- How to Invest
- Posts
- How to Invest: Options
How to Invest: Options
In partnership with
Welcome to How to Invest. In this article:
Main Feature: Investing in Options: Strategies, Benefits, and Risks
Investment Ideas for All Budgets
Educational Corner: Understanding Option “Greeks”
Did You Know? A Quick Financial Fact
Investing in Options: Strategies, Benefits, and Risks
Options are versatile financial instruments that give investors the right, but not the obligation, to buy or sell an underlying asset (such as a stock, ETF, or commodity) at a specific price before or on a particular date. Although options can offer leveraged returns and strategic flexibility, they also come with greater complexity and risk than traditional stock investing. This section explores how options work, their potential advantages, drawbacks, the different types of options, and how to get started in a responsible way.
What Are Options?
An option is a contract between a buyer and seller. The buyer pays a premium to control a certain number of shares or units of the underlying asset without having to purchase them outright. There are two primary types of options:
Call Options
Grant the right to buy the underlying asset at a set strike price. Investors often purchase calls when they anticipate a price increase in the underlying asset.Put Options
Grant the right to sell the underlying asset at a set strike price. Investors often purchase puts when they anticipate a price decrease in the underlying asset, or when they seek downside protection for an existing position.
How Do They Work?
Each option has a strike price (the agreed-upon price for buying or selling the asset) and an expiration date (the point at which the option contract ends). If the market price makes the option profitable at or before expiration, the holder may choose to exercise the option. Otherwise, the option may expire worthless, causing the holder to lose the initial premium paid.
For example, if you buy a call option on a stock with a strike price of 50 dollars per share and the stock rises to 60 dollars, your option may become more valuable. You can then sell the option for a profit or exercise it to buy the stock at 50 dollars per share. However, if the stock stays below the strike price, your option could expire worthless.
Benefits of Options
Leverage
Options can control a larger quantity of shares for a lower upfront cost compared to buying the shares outright.Flexibility
Multiple strategies exist for bullish, bearish, and even neutral market outlooks.Limited Loss for Buyers
When purchasing options, the maximum loss is typically the premium paid, which can be smaller than losses on direct share ownership.Hedging Capabilities
Put options can protect an existing position from downward price moves, acting as a form of insurance.
Drawbacks of Options
Complexity
Options involve various terms and concepts—like strike prices, time decay, implied volatility, and more—that require careful study.Time Decay
The value of many options erodes over time, meaning you may lose money even if your overall price predictions are correct, but not realized fast enough.Potential for Significant Losses (for Sellers)
Selling certain types of option contracts, such as naked calls, can expose you to theoretically unlimited losses if the underlying asset’s price skyrockets.Trading Costs
Some brokers charge higher commissions or fees for options. Even small fees can accumulate if you frequently trade complex strategies.
Types of Option Strategies
Long Call or Put
Buying a call or put based on a directional outlook. These are the simplest strategies for bullish or bearish views.Covered Call
Holding a stock and selling a call option against it to generate income. This limits upside potential but provides extra cash flow from the option premium.Protective Put
Holding a stock and buying a put option to hedge against price declines. This can cushion downside risk.Spreads (Bull or Bear Spreads)
Combining two options on the same underlying asset with different strikes or expirations to limit both potential gains and losses.Straddles and Strangles
Buying both calls and puts to profit from significant price moves in either direction when you expect volatility but are unsure of the direction.
How to Invest in Options
Educate Yourself
Learn basic and advanced concepts through books, reputable websites, or dedicated courses. Understand key terms like time decay, intrinsic value, extrinsic value, and implied volatility.Choose a Brokerage
Find a platform that offers transparent commissions, strong research tools, and user-friendly trade execution. You may need to apply for option-trading privileges and meet eligibility requirements.Start Small
Begin with straightforward strategies—such as buying calls or puts—before considering complex spreads or naked options. Limit your capital to an amount you can afford to lose.Monitor the Market
Pay attention to the underlying asset’s price movements, volatility levels, and relevant economic events. Options can react quickly to news or shifts in sentiment.Use Risk Management
Carefully position size, consider setting stop-loss levels, or use spreads to limit maximum downside.
