Let’s talk about option trading

Dear Money Lady Readers:

Many millennials and now a new wave of seniors are trying their hand with options. I really don’t understand the allure to this platform since it can be quite complicated for those that don’t learn it proficiently and paper trade before they jump in with real money. I have had many emails from readers over the summer, asking how to trade in options, with some crying the blues about losing thousands in this arena. So today, let’s go over the basics.

When option trading, you will use a security or derivative in an existing or anticipated position and speculate on the value of the asset. Options are widely available, easily tradeable on most broker platforms, very liquid, and can be bought or sold with very little initial capital requirements. There are two elements that make up an option: a call and a put. A call option gives the rights to buy the asset and the put option gives you the right to sell.

The buyer of an option has the right, to either buy or sell a stock, sometime in the future at a strike price that is always agreed upon at the time the position is opened. The seller, on the other hand must sell or complete the transaction if the option is exercised. You may often hear the terms “long and short positions” when trading in options. The buyer is considered the long position or holder of the contract and the seller is considered the short position or writer of the contract. If you are wanting to be the buyer of the option, you will have to pay a fee or premium to do so, which varies in price, based on volatility and the time to expiration of the contract. Once this fee has been paid by the buyer, they really have no further obligation to the contract other than to decide if they want to exercise the option or not. Basically, most people choose to “gamble” with their options as a buyer since they only stand to lose the premium, paid up front. Now, if you are the seller or option writer, you will always be forced to buy or sell if you are assigned, and if you are “right,” you get to keep the premium from the buyer, but if you are “wrong,” you could potentially lose a lot. The reason for this is because the trade units are always 100 shares at a time.

The allure of option trading is quite real with many people gravitating to this platform because it can be very exciting. Let’s look at an example together. If you had a favorite stock that you believed would go up in value over the next few weeks, you could buy a call option. If the stock does go up before the expiry date of the contract and it moves above the strike price plus the premium (this is your break-even cost) then you would be, as they say in the industry, “in-the-money,” potentially winning big because the share unit is 100, (every one dollar rise in the stock price above your break even price will lead to a $100 profit). But, if the stock stays below the strike price, you will have lost your paid premium. The opposite side of this equation is the seller or writer of the option. This would be called a short put. When selling options, you will have more risk, and will have to be a little more tactical to pivot with stock market swings. When you believe the stock will stay high in a volatile market, you can sell a put. If the stock stays above the strike price, then you keep the premium; but if it doesn’t, you could stand to lose your shirt. To reduce your risk you will need to utilize either a vertical put credit spread, iron condor, or butterfly spread option strategy, but this is too detailed to discuss here.

Whatever you do, please be careful when trading in options. Only use funds that are not important to your future. The minute you start to dip into your retirement savings to make up for losses, guaranteed the environment will become lethal, and your emotions will always cloud your judgement.