Options enable investors to use many different strategies to achieve their desired financial goals. There are three primary reasons to trade options: to protect or “hedge” a position, to generate income, or to speculate on the future price movement of an asset.
Options traders can purchase or sell different options contracts to tailor positions to their market expectations. Options strategies can benefit from directional moves or from stock prices staying within a defined range. Strategies vary significantly from single-leg options to more complex multi-leg positions with long and short options.
Risk defined strategies are positions where the maximum loss is defined at trade entry. Risk defined strategies can be used to create a maximum loss scenario and help investors manage downside exposure. Single-leg long options have a maximum loss limited to the cost when the position is opened.
For example, purchasing a long call or put option for $2.50 means the most that can be lost on the position is $250 per contract, no matter what happens with the underlying asset.
Multi-leg options can be used to define risk by simultaneously buying and selling long and short contracts. With multi-leg options strategies, profit potential may also be defined. With net debit multi-leg strategies, the loss is still limited to the original debit paid, and profit may be limited to the width of the spread minus the cost of the trade.
For example, a $5 wide debit spread that costs $2.00 has a max loss of $200 and a max gain of $300 per contract. Short multi-leg options collect a credit when the contract is opened. The credit received is the maximum amount that can be gained. The maximum loss in a risk defined strategy is the width of the spread minus the credit received.
Risk defined options strategies have lower margin requirements than unlimited risk strategies, reducing the capital needed to initiate the position.
Unlimited risk strategies have an undefined or unlimited risk of loss at trade entry. Unlimited risk is a possibility with naked or uncovered options selling.
For example, when selling a naked call option, the option writer is required to sell shares at the strike price if assigned stock. Because stock can potentially go up indefinitely, the risk is not defined. Selling a call option with a $100 strike price for $2.00 has $200 of potential profit but unlimited maximum loss if the underlying stock rises significantly.
Unlike risk defined strategies, naked options require more margin to be held in the account and more capital to hold the position. The margin needed to hold an unlimited risk strategy may not be static. If volatility in the market rises, margin requirements may increase because the brokerage firm wants to ensure enough money is in the account to cover an assignment in the underlying asset.
Payoff diagrams illustrate where options strategies will make or lose money at expiration based on the underlying asset’s different price points. Profit and loss diagrams are visual aids that can be used with single-leg and multi-leg strategies. Payoff diagrams help to explain all potential profit and loss outcomes of a strategy including break-even points, maximum loss, and maximum gain.
The green portion of the payoff diagram line shows where the position is profitable at expiration relative to the underlying security’s price. The red portion of the payoff diagram line shows where the position is at a loss at expiration relative to the underlying security’s price.
The further above or below the payoff diagram line is from the x-axis, the greater the profit or loss at expiration. The point (or points) where the payoff diagram line crosses the x-axis is the break-even price at expiration.
Before expiration, the position’s profit or loss will differ from the payoff diagram because of extrinsic factors like time value and volatility.
An option is a leveraged financial instrument that derives its value from an underlying security. An option contract is an agreement between a buyer and a seller that gives the buyer the right, but no obligation, to buy or sell the underlying security at a specific price on or before a specific date.
Option contracts consist of three main components that determine their premium, or cost: the underlying security's price, the option contract's strike price, and an expiration date.
Options trading enable investors to be more dynamic than buying and selling stocks. Traders typically use options to generate income, speculate on future price, and hedge existing positions in their portfolio. Options are available for a wide variety of stocks and ETFs.
Most investors are familiar with stocks, and they are relatively straightforward: buy stock from a company, and hope to sell the shares at a higher price in the future. Options are more complex, but also give investors more flexibility and make it easier to capitalize on bullish, bearish, and neutral market conditions.
One key difference is every options contract has an expiration date, which introduces a time component to every position. Options pricing is determined by multiple factors and is constantly changing based on market conditions and the underlying's price movement.
Stocks and options can be combined to hedge positions or generate passive income.
There are multiple investment accounts that traders can use to buy and sell options. Investors must have option approval to trade certain position types, and may need to have a margin account.
Most options positions can be traded in an IRA retirement account. Standard accounts include cash and margin brokerage accounts and are not tax-advantaged.
Options trading is available at many brokers. Each brokerage offers a wide range of platform tools, online resources, desktop and mobile applications, and education. However, most popular brokers offer similar capabilities and fees.
Option Alpha's integrations include TradeStation, Tradier, and TD Ameritrade.
Options trading typically includes commissions charged by the broker, as well as exchange and regulatory fees. However, Option Alpha's autotrading platform includes commission-free* trading through exclusive agreements with TradeStation and Tradier brokerage.
Many new options traders start with covered calls. Covered calls are a natural bridge for investors because they combine stock ownership with options trading to generate income on long equity positions.
Long calls and long puts are popular single-leg strategies that offer traders a cost-effective, risk-defined alternative to buying or selling stock.
Traders can also use slightly more complex multi-let strategies known as spreads. Spreads include two, three, or four legs and typically have defined risk and limited profit potential. Selling options spreads, such as iron condors and iron butterflies, can be used to generate income.
Single-leg call and put options are generally a great place to start if you're new to options trading. Debit spreads and credit spreads are also good for beginners looking to take the next step and build slightly more complex strategies with defined risk/reward profiles.
The United States stock market has regular trading hours Monday through Friday. The market opens at 9:30 a.m. EST and closes at 4:00 p.m. EST.
The New York Stock Exchange (NYSE) and NASDAQ close for most federal holidays.
