If you’re thinking about getting into options trading, you may not know where to start. While there are some inherent risks in options trading, you can also trade options to protect against losses or grab stock for less than what you would buy it for on the open market. Learning more about the pros and cons of buying and selling options can help you better understand if this form of investing is for you.
What Are Stock Options?
A stock option is a contract that gives an individual the right to purchase shares of a company’s stock at a specific price within a specified amount of time, although they are under no obligation to buy the shares.
There are two different types of options: puts and calls. If you have a call option, you have the right to buy the shares at the price. You would usually buy a call option because you anticipate that the market price of the stock will go up in the future. When you buy a put option, you buy the right to sell at a specific price within a time frame. Options traders who buy puts are betting that the stock will fall. There are both benefits and drawbacks to buying and selling options.
Pro: Low Upfront Financial Commitment
Options are much more affordable than buying shares of company stock directly, especially if the stock is expensive. However, you can benefit the same if the price of the stock goes up. You never have to worry about losing more than the cost of the options as well, so the risk is low.
Con: Sellers Are Exposed to Amplified Risk
Unlike someone who is buying options, the option seller, or writer, is open to a much higher risk. The buyer is not obligated to exercise the option, but the seller is obligated to buy or sell shares within the time frame of the contract, and there’s no limit to how high a stock price can go up.
Pro: Flexibility for Traders
Options traders can deploy multiple strategies before an options contract expires. They could exercise their option and purchase the shares of stock, or they could buy the shares and then immediately sell some or all of them for a profit. They could also sell options that are in the money to another trader or sell an out-of-the-money option to another trader before it expires.
Con: Time Limits
Traders have a limited amount of time to act before a stock option expires. An options trader is hoping to capitalize on price movement. They are betting that the market will go up or down. However, they could take days, weeks, or even months. For the trade to pay off, they must choose the right time to buy the options and the right time to take some kind of action before the option expires.
Though there are downsides to options trading, it does allow you to limit your losses. The key is to have solid a strategy. With the right strategy, options trading can be a great way to earn income through the stock market.