Investing for Beginners – Options

Now that we have a firm understanding of bonds, it is time to take a look at options. The main reason why we talk about options even though we are learning the basics of investing is the fact that options have been getting a lot of attention recently. This is because options can be very profitable quickly but are also considered one of the hardest investments to manage as they are risky and one bad move can lead to a large decrease in the value of your portfolio in a short period of time. Trading options should not be tried by beginners until you have a firm grasp on investing.

Options – Hard Difficulty

So what is an option? An option allows the investor the right – but not the obligation – to buy (call) or sell (put) shares of a company at a specific price (known as the strike price) and at a specific date in the future. With this in mind, we note that there are currently two general kinds of options: American options and European options. Although very similar, the main difference is that European options can only be exercised on a specific date agreed upon in advance and the American option can be exercised any time between the date that the option is purchased and the expiration date of the option. As an example, if you purchase a call option – meaning that you want to buy shares of a stock at a given price – on January 1, 2020 that expires on February 1, 2020, than you would have the right to exercise your option any day between January 1 and February 1 if you had an American option or only on February 1 if you had a European option. As the example highlights, an American option is much more convenient as it allows you to analyze the market and pick a date that provides the highest return for yourself. 

Calls and Puts?

So now that we have explained the difference between the American and European options, we look at the two main stock options that are widely available in most stock markets: calls and puts.

A call option gives you, the investor, the right but not the obligation to buy shares of a specific company at a specific price (referred to as the strike price), within a specific amount of time. Usually call options are bought if an investor expects a rise in the stock price. 

A put option is a contract that allows the holder the right, but not the obligation, to sell their shares at a specific strike price within a specific amount of time. Usually put options are bought if an investor expects a drop in the stock price.

Who Uses Options?

The investors who are using options to make their returns are those who believe that a specific stock price or company will fall or rise and prefer not to put up a lot of their own money and instead borrow the actual stock from another investor with the hopes of making a return before having to give it back.

Instead, they only have to pay a small fee for the right to these options – depending on your brokerage these fees might be as little as $0.65 per contract but vary based on the strike price along with many other factors such as the volatility of the stock price and the expiration date of the contract.

Overall, options are used as a method to multiply your gains quickly as they have the ability to make a large profit – or a large loss – quickly. As I mentioned above, options tend to be very risky for investors and is riskier than the stock market. But this high risk also comes with a very high return. If you are not a beginner and are aware of the risk necessary to trade options, you can consider investing in options as a high risk, high reward way of investing.

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