Options Trading: Why Trade Options? | Ally Invest®

Use of options for investments

But those are the visions of market-timing speculators, not long-term investors.

What are the Benefits & Risks?

For most investors with a long-term view, trading options is a way to protect individual stocks or an entire portfolio from a downturn. Moreover, used conservatively, options can generate cash in amounts that far exceed the average dividend. This guide is meant to walk you through some of the basics. Best Online Brokers, First, the nuts and bolts: An option is a contract that gives its holder the right either to buy shares at a fixed price a call option or to sell shares use of options for investments a fixed price a put option.

The price at which you can either buy or sell the underlying shares is the strike price, and the price of the contract itself is the premium. An option contract represents shares of the underlying stock, and the contract expires on a fixed date; the holder may exercise an option on or before that date.

Listed premiums are multiplied by The vast majority of brokers make it simple to read the matrix and do not confuse you with the actual symbols used by the exchanges.

Many smaller companies, such as Square SQhave option chains that are also easy to trade. While many thousands of stocks have options with one expiration date per month—the third Friday—roughly stocks have options that expire every Friday. These chains have many numbers on one screen, so at first glance they may look confusing. But they are, in fact, very orderly. Available strike prices are typically found in the center column of the table. Most brokers align information for a specific strike price the same way: puts to the right, calls to the left.

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The bid is what someone is willing to pay for the option, and the ask is what the seller wants to receive similar to when you are buying or selling a stock. The greater the open interest, the narrower the difference between the bid and the ask, making the option easier to trade. Options are just another investing tool that could become an integral part of how you generate income or protect yourself from a market sell-off.

Ready to trade? Consider two popular ways to use options to protect your capital and generate cash and income. Selling covered calls A covered how to make money student ways is an option contract that is backed, or covered, by shares of a stock that you own. The person who buys your call has the right to purchase your shares at the strike price at any time, until the option expires.

Stocks with call options that expire every week can generate double the cash collected from selling a single monthly option.

The sale of a call with a strike price above the share price is said to be out of the money and can generate income in two ways: the cash collected when the call is sold, and the profits made if and when the buyer exercises the contract and buys the shares. This is the equivalent of a 1. Sound too good to be true? Sometimes it is, depending on the whim of the market.

How Options Can Help Your Portfolio

Then, the call is in the money, and the buyer is almost certain to exercise the option. Forgone profit is the biggest potential downside of selling calls. These ETFs typically buy shares and immediately sell calls against them, limiting capital gains but increasing yields.

At present there are 18 such ETFs. None is very large. Such ETFs are a good place to start for someone who is new to calls and wants more income. That said, in volatile markets, calls sold on individual stocks have a greater potential to generate income. Buying protective puts You can protect your portfolio in a falling market with put options.

Is it Risky to Invest in Options?

When you buy a put, you have the right to sell binary options reviews bnex to the option seller at the strike price.

Investors holding stocks for the long term avoid this multistep process by selling the put itself because it will have risen in price with the decline in the stock price. How much the put rises depends on how much time is left before it expires and how much more volatile the stock has become.

Traders betting that the stock will continue to fall over that period will bid up the value of the put; the extra price they are willing to pay for the time until expiration is called, appropriately enough, the time value.

Using protective puts has three major limitations.

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First, there is no such thing as a foolproof hedge. Second, it is difficult to manage these puts unless you are an active trader, because puts can vary widely in value from day to day, requiring use of options for investments to monitor your portfolio closely.

Third, puts are expensive. But fans of put options have an answer to these objections.

use of options for investments

First: So what if you lose some money when the market goes up? Plus, puts can throw off huge profits when a stock falls suddenly and dramatically think crash, not sell-off. In that case, the profit might erase the losses from a downturn in the share price. Second: Less-active traders can always place a good-until-canceled order with their broker to sell the put at a specified price.

Such a trade is automatically executed if the put hits that price as the stock sells off.

Four Advantages of Options

Third: You can offset the high price of puts with cash from the sale of a call. And in a calm market, when use of options for investments might find it least desirable to buy a put, puts are relatively cheap.

The Bottom Line Exchange-traded options first started trading back in Here we'll look at the advantages offered by options and the value they can add to your portfolio. Key Takeaways Options are derivatives contracts that give the buyer the right, but not the obligation, to either buy or sell a fixed amount of an underlying asset at a fixed price on or before the contract expires. Used as a hedging device, options contracts can provide investors with risk-reduction strategies. For speculators, options can offer lower-cost ways to go long or short the market with limited downside risk.

When markets fall sharply, the cost of buying puts increases dramatically. But so does the cash from selling a call. A limit order allows you specify the price at which you want a trade executed; a market order is executed at the next available market price. But in order to trade options you must first apply to your broker for permission.

Options Trading

Options trading rules vary widely from broker to broker—some restrict options trading in retirement accounts, for example. But all brokers adhere to a system of trading levels, each of which requires permission. These permissions vary slightly but are typically based on your trading experience, the size of your account and how frequently you trade.

use of options for investments

The levels are built one on the other; each higher level includes the privileges of the levels beneath it. Most brokerage levels correspond roughly to the following: Level 1: You can sell covered calls. Level 2: You can sell cash-secured puts and buy calls and puts.

use of options for investments

Level 3: You can trade option spreads—trades in which you are buying or selling more than one option at the same time. Levels 4 and 5: Forget about it. These levels give you the ability to sell naked calls and puts, something an individual investor should never do.

The language of options Assignment: The process of an option contract being exercised by the buyer. Call: A contract giving the buyer the right to buy shares at a specified use of options for investments on or before a specified date from the seller.

Individual investors should sell only covered calls secured by shares of the underlying stock.

use of options for investments

Selling naked calls, or calls not supported by shares that you own, is too risky for most investors. In the money: An in-the-money put is when the strike price is higher than the share price. An in-the-money call is when the strike price is lower than the share price.

Option chain: The list of option contracts available for a stock.

use of options for investments

Out of the money: When the strike price of a call is above, or the strike price of a put is below, the current share price.

Put: A contract giving the buyer the right to sell shares at a specified price, on or before a specified date, to the seller. Individual investors who sell puts should sell only cash secured puts, backed by cash or a margin-loan equivalent of the cost of buying the underlying shares. A naked put does not have this support and is far too risky to be sold by most investors, because in a market downturn the option seller may have to buy the stock from the put buyer at a substantial loss.

Strike price: The price at which the seller of the option must either buy or sell shares.

use of options for investments

Premium: The price of an option contract. A premium is multiplied by to determine the cash value of the contract. Time value falls as an option nears expiration, a process called time decay.