What are Stock Options (and How to Trade Them)

With all the current talk of the stock market, you may be wondering yourself if it’s worth attempting to invest. The good news is that entering the stock market is likely easier than you imagine; all you need is a little basic knowledge and the right tools to enter the market.

What are Stock Options?

Recently, GameStop has made headlines as users of the social media platform Reddit snatched up GameStop stocks to drive up the price of shares. While this GameStop frenzy was great financially for Reddit investors, it delivered a crushing blow to hedge funds that had been short selling GameStop (GME) stock.

Okay, so what is short selling, and why would stock options be a better option for beginners?

Short Selling

Short selling is the act of selling a financial asset that one does not actually own but borrows. This asset must be bought back later, which can mean significant profit if the market drops (as Wall Street hedge funds expected to happen with GME stocks) or significant losses if the market rises (what actually happened thanks to the buying spree of Reddit investors).

Stock Options

Investopedia states that a stock option “gives an investor the right, but not the obligation, to buy or sell a stock at an agreed upon price and date.” There are two types of stock options, which are puts and calls. For comparison to short selling, we’ll focus first on put options.

Put Options

Purchasing a put option is similar to short selling, in which one effectively buys the right to sell an underlying financial asset at a stated price (strike price). Although, there is no obligation to sell said asset with put options. As such, with put options, the maximum loss is capped at the premium paid for the financial asset itself. In other words, while you can still make a cool profit with put options and short selling, the potential losses are far less with put options.

Overall, put options are you effectively betting that the value of a certain financial asset will fall.

Call Options

Calls are the flip side of the stock options coin. Whereas puts mean you bet an asset will depreciate in value, a call option effectively means you bet that the value of a financial asset will rise. That is because, unlike puts where you buy the right (not obligation) to sell an underlying financial asset at a stated price, with calls you instead buy the right to buy said asset at a prearranged price by a prearranged deadline (expiration date).

How to Trade Stock Options

It’s important to understand that investing, particularly trading stock options, is somewhat similar to gambling: there is the potential for great gains while also the very real potential for significant financial losses. As such, beginners should be aware that stock options may not be the right first step into the stock market for them.

For those who are undeterred, keep reading.

1. Open an Options Trading Account

Options trading is a little different than stock trading. Not only will you need more capital to start trading options, but you’ll also have to show investors a trustworthy investment portfolio of your own. Each options trading account will have different requirements, although the following are fairly standard across the industry:

  • Outline your objectives
  • Show your prior trading experience
  • Provide your financial situation
  • List what type of option you want to trade

2. Determine Which Way the Market Will Move

This step requires diligent research on your part, which will require the right financial tools. Essentially, you must determine whether you think a certain stock will increase or decrease in value. If you think your targeted asset will increase in value, you’ll purchase a call. If you think the asset will depreciate, you’ll opt for a put.

3. Determine How Much the Market Will Move

With stock options, you maximize profits not just by predicting which way the market will move, but by how much. In other words, you need to determine just how much you think an asset will rise or fall in value.

4. Determine a Suitable Deadline

Last but not least, one you’ve predicted which way the market will move and by how much, you’ll need to predict when this will happen. Longer expirations are safer bets than shorter ones, since you have more time to watch how the market moves.

Disclaimer: this article should not be used as financial advice.

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