What Is Option Trading in Stock Market? | Benefits Over Other Investments

December 18, 2021 | Editorial Team

Options trading may appear challenging at first, but it’s simple to grasp after learning a few basic concepts. There are plenty of choices investors can choose from concerning investing in securities. An option is an asset class that, when used appropriately, can offer many advantages that ETFs and trading stocks alone cannot.

Investors and brokerages employ options for various reasons, including income, speculation, and risk mitigation. Other asset classes construct investor portfolios, including bonds, mutual funds, ETFs, and stocks.

This article focuses on options trading in the stock market and why we use them.

What Is Option Trading In Stock Market? Examples and Strategies

An option is a contract an investor can use to buy or sell an underlying security for a specified price at a set length of time. You can buy and sell options on the market that trades option contracts depending on securities (see also day trading and the day trading options in Canada as a way of trading in the stock market).

A “call option” is purchasing an option that allows you to purchase shares later. However, a “put option” is the purchase of an option that will enable you to sell shares at a later date. Put options or call options do not represent ownership in a company as they are not the same thing as stocks.

Just like trading options, futures also use contracts. You can pull out from option contracts at any time because they have a lower-risk investment. Therefore, the premium paid price of an option contract is a percentage of a security or underlying asset.

If you buy or sell an option, it does not mean that you have to exercise it at the buy/sell point. However, as an investor, you have the right to exercise the option under any circumstances before the expiration date. An option is a derivative security, which derives its price from an underlying asset. Therefore if you use an option correctly, there is less risk than the underlying stock.

Essential Options Trading Strategies Guide

Investors usually get started with trading options with little to no understanding of the examples and strategies available. Many tactics and techniques will maximize returns and limit the risks involved in driving you on top of trading.

Investors can learn and take advantage of the power and flexibility these stock options provide with little effort. Several option trading strategies vary in reward, risk, and other factors. For example, swing trading is a unique trading style that shows key differences in day trading, position trading, and options trading, but we deal with that elsewhere. Here are some of the few strategies beginners recommend:

Straddles and Strangles

An investor might expect the underlying asset’s price to be volatile with straddles. However, the investor does not know how the asset will move. For instance, when employing the straddle strategy, you might consider buying a call and put option at the same strike price, expiry date, and underlying price.

In strangles, an investor might consider buying an “indebted” call or put option for a similar underlying asset and expiry date. The investor expects a dramatic price movement on the underlying asset. However, the investor still does not know how the asset will move.

The investor needs the stock to move more than the total premium paid, and that is what will make a long strangle relatively secure. The direction in which the assets move does not matter. However, there is less risk of loss when there is an upside of a strangle strategy. The premiums will be cheaper to buy because the options are “indebted.”

Covered Call

A covered call is an excellent option for investors with long asset investments. If you are a somewhat optimistic or neural investor, this strategy is good for you. To get started with a covered call, you need to purchase 200 shares of regular stock. You have to sell a single call option per 200 shares of that stock.

The covered call strategy provides you with a chance to profit with the call option and minimize the risk of your current stock investments. Investors can make money from covered calls when the market price falls or stays constant while still in contract with the call option.

However, when the market prices fall more than expected, you might end up losing more money. You need to protect your investment while the share price decreases and make money when the stock price is flat.

Selling Iron Condors

Based on the preference of selling iron condors, the investor’s risk can be high or conservative. The direction in which the assets move is either up or down. Therefore, there is potential profit for a moderately broad range.

To get started with iron condors, you need to sell a put and purchase another, this time at a lower strike price. It would be best to combine the put option by buying and selling at a greater strike price. You will make a profit when the stock price stays between the two calls or puts.

You will probably make money when the price fluctuates. However, when the current market price either escalates extravagantly or decreases drastically, the strategy loses money. If you are looking for a market-neutral position, selling iron condors is for you.

Options Trading Examples

There are several examples of trading options that vary greatly depending on the strategy and analysis you employ. Let us consider a general idea of what a typical call or put option can be. Suppose an investor purchases a pull and call option on Oracle Corp (ORCL).

For instance, if an investor purchases a long call option for 200 shares of Oracle stock at $220 each on January 1. You will have the right to purchase 200 shares of that similar stock at the same stock price per share, whether there are changes in the price or not, by January 1.

If Microsoft’s price increases, the investor will reap the profits of the long call option only if they purchase it at a cheaper price than its market value. However, you will probably lose the premium paid for the option if you fail to exercise the right to buy the shares.

two men looking at the monitor with stock graphs

In the second example, let’s consider buying a long call option for 100 shares of Microsoft Corp for a $2 premium. Suppose the option has a strike price of $40 per share that will expire in 30 days. If the market price hits $50 at the end of the 30 days, your call option to purchase at $40 per share will now be $10.

You will now have a contract worth $1000 from your initial 100 shares of the stock. Since your original contract is worth $200, if you exercise your call option by buying the stock at $40 per share other than the $50, your original contract will now be worth $1,000. You will have an $800 profit which means a 400% return. 

Buying, Selling Calls and Puts

Now we’ll look at how to buy and sell call and put options that most investors confuse to differentiate. Since both strategies are bearish, the difference between the options is that while the former is a right to buy, the latter is a right for selling.

You limit your earnings to the premium you pay if you buy an option. The reason is, your losses remain limited while your profits are unlimited to the premium you paid. Contrarily, if you sell an option, you limit your income to the premium you pay, but the losses remain unlimited.

Below is a guide of four considerations you should follow before deciding whether to buy a put option or sell a call option or vice versa:

Do You Believe That the Stock or Index Will Fall?

If that is the case, purchasing a put option will be the right choice. You will limit your downside risk to the amount of the option premium you paid. If the stock falls, your profits will be unlimited.

Do You Have a Cautiously Negative Outlook on the Stock?

If that is the case, the stock price is not likely to rise above a certain level. You have no particular interest if the stock price falls or remains stable at current levels. In such a scenario, selling the call at the strike, believing the stock will climax, might be the right choice. Some investors might sell at a lower call for a higher premium. However, by doing so, it exposes them to unnecessary risk.

Can You Pay the Trade’s Margins?

You limit your total liability to the option premium paid if you buy a put option. Therefore, this is the most you can lose. The potential loss might be unlimited if you have a call option. Your margins will be the same as those imposed on futures contracts. In this case, you should prepare for a higher capital outlay.

a person holding a cell phone and a cup of coffee

Are You Betting on the Market’s Volatility?

Buying a put option is better if you are playing for a rise in volatility. However, selling the call option is better if you are playing on volatility falling.

The Bottom Line

Options are easy to comprehend when you understand their fundamental risk and return potential concepts. They can give you a lot of benefits over other investment instruments, depending on how you use them.

If you use the options correctly, and yes, you can ask robo advisors for advice, you stand a chance to make money even during times of uncertainty. However, if you use them incorrectly, they can also cause financial ruin. If you are a beginner, you should get acquainted with basic strategies like buying calls, selling covered calls, buying puts, and buying protective puts.