Option trading is different from buying and selling stocks and can be profitable if done correctly. It also has some benefits when compared to simply buying and selling individual stocks.
Table of Contents
Leverage
Option trading gives traders leverage that they cannot get when buying stocks. One option allows the trader to control 100 shares of the underlying stock, exchange-traded fund, or index.
If a trader wanted to buy 100 shares of a stock that cost $45 per share, the cost would be $4,500 to buy. Or a trader could buy a call or put option that controls 100 shares of that same stock, but for much less money, many times under $100, depending on the option price.
Numerous variables go into the pricing of an option. An important variable is time to expiration. The more time left on the option, the more it could cost. If an option (called a contract) costs 95 cents per contract, the total cost for one option or contract would be $95 per contract or 100 shares times 95 cents.
Profiting in a Bear Market
Sometimes during a bear market, there is nothing to do but wait it out. Option traders can make good profits by trading options in a down market. When a trader believes a stock will go up in price, they can buy a call option and profit when the underlying stock increases in price.
If the stock or the overall stock market is going down, option traders can buy put options. If the underlying stock price goes down enough before the expiration date, the trader will profit, even though the stock has dropped in price.
Strategies
Buying calls or puts is basic option trading. There are trading strategies that can reduce the risk of a trade. These strategies go by names like spreads and straddles. These strategies usually involve the buying and/or selling of various options at the same time.
When a trader first learns how to trade options, they also learn about different strategies. An example of a spread strategy from the experts at SoFi is explained as, “These trades involve buying or selling an equal number of options for the same underlying asset but at different strike prices or expiration dates. Horizontal spreads involve different strike prices, while vertical spreads use different expiration dates.”
Hedging a Portfolio
One way to reduce losses in a stock portfolio is to buy put options or use a hedging strategy. For example, if an investor has a large position in IBM, and they were concerned that the stock or the entire market is about to drop, the investor could buy IBM puts.
Even though IBM would fall in price during a price correction, the investor would profit when they sold their put options. An investor could also buy stock market index put options, which would protect the entire portfolio during a stock market downturn.
Options can be risky, but being able to manage risk is one of the benefits of option trading. Once a person learns how to trade options, it will open up other profitable trading opportunities.
