Trading Options Is a Sound Investment (and It's Simpler Than You Think!)

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It's nice to have options.

You know, choices. It's good to have them. We seem to feel safer, more secure, and more in charge when we have more than one possible path set before us. (See also: 6 Basics You Must Know Before You Begin Investing)

Wouldn't it be nice to feel all of those things about your investments, too?

These feelings are part of the reason that some people choose to invest in securities called, amazingly enough, options.

If you haven't heard of an option before, you aren't alone. I hadn't heard much about them either, until a couple of months ago. But my family has recently started investigating ways to broaden our horizons, financially speaking, and options are… well… an option that we have come up with.

Intrigued? Read on to discover the basics of what we have learned.

What Are Options?

At it's most fundamental, buying an option means that you are purchasing the right to buy or sell a security at a certain price on or before a certain date. It sounds confusing, but actually it's pretty straightforward.

Buying a Call

Let's say you want to buy a particular stock at $50 a share, but it currently costs $75. If you're pretty sure the stock's price will fall (or you're willing to bet that it will), you can pay to have the choice to buy it if the price goes down to $50 within a certain amount of time (a week, two weeks, 30 days, etc.). This is called buying a call.

Buying a Put

On the other hand, maybe you purchased a stock at $100 a share, and you think it might soon fall significantly. You can buy the right to sell your stock at a certain price (like, before it bottoms out), if the stock does lose value within a particular time frame. This is called buying a put.

In actual practice, buying options can be much more complicated than this. People link all sorts of puts and calls into one trade, so that several (or many!) conditions have to be met for them to be able to exercise their option. This can provide additional investment security, if you know what you're doing.

There are also different types of calls and puts, like the covered call and the cash-secured put, to name only a couple.

Even with all the possible layers of complexity that options offer, buying a basic call or a put is pretty straightforward. The best way to learn the ins and outs of complex options trades is to trade alongside someone who has experience. Offer to help them with their research in exchange for some investing mentorship. If you don't know anyone like this, practice online with fake money before you actually risk anything.

The Pros of Trading Options

If the possible complexity of the trades doesn't scare you off, trading options has a lot of things going for it.

Less Risk

When you buy an option, you are committing less of your own money up front, which means that you are risking less. An option is considered a fairly dependable form of hedging your investments, so it can help you save money in the long run.

Of course, an option can be used poorly, too. You still expose yourself to risk if you don't know what you are doing, or if you jump into options investing without researching the securities involved in your trade.

Flexibility

When you buy an option, you're buying just that: a choice. Most of the time, you don't have to follow through if the deadline comes and you choose not to (though, in some cases, if you commit to selling at a certain price, then you must sell when the security hits that price). This expands the horizons of your investing, because you can basically wait and see what happens while maintaining the right to act if you so choose.

Low Capital Required

If you don't have the money to make a dent in the stock market, options investing can give you the chance to still play the game. In fact, many people start with amounts as low as $1,000, learning how options function and working their way up to larger and larger trades as they come to understand what they're doing. As long as you have at least a bit of money that you're willing to use, options trading can give you the opportunity to make more.

Make Money off Volatility

If you think the market is going to be moving around a lot, options are a way to make money off of that movement. Similarly, if you see the market beginning to move (up or down, it doesn't matter), you can use options to take advantage of that. Thus, market loss doesn't have to mean loss for everyone. After all, options were part of Warren Buffett's investing strategy in the recent economic downturn.

The Cons of Trading Options

Many people find that the benefits of investing in options outweigh the risks, but it's still smart to know what those risks are before you jump in.

Tax Rate

Most of the money you gain from options trading will count as short-term capital gains on your taxes, which face a higher tax rate than money held longer. This means that you could end up losing money even if you make money, which would be awful. Some options software will automatically calculate these taxes, so you have a better chance of making money.

Forecasting Is Hard

It's almost impossible to know exactly what the market is going to do, even if you have done good research and you have some experience. While you are only liable for the cost of purchasing the option even if you're wrong, being wrong a lot can add up and can end up being costly.

Liquidity Problems

A security has high liquidity if there are a lot of buyers and sellers in the market for it. You want this for the securities involved in your options trades. Without this liquidity, you can run into problems where the bid-ask spread, which is the difference between what a buyer is willing to pay and what a seller is willing sell, is large. That usually means that you are more likely to end up losing your money.

You can usually get a sense of the liquidity of a particular security using several different methods, which should help you avoid this problem.

In the end, options trading has a steep learning curve and can be just about as difficult as you want to make it. On the other hand, getting started is pretty easy, and you can make some significant money even if you don't understand every detail. So evaluate the pros and cons, do some research on your own, and decide if it's right for you.

Have you ever considered trading options? Please share your experience in comments.