Options are a type of contract that gives the buyer the right to buy or sell a security at a specified price at some point in the future. An option holder is essentially paying a premium for the right to buy or sell the security within a certain timeframe.

 

If market prices become unfavorable for option holders, they will let the option expire worthless and not exercise this right, ensuring that potential losses are not higher than the premium. If the market moves in a favorable direction, the holder may choose to exercise the contract.

 

Options are generally divided into “call” and “put” contracts. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, known as the exercise price or strike price. With a put option, the buyer acquires the right to sell the underlying asset in the future at the predetermined price.1

 

Key Takeaways

  • Options trading may sound risky or complex for beginner investors, and so they often stay away.
  • Some basic strategies using options, however, can help a novice investor protect their downside and hedge market risk.
  • Here we look at four such strategies: long calls, long puts, covered calls, protective puts, and straddles.
  • Options trading can be complex, so be sure to understand the risks and rewards involved before diving in.
Traders working in front of banks of computers

xPACIFICA / Getty Images

How to Trade Options in 5 Steps

Embarking on the path to options trading encompasses five pivotal steps. First, you should assess your financial health, tolerance for risk and options knowledge. This is fundamental to align with the volatile nature of options trading. Then you should choose the right broker. This involves evaluating fees, platform capabilities, and support services.

 

Next, you need to gain approval for options trading, proving your market savvy and financial preparedness to the brokers. Success in options trading hinges on crafting a comprehensive trading plan that includes clear strategies, risk management techniques, and defined objectives. Lastly, you should understand the tax implications of options trading and continue to learn and manage your risks.

 

1. Assess Your Readiness

Options trading can be more complex and riskier than stock trading. It requires a good grasp of market trends, the ability to read and interpret data and indicators, and an understanding of volatility. You need to be honest about your risk tolerance, investment goals, and the time you can dedicate to this activity.2

 

2. Choose a Broker and Get Approved to Trade Options

You should look for a broker that supports options trading and suits your needs in terms of fees, platform usability, customer service, and educational resources. The best options brokers should offer a good balance