How To Invest In Options

Investing in options gives investors the opportunity to hedge their current portfolio positions and potentially maximize their profits. It can also be a sure way to a depreciating portfolio if not done right. Suffice it to say it's worth taking your time to understand how options work before getting your feet wet. If this sounds like you, then you're in the right place. Here's how to invest in options – even if you have no prior experience.

What Are Options In Investing?

Before understanding what options contracts are, it's worth listing out what they are not. Options are not the same as owning stock shares and do not represent any ownership in a particular company.

When you purchase an options contract, you're simply purchasing a legal right to buy or sell a stock at a stated price within a stated timeframe. The stated price is called the “strike price” and the stated timeframe is called the “expiration date.” An options contract gives its owner the right but not the obligation to exercise the buy or sell of the underlying stock stated in the contract. Each option contract allows the owner to buy or sell up to 100 shares of the underlying stock, and each contract is priced accordingly.

According to Investopedia.com “Options are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.”

Types Of Options: Calls VS Puts

There are two types of options contracts – calls and puts. Owners of each type of contract profit when the underlying stock price moves up or down. If you own a call option, you profit when the underlying stock price increases. If you own a put option, you profit when the underlying stock price decreases. An easy phrase to remember which type of option profits in which scenario is “call up, put down.”

Call Options

Call options are contracts that give its owner the right but not the obligation to purchase up to 100 shares of the underlying stock at a predetermined price within a set timeframe. Here's how it works.

Ivan the investor believes that the share price of ABC Computers stock is currently undervalued and will increase in price in the near future. If ABC Computers is priced at $100 per share and Ivan believes it will increase to $125 per share, he can purchase an options contract that gives him the right to buy up to 100 shares from the investor who sold him the contract. He can exercise this right to buy those 100 shares anytime within the next 6 months (for example) at $100 per share if the stock reaches its stated “strike price” – which is $125 in this case.

Why would he do this? Because purchasing a contract to buy 100 shares of a stock is much cheaper than actually purchasing 100 shares of the underlying stock. If his analysis of the stock is wrong, he isn't risking as much money. The most money that Ivan can lose in this scenario is equal to the total cost of the options contract. The most money that Ivan can gain is infinite.

Put Options

Put options are contracts that give its owner the right but not the obligation to sell up to 100 shares of the underlying stock at a predetermined price within a set timeframe. Here's how it works.

Ivan the investor believes that the share price of XYZ Computers stock is currently overvalued and will decrease in price in the near future. If XYZ Computers is priced at $100 per share and Ivan believes it will decrease to $75 per share, he can purchase an options contract that gives him the right to sell 100 shares to the investor who sold him the contract. He can exercise this right to sell anytime within the next 12 months (for example) at $100 per share.

Why would Ivan purchase a put option? Because purchasing a contract to sell 100 shares of a stock is much cheaper than actually buying 100 short positions of the underlying stock. Similarly, if his analysis is wrong, he isn't risking as much money. The most money that Ivan can lose when purchasing a put option is equal to the total cost of the put option contract. The most money Ivan can gain equal to the strike price of the put contract multiplied by 100 shares of the underlying stock.

Buying VS Selling Options

Much like purchasing stocks on the open market, there is a buyer and a seller to every options contract. If you want to buy a put or a call option, there needs to be a seller on the open market that is offering the desired options contract.

Buyers of options pay the seller a premium for the contract and will profit when the underlying stock increases or decreases in value – depending on whether you purchased a put or a call option. Buyers are risking only the dollar amount they paid for the premium in hopes of getting a higher return on the directional movement of the underlying stock.

Selling options contracts is also referred to as “writing” options. Sellers of options get paid a premium from the buyer for the contract. Sellers make a profit if the options contract expires worthless. If an options contract does not hit the strike price indicated in the contract within the specified timeframe, the option expires worthless. In that case, the seller would benefit from the premium received, and the buyer will have lost the premium they paid for the contract.

However, sellers of options have unlimited loss potential, because if the option surpasses the underlying strike price indefinitely within the stated timeframe of the contract, then the seller is liable for the purchase or sale of the underlying stock – depending on whether they sold a put or a call option.

Selling Options Before They Expire

Many options investors don't anticipate holding the contract until expiration. This means they purchase an options contract and sell it to someone else before the option expires. If Ivan the investor purchases a call option for ABC computers for $100, and ABC Computers rises in price but doesn't pass its “Strike Price” then Ivan can still resell that contract to the open market for a premium.

The closer the underlying stock gets to its strike price, the more valuable the option contract is. The more time until expiration an option has, the more valuable it is. Both price and time can make an option contract more valuable, creating an enticing option to sell the contract to someone else before it expires and still make a substantial profit.

How To Start Investing In Options

Investing in options was traditionally a process only available to investors with deep pockets and large investment accounts. However, modern investing platforms like Robinhood allow investors to purchase options regardless of your account balance – as long as you have enough in your account to purchase the options contract, or enough shares of the underlying stock to sell an options contract on. Here are the two recommended approaches to start trading options:

Invest In Options With Robinhood

This method is recommended. Why? Because it's seamless and Robinhood makes it easy to understand for beginners while still being powerful enough for seasoned options traders. Here's how to invest in options with Robinhood:

1. Open up a Robinhood account for free. Get a free share of stock when you open an account!
2. Make your first deposit.
3. Search for the company on which you'd like to buy an options contract.
4. Select the “Trade” button and it will give you the option to trade options, buy shares of that stock, or sell shares of that stock. Select “Trade Options.”
5. Select the expiration date of the option you wish to buy or sell
6. Select whether you wish to buy or sell a call, or buy or sell a put.
7. Finally, select the strike price (the price you believe the stock will reach within the selected timeframe)

Robinhood is great because it clearly explains the different scenarios and what to do in each. For example, you can see what to do if you think the underlying stock is going up, going down, think it could go up or down, or think it's staying the same.

Invest In Options Through An Investment Bank

This method is simply using a traditional investment bank like Fidelity, TD Ameritrade, or Charles Schwab. All you have to do is open a brokerage account, fund it, and request access to buy and sell options contracts. The downside to investing in options with a traditional brokerage account is they likely have minimum account balance requirements. If the balance requirements aren't met, then they will have limited access to investing in options.

I personally invest with Fidelity, and highly recommend them as a fantastic investment firm to manage all your invested money, including options. I also have a Robinhood account and love the seamless process of buying and selling options contracts.

You Might Also Like: Robinhood VS. Fidelity – Which Is Right For You?

Can You Lose More Than You Invest In Options?

Absolutely! That's why it's absolutely necessary to understand the basics of trading options before starting. The most probable way that investors can lose more money than they invest is when they sell options contracts and the underlying stock price moves against their assumed price direction (depending on whether they sold a call or a put). This would require them to buy or sell up to 100 shares of the stock at the stated price in the contract – which could easily be more than the premium you received from the sale of the option.

“Should I Invest In Option Contracts?”

Should you invest in options contracts? The answer to this question is dependent on your overall risk tolerance, your understanding of stock options, and whether options fit your overall investment strategy. Remember that options are not the same as owning stock. You do no town any underlying company when you purchase an options contract. Rather, you own the right o buy or sell the underlying stock at a stated price within a stated timeframe.

If you're not sure where to start – I suggest opening an account with Robinhood and getting your feet wet with an amount of money that you are comfortable losing. That way, you can see and better understand how options trading works.

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