Options can enhance your portfolio’s flexibility and potential returns, but they require a solid understanding of the mechanics and risks involved. By starting with simple strategies and practicing sound risk management, investors can leverage options as part of a broader, diversified plan.
Tackle your credit card debt by paying 0% interest until nearly 2027
Reduce interest: 0% intro APR helps lower debt costs.
Stay debt-free: Designed for managing debt, not adding.
Top picks: Expert-selected cards for debt reduction.
Investment Ideas for All Budgets
For Small Investors (1 to 100 Dollars)
Buying a Single Call or Put
Description
Purchasing one option contract can be done with relatively modest capital, especially for lower-priced underlying assets. This approach allows newcomers to gain hands-on experience with the basics of options.
Advantages
Minimal capital outlay compared to more extensive option strategies
Direct exposure to potential upside (calls) or downside (puts)
Defined risk, limited to the premium paid
Limitations
Rapid time decay means you could lose your entire premium if the market doesn’t move in your favor
Smaller account sizes magnify the impact of trading fees
Selecting strike prices and expirations requires some research
Implementation
Open an options-enabled brokerage account
Identify a stock or ETF that aligns with your bullish or bearish view
Choose an option with a reasonable expiration date and strike price
Invest only a small portion of your overall portfolio as you learn
For Medium Investors (101 to 10,000 Dollars)
Covered Calls
Description
If you already own shares of a stable, dividend-paying company, selling call options on that position can generate extra income. You keep the premium from the sold call but risk having to sell your shares if the price rises beyond the strike price.
Advantages
Generates immediate cash flow
Lowers the effective cost basis of your stock
Relatively lower risk, as you already hold the underlying shares
Limitations
Caps upside potential if the stock rallies above the strike price
Still subject to downside risk if the stock’s price declines
Requires enough shares (typically 100 per option contract)
Implementation
Hold at least 100 shares of a stock in your brokerage account
Sell one call option per 100 shares, choosing a strike price above the current market price
Collect the premium as extra income
Consider repeating the process monthly or quarterly for ongoing returns
For Large Investors (10,000 Dollars and Above)
Spread Strategies
Description
Spreads involve trading multiple option contracts simultaneously (for instance, buying one call and selling another at a different strike) to manage cost, limit risk, or create specific risk-reward profiles.
Advantages
Can reduce net premium cost compared to buying a single call or put
Controls maximum loss, making risk more predictable
Offers a range of strategies for various market conditions (bullish, bearish, neutral)
Limitations
More complex to set up and requires deeper knowledge of options
Profits are often limited relative to outright long options
Each leg of a spread can generate additional transaction fees
Implementation
Learn common spreads such as bull call spreads, bear put spreads, or iron condors
Work with a brokerage that supports multi-leg orders and provides strategy tools
Set clear entry and exit rules based on your market outlook and risk tolerance
Track each leg’s performance to understand how changes in volatility or price affect your position
Educational Corner: Understanding Option “Greeks”
The “Greeks” are metrics that help investors gauge how various factors affect an option’s price:
Delta
Measures how much an option’s price moves for each dollar change in the underlying asset.Gamma
Tracks the rate of change in Delta as the underlying asset shifts in price.Theta
Represents time decay, showing how much value the option loses each day as it approaches expiration, assuming all other factors remain constant.Vega
Reflects how much an option’s price changes when implied volatility changes.
Grasping these metrics can guide more precise trade decisions, helping you pick suitable strike prices, expiration dates, and option types for your strategy.
Did You Know?
Modern options trading has roots that date back to ancient Greece, where the philosopher Thales allegedly made an early “option” contract to secure the exclusive use of local olive presses, betting on a larger harvest. In the United States, options as a standardized market tool gained prominence with the founding of the Chicago Board Options Exchange (CBOE) in 1973, which introduced listed and regulated options contracts.
That concludes this article of How to Invest. Options can unlock a range of strategies for both speculation and risk management, but they demand a solid understanding of pricing dynamics, expiration timelines, and market conditions. Take time to learn the fundamentals, start with small positions, and apply prudent risk management as part of a well-rounded investing plan.
Did you enjoy this article? |
Where the People in the News Get Their News
Read religiously by C.E.O.s and West Wing staffers, Puck brings readers behind closed door conversations across Hollywood, Wall Street, Washington, fashion, media, sports, and the art world.