What Are Options?

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Before you get carried away with fantasies of striking it rich with best options trade that outsmarts the market, you have to first figure out exactly what options are, how to trade options, and most importantly, whether or not you even should be in the business of trading them in the first place.

On the most basic level, purchasing an option gives you the right to buy a particular a stock at a later date for pre-negotiated price. What’s different about buying an option as opposed to a regular stock? One of the main differences with an option is that you have two decision points (timing and direction) instead of just one (direction). Not only do you have to pick the right movement of the underlying stock, you also have to do it in a specific timeframe. Every option has an expiration date before which the option must be exercised, or else it becomes worthless.

Calls versus Puts

The above example represents a call option. A call option is like going long on a stock – you have the option to buy the underlying stock at a predetermined price (called the strike price) by a specific expiration date. The seller of call option, on the other hand, is the equivalent of a short seller in that they have the view that the price of the stock is going to fall, or not ever exceed the strike price, before the expiration date.

Conversely, buying a put option gives you the right to sell a stock at a certain price. Buyers of puts hope that the price of the stock will fall before the option expires.

Why Bother With Options?

While you can directionally mimic a long or short position through an options trade, this alone is not a reason to invest. If options just add an additional layer of complexity, why invest? There  below are the two main advantages:

  1. Leveraging Power Leads to Greater Potential Returns – An options trade requires a smaller initial capital outlay than an equity trade. This can magnify your returns if things work out. At the same time, there is also the possibility that the options contract does not hit its strike price by the expiration date, in which case you would lose 100% of your investment.
  2. Hedging Instrument – Options can be less risky, depending on how they are utilized. On the most basic level, options are less risky because they require less initial capital than buying stock. Also, and perhaps more importantly, they can serve as a great hedge. You can lock in specific prices through options. In an equity trade on the other hand, you place a stop-loss order, but it will only kick in once the stock is already trading below the limit, and at that point it can only be sold at what the market will bear. This leaves the door open for the possibility of having to unload your stock at a price far below your loss limit.

Should I Invest?

Options are not appropriate investments for the vast majority of retail investors out there. This is because the investment objectives of most people are really long-term wealth building for either retirement, purchasing a house, or some other major financial commitment. The problem is the very nature of an option is short-term – they have fixed expiration dates and thus aren’t all that compatible with the investment strategies of people who have longer time horizons. That said, they are extremely useful tools for active and sophisticated traders, or can be appropriate in unique cases where you may have an unusually large position (possibly from a large stock option windfall you received from your company that just went public) that you need to adequately protect.

Picking the Right Options Broker

If you are still interested in trading options, we have done the legwork and found the best online brokers for options trading. Ultimately, the most important considerations for options trading come down to pricing and service. We reviewed 61 online brokers, and found three that really fit the needs of most options traders:

 

 

 

Commission  Account Min Promotion Why We Love Them
$9.99 per trade + $0.75 per contract $2,000 Trade free for 60 days + get up to $600 (when you make an initial deposit of $2000) A top option for volatility traders, it provides estimated volatility of an option chain with at-a-glance volatility graphs. Learn More…

Commission  Account Min Promotion Why We Love Them
$5 per trade + $0.15 per contract $2,000 Offers a free online trading simulator with $100,000 in virtual funds Combines the cheapest all around pricing with a fast and powerful platform. Learn More…

Commission  Account Min Promotion Why We Love Them
$1/contract over 5 $1,000 150 free trades within 90 days of funding your new account (with a minimum balance of $5000, must use Promo Code: FREE150) Features the most pricing flexibility as well as the top tools for traders. Learn More…

 

Image Courtesy of Wikimedia Commons

Contributed by Joseph Egoian

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