What Are Stock Options?

Stock options, commonly referred to as just “options” are financial contracts, bought and sold on stock exchanges around the world. Options trade on something called the derivatives market. It is estimated that the derivatives market has over a trillion dollars in notional value. 

What are stock options? Why do so many people trade them? 

In this blog, we’re going to discuss what stock options are.

Table Of Contents:

• What Are Stock Options
• What Are Options Used For
• Who Uses Stock Options
• Option Trading Platforms
• Risks involved with options

What are stock options?

What are stock options? When most people think of investing in stocks, they envision buying shares of a company on the stock market. However, there is another way to invest in stocks that can provide greater flexibility and potentially higher returns: stock options. 

A stock option is a securities contract that conveys to its owner the right, but not the obligation, to buy or sell a particular stock at a specified price on or before a given date. 

 Unlike buying shares outright, Options provide the holder with potential upside while limiting downside risk. 

As such, they can be an attractive investment for those with a high degree of risk tolerance. Of course, like all investments, stock options come with a certain amount of risk. The key is to understand these risks before making any decisions.

What are stock options used for?

Options are most commonly used in two ways: to speculate on the future price movement of an underlying asset, or to hedge an existing investment. 

If a trader expects that a stock will move in a specific direction, they can buy an options contract that gives them the right to buy or sell the underlying stock at a previously agreed upon price. If the investor or trader is correct about the stock’s movements, then they can make a profit when they exercise their option and buy or sell the security at the pre-determined price, or by selling the contract outright. 

However, if the stock does not move in the desired direction, then the option will expire worthless. The trader will lose the premium that they paid for the option. 

Stock options can be used to hedge against losses in a portfolio. If you are an investor holding stock for long periods of time, you can use optons to hedge against adverse movements in the stock price.

Who can trade options?

The vast majority of option trading takes place on major exchanges such as the Chicago Board Options Exchange (CBOE) or the New York Stock Exchange (NYSE). These exchanges are regulated by the U.S. Securities and Exchange Commission (SEC) and offer a safe and secure environment for trading. 

In order to trade options on these exchanges, you must first open an account with a registered broker-dealer. Once you have opened an account, you will need to apply for approval to trade options.

After you have been approved, you can start trading!

Day Traders

A day trader is an individual who buys and sells securities within the same day. Day traders typically work from home and use online platforms to execute their trades. They are often self-employed and rely on their own capital to finance their trading activities. Day traders aim to capitalize on short-term market movements and typically hold their positions for a few minutes to a few hours. Due to the high level of risk involved, day trading is not suitable for everyone. Those who are successful in day trading must be able to control their emotions, manage their risks, and have a deep understanding of the markets.

Investors

Investors often choose to hedge their portfolios with options trading. By buying or selling options, investors can minimize their losses if the market unexpectedly turns against them. 

For example, let’s say an investor owns shares of ABC Corporation. They are worried that the stock might drop in value, so they decide to buy a put option. This gives them the right to sell their shares at a set price, no matter how low the stock might go. If the stock does drop in value, the investor will be able to sell options contract and offset a potential loss. 

However, if the stock goes up, the investor will still make money from their original investment. Options trading can be a useful tool for investors who are looking to protect their portfolios from market fluctuations.

Institutional Buyers

On a much larger scale, hedge funds use options to offset potential losses, or hedge, against stock market volatility. Hedge funds are well known for their aggressive investment strategies, and options trading is one of the tools that they use to achieve their goals.  

Hedge funds use options to speculate on the future direction of the markets, and to take advantage of potential changes in market conditions. 

Options can be used to hedge against risk, or to take on additional risk in the hope of generating higher returns. Hedge funds typically use options to generate leverage, which can magnify both profits and losses.

Options Trading Platforms

When it comes to trading options, there are a few different brokerages that stand out from the rest. One of the most popular is thinkorswim, which is known for its user-friendly platform and extensive research capabilities. Another popular choice is tastytrade, which offers a more hands-on approach to options trading. Finally, Trade Station is another well-regarded option that offers a suite of powerful tools for serious traders. Ultimately, the best brokerage for trading options depends on your individual needs and preferences. However, all of the aforementioned brokerages are worth considering if you’re looking to get started in the world of options trading.

Risks Associated With Trading Options

It’s important to remember that stock options are a leveraged instrument. This means that they can magnify both gains and losses. For example, let’s say you buy a call option with a strike price of $50 and the stock price goes up to $60. In this case, your option would be worth $10 per share, or a 100% return on investment (minus the cost of the contract). However, if the stock price fell to $40 instead, your option would be worth $0 and you would have lost 100% of your investment.

As you can see, stock options can be quite risky and should only be traded with caution. It is also possible to have unlimited downside risk when selling naked options. For these reasons, traders who do not want to lose money in the markets should consider learning from a professional.

Learn more about the markets and trading by joining the Simpler Free Trading room, where you can trade alongside the simpler community led by expert traders. Don’t trade alone, trade with us!