Your Cart is Empty

January 24, 2023 8 min read

The stock market has always been a popular investment vehicle for people. A Gallup News poll found that approximately 58 percent of Americans own stock. Their reasons are understandable, considering the stock market has historically outpaced inflation. As a result, investing money into the stock market ensures that Americans don’t lose the value of their money over time. It’s not an unfounded concern, especially as the United States currently experiences 40-year record-high inflations.

While stocks have always been a popular investment vehicle, many often argue if they’re the best investment vehicle for individual and retail investors. It’s well-known that the stock market is extremely volatile. Price movements occur frequently. It’s also why most young Americans refrain from holding most of their assets in stocks. A recent survey from Bank of America shows that Americans between 21 to 42 with at least $3 million to invest only hold 25 percent of their assets in stocks. It marks a significant departure from older Americans (43 and over) who hold most of their assets in stocks and stock funds.

It’s important to understand the difference between trading and investing in stocks. The former is also known as active investing, while the latter is passive investing.

Most people understand passive investing. You purchase a few stocks you believe will appreciate. Then, you check on them once in a while to ensure they’re trending in the correct direction. Passive investors benefit from holding these stocks over the long run by getting dividends.

On the other hand, active investing is very different. It involves trading stocks and holding them for shorter durations because the trader aims to outperform the market by capitalizing on the stock market’s price fluctuations and movements.

While active investing is a broad strategy, it encompasses several sub-strategies. For instance, you might have heard of day and swing traders. These different active trading strategies are derived from how long a trader prefers to hold a position in a commodity. For instance, day traders prefer to hold positions for a short while. They’re averse to overnight risk, meaning they’ll close all positions before the trading day elapses. On the flip side, swing traders have a more patient approach. They like observing trends and momentums over a few days or weeks and use this information to inform their trading decisions.

As previously mentioned, the stock market is extremely volatile. Let’s use an example to illustrate this point. Let’s assume you purchase stock in Nvidia for $165. However, the company’s stock price the day before closed at $160. This example represents only a small price fluctuation. Some stocks can often witness significantly higher price swings during a single trading day.

This volatility is also a significant problem because stocks were the biggest form of executive compensation. Most mergers and acquisitions would result in the bought-out party receiving stock compensation in the acquiring company. However, this tradition has become less important over time as businesses and executives have realized that stocks are too volatile to be an effective form of executive compensation. It has led to stock options becoming more prominent.

Trading stock options isn’t something new. However, options trading has become common in the past few years. Research shows that a record 39 million options were traded daily in 2021 – a 35 percent increase from 2020. In addition, retail investors also accounted for over 25 percent of this trading activity.

As an interested participant in the financial markets, you might want to learn more about options trading.

Traders analyzing trading activity

What Are Options?

Options have become more popular in the past few years. They’re tradable contracts investors use to determine if an asset’s price will increase or decrease in the future. Since options are expirable contracts, they’re beneficial because you don’t have to exercise them.

It’s also important to understand that options don’t only exist for individual stocks. They’re also available for exchange funds, like the S&P 500. You can purchase put or call options for the S&P  500 to determine the direction the stock index will move in the future.

Options can be difficult to understand, especially since you’ll need to understand some essential terms that affect how options work. These include:

  • Derivatives: Options are also called derivatives because their value is obtained from another asset. For instance, consider stock options. They derive their value from the stock’s price.
  • Call option: Call options allow the holder of the options to purchase a stock at a later date for a specified price. This price is also called the strike price.
  • Put option: Put options give the holder of the options the right to sell a stock at a later date for a predetermined price.
  • Strike price: Strike price refers to the predetermined price agreed upon in an options contract.
  • Expiration date: Expiration date refers to when the options contract expires. The options contract holder must exercise their options before this date elapses. Otherwise, the contract becomes void. In addition, they also lose the premium paid.
  • Premium: Purchasing options require paying for them. This payment is also called a premium and is derived from the stock’s price.
  • Intrinsic value: Intrinsic value refers to the difference between the stock’s current price and the strike price in the options contract.
  • Extrinsic value: Extrinsic values refer to factors other than those considered in intrinsic value that affects the premium.

How Are Options Priced?

Understanding how options are priced can often be challenging. It’s important to understand you must pay an upfront premium when buying put options. Similarly, you’ll receive a premium from the buyer if you’re selling call options.

It’s also worth noting that the strike price affects the options pricing. Lower strike prices carry more intrinsic value for call options because they let the trader purchase the stock for a lower price than its current stock price. For instance, let’s assume you sold call options for a $100-priced stock at $80. It had an expiration date of three months. However, the stock’s price remains steady, and the call options purchaser exercises their options. That trader will be in the money because they’ll profit.


How Does Options Trading Work?

