We introduced you to the concept of trading options back in classes 6 and 7 of Foundations of Stocks and Options Level 1, and you can do a refresh reading of those two blogs here and here if you like. But in short, one of the best reasons for learning to trade options is their capability to limit the risk of your capital. They accomplish this by allowing you to control a hundred shares of a company’s stock with only one option contract. This means you could have control over more shares of a company with less capital investment, which in turn keeps the possible risk of financial loss to a minimum. Plus, anytime you can reduce your risk in the market, that is a good thing.
Remember, when you are trading, you are buying and selling actual shares of a company’s stock; however, when you trade options, you are buying and selling the right but not the obligation to trade those same shares. If you own an option that grants you the right to purchase a company’s shares, you can purchase the shares in question as long as your option contract is still active. However, you do not have to purchase the stock as you can let your option or your right to purchase them expire as option contracts are only good for a limited amount of time.
There are two types of options you can trade: a call option and a put option.
A call option gives you the right to buy a stock at a certain price. The monetary value of a call option increases as the value of the stock increases, which means call options are bullish in nature. These options are valuable to short sellers as they function as a type of price insurance. For example, if the price of a stock goes up on a short trade and you have a call option in place, you can exercise that option to purchase the stock in question for a previous price point, which is lower and cover your short sale. The benefit of trading call options is the lower cost of entry, the ability to leverage more shares, limited risk, and unlimited reward.
On the flip side, a put option gives you the right to sell a stock at a certain price. The monetary value of a put option increases as the value of the stock decreases, which means put options are bearish in nature. These options are valuable to long buyers as they function as a type of price insurance. For example, if the price of a stock goes down on a long trade, and you have a put option in place, you can exercise that option to sell the stock in question for a previous price point, which is higher. The benefit of trading put options is the lower cost of entry; they do not have any margin requirements, the ability to leverage more shares, limited risk, and unlimited reward.
In closing, the main point to take away from all of this is when beginning options trading, you should buy calls for bullish trades and buy puts for bearish trades. That is it: call the bulls and put the bears. Once that piece of the puzzle has been established, we can dive deeper into the topic, which we will do in the next few blogs, so stay tuned.
As always, if you wish to learn more regarding this topic, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you for reading, and we look forward to seeing you in next week’s Foundations of Stocks and Options blog!