More people than ever are jumping into the stock market, and that’s a good thing.
The stock market represents an excellent opportunity to bolster your retirement fund or to make some money on the side. Some people are so successful that they primarily trade on the stock market for most or all of their income.
But options trading is a little more complex than buying and selling basic stocks. While anyone can participate in options trading, this market activity is a bit opaque, and it can be difficult to succeed at first. Let’s break down four crucial tips you need to know about options trading in detail.
What Is Options Trading?
Put simply; options trading involves trading options contracts. An option contract is a document that says you, the contract holder, have the right to purchase or sell an underlying asset or stock at a specific price up to a specific time.
For example, you might purchase an options contract that allows you to purchase a stock at $50 up until May 10 at market close. Then, even if the stock price skyrockets to $100, you can still exercise your contract option and purchase the stock at a discount. With your new stock, you can turn around and sell it for a significant profit.
Options trading involves a lot of analysis of underlying stock performance and market
signals. You can purchase two different types of options:
- Calls, which are options to purchase a stock
- Puts, which are options to sell a stock at a specific price up to a specific time
Options trading can be highly profitable, and many investors use options trading to hedge their investments and protect against market risk. But to master options trading, you need to keep a few key tips in mind, especially as you learn how this market arena performs.
Tip 1 – Options Can Reduce Risk (in Some Cases)
First, remember that options aren’t inherently risky. In fact, when used wisely, options can reduce overall risk for your portfolio.
But how? A put option allows you to purchase a contract that reserves the right to sell an underlying asset, like a stock, at a specific price up to the expiry date. So, in theory, you can purchase put contracts for stocks you own if you have enough disposable income or extra cash.
Then, even if your stocks significantly decline in value, you can exercise your put contracts and sell the stocks without losing too much money in the process. This is how many skilled traders leverage options to maximize risk management rather than using options as stock market betting tools.
Using options to mitigate risk can be particularly wise if a majority or all of your portfolio is concentrated in one or a few stocks, such as the stocks for your small business or personal company.
Tip 2 – Think of Options as Extensions of Stocks
Next, to trade options smartly, try to think of options as extensions of stocks rather than separate items in and of themselves.
That’s because options give you additional flexibility when trying to guess the market direction of individual stock assets. As you analyze the stock market, you invariably try to determine whether some stocks will increase or decrease in price.
With options, you can bet in one direction or another without increasing your overall risk. By thinking of options as new ways to invest in or guess the direction of stocks, you’ll use these tools wisely and less riskily than otherwise. This is one of the most important tips for newcomers to options trading, as options themselves can be tricky concepts to wrap your head around.
Tip 3 – Use Options to Enhance Your Portfolio
Like trading cryptocurrency, you can and should use options to enhance and diversify your portfolio.
A diverse portfolio is one that is resilient against market risk – it usually means having a lot of different stocks under your ownership so that if any of them fail, your whole portfolio doesn’t take too much of a hit.
Options can also enhance your portfolio. For example, if you already have a diverse portfolio but want to jump into a new stock or company, options can give you a way to do so without opening your portfolio up to too much risk.
You can purchase a lot of call options contracts, for instance, and reserve the right to purchase the stocks for that new company in the future. If the company performs worse than expected, your portfolio is still safe. But if the company performs better than expected, you can exercise those options contracts and shift the direction of your portfolio quickly and profitably.
Tip 4 – Patience Is a Virtue
Last but not least, don’t forget that patience is a virtue, especially when it comes to options trading. Whenever you trade options, you should be patient and calm and wait for the right opportunity before pulling the proverbial trigger. Don’t feel like you should always be buying and selling options contracts to make a profit.
Instead, you should focus more on identifying good and bad trades for most of your time on the market. As you trade smarter, you’ll find that your percentage of profitable options trades will increase, and your duds or misses will become less frequent.
Options trading requires you to take a long look at the market and use all of your analytical trading abilities to determine how a stock will move. The longer you take, the more information you’ll give yourself and the more informed guesses you’ll make when the time comes to buy or sell a contract.
Options trading could be a great way to make money and protect your portfolio’s health in the long term. Just don’t jump into options trading without educating yourself extensively beforehand! Keep these tips in mind, and you’ll be much more likely to make smart options choices and earn money rather than waste it.