Options trading can involve straightforward or intricate trades. However, most approaches revolve around using call and put options. Call options are generally used to wager on rising prices, while put options help traders bet on declining prices.

Options contracts are beneficial because they allow traders the right to buy or sell a minimum of 100 shares of stock. However, they also give traders flexibility because these options don’t have to be exercised. Traders can let them expire, although it’ll cause them to lose the premium paid for those options.

Hence, most traders view options trading as a low-risk way to speculate on price fluctuations of commodities.

Traders can speculate on the following things:

  • Whether a stock’s price will increase or decrease
  • How much the stock’s price will increase or decrease
  • When will these changes occur
A trading chart

Why is Options Trading Advantageous?

Options trading is becoming more prominent because it provides flexibility. It also helps traders minimize their losses and maximize their profits on stocks if used correctly.

A quick glimpse at real-world examples of successful options trades will help you understand why traders consider them advantageous. The most-profile example is arguably Mark Cuban, the billionaire who kick-started the streaming revolution with his company Broadcast.com.

Broadcast.com was purchased by Yahoo for $5.7 billion in April 1999. As previously mentioned, stocks were the most popular executive compensation, especially then. And Yahoo provided nearly 15 million of its shares to Cuban as payment. The internet giant’s stock price was valued at $95, placing Cuban’s stake at approximately $1.4 billion.

Cuban was already knowledgeable about exits and had extensive experience in the stock market as a trader. He had amassed a sizable fortune from day trading after selling his first company, Microsolutions.net.

This prior experience told him that the tech industry was overvalued and the market would correct itself eventually. Unfortunately, he also couldn’t sell his Yahoo stock immediately due to restrictions. He feared his stock would become worthless if the market corrected itself, prompting him to turn to Goldman Sachs for help. They worked together to create a collar, selling call options and purchasing put options.

Cuban bought put options as insurance. They allowed him to sell his Yahoo shares for a strike price of $85. On the other hand, the call options with a strike price of $205 limited his potential profits but offset the price of buying put options.

The stock market continued to prove kind to the tech sector. Yahoo’s stock rose to $230 by January 2000. Cuban’s collar still wasn’t implemented yet. But a few months later, the bubble burst, and the tech sector crashed. Yahoo’s stock plummeted. Fortunately for Cuban, his hedge worked perfectly, protecting most of his wealth.

This example illustrates the benefits of using options. Options contracts provide flexibility and specificity. For instance, let’s assume you purchase a company’s stock for $50. You can also buy options at a specific strike price and expiration date. While you have limited time, you can still use these options to see if your bets play out as anticipated.

Options trading strategies also appeal to traders who want to minimize their exposure to a specific stock over a shorter duration. You can monitor the asset’s price to see if your position is working well or if you need to exercise your options.  

Similarly, traders also like options trading because it helps with hedging. You could buy put options to mitigate losses if a stock’s price decreases.

A trader using charts to determine entry and exit points

The Cons of Options Trading

While the popularity of options trading might convince you to try your hand at it, the reality is that it’s not the right option for everyone. Options trading is a particularly poor approach if you prefer a hands-off investing approach. In addition, options trading can also be complicated because you must consider three factors when deciding. These include direction, price, and time.

In addition, you’ll also have to overcome some hurdles before you can trade options. The US Securities and Exchange Commission (SEC) has instituted requirements that state brokers can only approve customer accounts for options trading if they sign an options trading agreement. Signing this agreement is necessary because it shows you understand options trading and its associated risks. These restrictions can pose problems for beginners to options trading.

Options trading is also a time-consuming endeavor. You’ll have to set price alerts and closely monitor the markets to ensure you know the perfect time to enter or exit a position. Otherwise, you’re sacrificing trading profitability.

Moreover, most brokers also have trading fees that affect various options trading strategies. While most brokers have eliminated these trading fees for stocks and exchange-traded funds, the same isn’t true for trading options.

In addition, they’ll also share a commission, which might be a flat rate or a per-contract fee. These apply when selling and purchasing options contracts. Ensure you account for these costs when developing an options trading strategy.

Finally, the most important thing to remember is that options trades are inherently shorter because options contracts have expiration dates. You’re also going to trigger short-term capital gains taxes when trading options, meaning it’ll be taxed as ordinary income since you’ll be holding the investment for less than a year. As a result, the tax rate for options can be as high as 37 percent based on your federal income tax bracket.

A graph depicting price movements

Get Started with Trading Alphas

Options trading can be difficult. New traders often struggle with it, but they’re not alone because even the savviest traders can have difficulties. As a result, traders often need the right guidance and assistance to help them achieve profitability when options trading.

That’s where Trading Alphas enters the mix. We have helped our diverse options trading community of over 1000 members make over $25 million in profits. You can sign up for an options trading subscription on our website. Alternatively, you can also join our options trading Discord server, or contact us to learn more.