If you’ve never traded stock options before, this type of investing can be somewhat intimidating. However, there are many reasons why trading options can be beneficial, even for beginner investors. Understanding how stock options work, along with the pros and cons of buying stock options, can help you determine whether this might be a good strategy for you.
What Are Stock Options?
A stock option is a contract that gives the option holder the right, although not the obligation, to buy or sell shares of a specific stock at a specified price by a set date. The majority of stock options usually follow an options calendar and typically expire on the third Friday of the month. Before the option expires, the holder needs to decide whether they will exercise their right to buy or sell the shares, sell the option contract to another investor, or simply allow the option to expire.
There are two different types of stock options: call options and put options. With a call option, you are buying the option to purchase the stock at a specific price by a particular time. With a put option, you are buying the right to sell a specified amount at a pre-determined price within a certain time frame.
Pros of Buying Stock Options
Options trading has several advantages that make it appealing to investors, including:
- Ideal for starting investors: Because you’re only buying the option to purchase or sell, you don’t need to have a large amount of cash available. With options, you can maximize the use of leverage to get greater trading power from a small amount of capital.
- Low risks: Options allow you to minimize your risks while making money from short-term or medium-term changes in stock prices.
- Flexibility: Options give you the opportunity to earn money from the market, regardless of market conditions. If you have a knack for predicting market changes in certain stocks, you could leverage that skill to find suitable options trades.
Cons of Buying Stock Options
Some of the primary downsides of buying stock options are:
- Potentially high losses: Unlike stocks, options prices can change by large amounts within minutes or even seconds. Depending on the type of option you bought, you could lose the cost of the option, which could potentially be more than you would have lost if you purchased the stock outright.
- Complicated: Options trading is complex, especially for beginners. To be successful, you should observe the market consistently to look for potential opportunities. You should also be familiar with different strategies and understand how to handle a volatile market.
- Limited time: With options, you have a limited amount of time to decide whether you want to exercise that option. Yet, it could take months for a trade to pay off. The market may not move enough in the time frame you have to make a profit.
One of the most important factors for successful options trading is to be realistic with your expectations. This will help you better manage trades and minimize risks. You can also practice paper trading with fake money until you develop the skills and confidence to try it in the real world.