock and then sells a put option on that same underlying asset. The investor gets some immediate funds from the put with the option to buy the stock back and close the short.
Options Trading Strategies
There are a few other notable options trading strategies you should be familiar with if you’re hoping to get in on the options trading game:
- Married-put strategy: The purchase of identical put options after the purchase of stock.
- Long strangle strategy: The simultaneous purchase of call and put options that have the same expiration date but different strike prices.
- Long straddle strategy: The simultaneous purchase of call and put options that have the same expiration date and the same strike price.
- Protective collar strategy: The purchase of an out-of-the-money put option and out-of-the-money call option on the same asset.
Options trading can be highly lucrative, but it does require some know-how. Use covered calls and puts to help you build your wealth.