If statistics and probability are your passion, stock trading might be right up your alley. However, certain strategies pose high levels of risk; to maximize success before starting out it’s essential that you understand where any possible money losses could occur.
An option contract gives you the right, but not the obligation, to buy or sell shares of a security at a specified price and date.
Puts
Buy Put Options Today Buying Put options gives you the power to sell shares at a fixed price within an agreed-upon time period at a specific strike price and expiration date.
Purchase of a put requires finding a broker offering options trading, researching the underlying asset, analyzing the options chain and selecting one option to purchase from there. After making this selection, your brokerage account will be debited with its associated premium payment.
Puts can help limit risk exposure to an asset and provide leverage to increase potential returns, but they should be carefully assessed for premium costs and time decay as their expiration dates near. Such factors could reduce potential profits or raise breakeven points. To further decrease risk, an effective hedge is to purchase another call option with similar expiration and strike prices as your long put, creating a long straddle which reduces both risks but adds transaction costs to the equation.
Calls
Call options offer investors a way to bet on the price of an asset rising, providing more profit than simply owning it outright if it does rise; its maximum upside potential is limited by initial premium paid for an option contract. As with any investment strategy, there can be no guarantees; success with options can depend on understanding investor psychology.
One strategy investors often employ when trading options is the long straddle, which involves purchasing both call and put options with similar strike prices and expiration dates for an asset with similar strike prices and expiration dates to protect against price decline while participating in all potential gains if the underlying asset goes up in value. Another trading technique available to them is the covered call; an investor simply sells call options against shares they already own to collect an option premium and hope the price closes in-the-money at expiration.
Collars
A collar trading strategy involves purchasing put options and selling out-of-the-money call options to mitigate losses on an existing long stock position. An investor can construct this trading strategy via their brokerage, with losses limited to the difference between initial stock price and option strike price.
A trader should monitor and adjust their collar according to market conditions. If the stock price drops below its option strike price, then exiting will occur and shares sold at that lower price will be purchased by investors.
Collar options strategies may be ideal for investors with a moderately bullish view of a stock, yet are concerned about short-term market downturns. They’re especially effective in high-volatility environments. Before embarking on such strategies, however, investors should carefully assess their own risk tolerance and trading goals before taking steps that limit upside potential in exchange for downside protection.
Volatility
Anyone with investing experience knows that markets and individual stocks can experience sudden price swings known as volatility – where more dramatic swings increase risk. Many buy-and-hold investors disregard volatility as background noise, opting instead to focus on incremental gains over years or decades.
Of those that actively trade, those that take an active approach might view volatility as more of a threat; however, knowing the difference between historical and implied volatility1 can assist a trader with aligning his/her trading strategy more closely to market expectations.
Historical volatility measures past price movements while implied volatility relates to options contract pricing. Tools like InsiderFinance’s Options Profit Calculator allow traders to accurately gauge current implied volatility levels as well as project future profits or losses accurately.