Many people hear the word options and start to run. That’s probably because there’s plenty of misinformation out there about these flexible, powerful, endlessly fascinating financial instruments. The question is whether they’re a good way for beginners to seek a profit while operating in the securities markets. The short answer is yes, but there are a few qualifying parts to the answer.
One of those qualifiers is that vanilla options are an appropriate way for new investors to seek profits, portfolio diversification, and hedge financial protection. The other pieces include warnings about making sure you know how to buy a put or a call, which are two of the most common forms of the instrument. What should beginners know before they get started? Here are six key concepts that you should review before entering your first transaction.
There are Many Benefits
Why are there many that venture out from traditional kinds of trades in the stock, bond, forex, and other markets? It’s not always boredom or greed, as some would suggest. In fact, when it comes to buying an option contract of any kind, most investors are looking for protection from wild price fluctuations on other securities they already hold. Still others are in search of general portfolio diversity, hedging strategies, and the chance to earn large profits on very small capital outlays.
Not All Options are Equally Complex
No one would argue that options are simple. It’s a well-known fact that they’re complex financial instruments and are not something for traders to approach on day-one. The good news is that vanilla, or ordinary, puts and calls are not all that difficult to use as part of a diverse portfolio. Any investor can master the basic concepts in a few minutes by studying examples, doing a few practice trades on a simulator, and starting out small. Once you get the hang of it, it’s possible to take advantage of all the benefits these unique trading instruments offers.
It’s Essential to Grasp the Basic Concept
The key concept behind buying a put or call option is that you’re not buying a security. Instead, you are purchasing the right to buy or sell some set number of shares at a fixed price. When you buy a put, you have the right to sell a specified number of shares at the stated price, also called the strike price before or on a set date. Calls are the same, except they give you the right to buy rather than sell.
You Can Limit Losses
Unlike many kinds of investments, it’s possible to limit your losses when you purchase an option, but only with puts. That’s because your upside is unlimited but your downside is restricted to the cost of the contract. Think of it that if you paid $100 for a contract that expired worthless, your biggest book loss is the initial cost, or $100. No matter how wildly prices fluctuate, the most you can suffer is that original $100 you put out for the right to sell at a given strike price. But your upside is infinite, only limited by how much price moves in your preferred direction.
It’s Possible to Hedge Effectively
When you hold a large number of shares of a single company’s stock, it’s usually a good idea to have a hedging strategy in place. There are endless ways to hedge, but one of the most effective involves buying either puts or calls, an option contract in other words, on the same company whose shares you hold. Depending which way you think prices will go, and whether you’re short or long the stock, a put or call can offer much protection against unexpected price swings and volatility.
There are Specialists
It’s true with any kind of security and the marketplace is full of specialists who trade nothing but their favorite instrument. This happens with stock enthusiasts who buy and sell nothing but shares in one sector or those sold by one company. Day traders are famous, or notorious according to some who tell it, for only ever buying one company’s stock. They follow daily price fluctuations closely and earn profits by taking small gains on large positions. In a similar way, forex enthusiasts often stick to just one or two pairs that they study in depth. Specialization can be an effective way to dig deep and gain a thorough understanding about how a stock, bond, option, ETF, or other instrument behaves. Vanilla options traders are no different. In fact, some trade nothing else but puts and calls.
