Many investors or those new in the trade, would most likely stay away from options trading since they find it risky and akin to gambling. They may be right, as options are sometimes compared to the racetrack that uses parimutuel betting, to bet on horses. It is a zero-sum game, where each person plays against all the other players in the racetrack.
In comparison, stock options are used by traders to bet on the direction of the stocks – up, down, sideways – at a strike price and within a specified time period. It is like stock trading itself, but diversely different in character and trading methods.
How to Buy Stock Options
1. Buying Calls and Puts
The simplest way in going about stock option trading, is buying calls and puts. Buying a call option is akin to buying the stocks itself, at a prescribed strike price, and within a specified expiration date, through payment of a premium. This process limits your loss to the premium paid, in case you were wrong in the direction of the stock.
On the other hand, when you buy a put option, you have the right but not the obligation to sell an underlying asset at a given strike price, on or before the expiration period. With the latter, you earn through payment of premium even if the option is exercised or not.
2. Long Expiration Period
As an option buyer, you should be buying stock options that gives you the longest expiration period, so you can have more leeway to work out your trade. It is the other way around when you write options. You go for the shortest expiration so as to limit your losses. When you buy a call option, you pay a premium in exchange for the right to buy the shares, but not the obligation, at a specified strike price, and at a specified time period.
The long call strategy is one of the most basic strategy in option trading. The argument about it, is that, the price of the underlying asset will rise beyond the strike price, given time. So, the longer the expiration period, the better for your trade in stock option investing.
3. Cheapest Price
Buying the cheapest option improves your chances of earning from a trade. Buying cheap options may be due to implied volatility, but can also be due to its being underpriced. If your trade pans out, you stand to gain enormously from this strategy.
Implied volatility refers the the volatility of a specific stock within the option's life span. It is influenced by market factors, like supply and demand. If there is an increase demand for the option, volatility rises, and so will option prices. Options with lower implied volatility results to cheaper option prices. Purchasing stock options with lower levels of volatility is preferable than those with higher levels, since the risk of greater loss is avoided if your trade does not work out.
4. Strike Prices and Expiration Date Trade Off
When buying stock options, you must remember that there is a relative trade-off between strike prices and option expirations. Other factors come into play when you do the technical analysis and see factors like support and resistance levels, as well as recent events affecting dividend pay-offs and earnings, and volatility.
Knowing these factors, could help you determine on which strike price and expiration period to use. Option expirations can also have a direct and measurable effect on the prices of stocks. This is generally seen during the last trading period before expiration. Factors affecting both technical and market considerations must be studied earnestly before you decide on stock options investing.
5. Industry Study
Before thinking of purchasing stock options, you need to study the industry to which those particular stocks belong to. Example are the biotech stocks. Biotechnology is one of the most interesting, scariest, and exotic industry that ever came about. Any industry who is out to save lives, can host a stock whose sheer number could multiply if company plans pushes through.
If a clinical trial is released, money calls or puts can be purchased on the possible outcome of this event. How you play with it, would depend if you are bullish or bearish on the stock.
Obviously, this is one of those situations where your risk profile would come into the picture. Would potential income compensate for the risk? Does it make sense to just concentrate on the low volatile stocks of the utility companies, instead? This is where research and intensive industry study would need to be done before you buy a call option at the blink of an eye.
6. Trade Events and Restructuring
it is often said, that how to purchase stock options, would depend entirely on stock volatility. During trade events, corporate restructuring, corporate spin-offs, and earning releases, can make the stocks volatile; thus, giving any investor/trader the opportunity to cash in.
This happens at times, when you are in a lucky spread -- like buying a cheap out of the money calls prior to the release of the annual corporate earnings or restructuring, with stocks that has been down the pits for sometime. When a turnaround happens, you can be in for the big money with an unbeknown incident of low expectations, suddenly bursting out of the seams.
7. Tax Treatment
Tax treatment for your trade would depend on your trading strategy. Simple option trading strategies like buying and selling of call and put options are known as "outrights." The corresponding tax for this strategy is fairly straightforward. The more sophisticated option strategies have a more complex tax schemes to prevent non-payment of taxes through illicit accounting in booking gains and losses.
8. Buy Stock Options Online
There are many brokers online with the right qualification and experience. Stock options were the first most commonly traded financial instruments online and remains to be so, till today. The choice of an online broker would depend on factors like: trading rates, easy to use platforms, trader support, and minimum fund requirement. There are many to choose from: single brokers or auto trading services, depending on your needs.
As we've mentioned, options trading isn't for the inexperienced, nor for the faint of heart. What you can do if you're new in the game is to arm yourself with training and knowledge. Look over the shoulder of the experts and veteran winners and watch how they do it. Jason Bond Picks has a program that lets you do just that — the Millionaire Roadmap. Click here to learn more.
How to Invest in Stock Options: A Recapitulation
Options offer various strategies for you to earn from trading underlying stocks. There are varied strategies that you can try on, from the basic buying of calls and puts, to the more sophisticated combination of options that would require more knowledge and skills in the stock options market. Option trading would have its inherent advantages, like insurance and leverage; but, also disadvantages like the required payment of premium and possible losses if your trade goes awry.
Investing in options trading would depend on your risk appetite. Wall Street gurus have advised neophytes to stick to the basic strategies of call and put buying. The more complicated strategies of call writing should be left to the more sophisticated traders with deep pockets and enough risks capital to help tide them in when things do not go their way. Stick to the basics and only buy/trade with the money that you can afford to lose.