Most traders and investors have heard of options but may not have any experience with them. While options are sometimes associated with reckless speculation, there are many low-risk option strategies that can enhance income, reduce risk or accomplish other goals without taking on excessive amounts of risk—or even very little downside risk!
Let’s take a look at what’s involved with trading options, who should consider using them and how to get started without all of the risk.
What Are Options?
Stock options are a relatively simple concept: They give you the right to buy or sell an asset at an agreed upon price before they expire on a certain date.
For example, you might buy a call option on April 1 that lets you purchase 100 shares of Apple Inc. stock at $130.00 per share on or before April 30 for a $136 premium payment. If the price rises above the $131.36 per share breakeven point on or before April 30, you will make a profit. The price of the option will fluctuate daily before expiration. You can sell the option anytime prior to expiration to close the positions.
Many traders are attracted to options because of their leverage. In the above example, suppose that you could have purchased 100 shares of stock for $12,000 or bought the option for a $136 premium payment. If the stock rose to $140.00, the long stock position would have gained 17% whereas the option position would have gained 735% over the same timeframe.
On the other hand, many investors use options to generate an extra income from their portfolios. For example, suppose that you own 100 shares of Apple Inc. and want to make an extra return above and beyond the dividend. You could write the same call option purchased in the previous example and make $136—and if the price never reaches the $130 strike, you keep the shares and the premium.
Should You Trade Options?
Options are easy to understand on a high level but difficult to master in practice. Many inexperienced traders that dabble in options lose money.
For example, an option loses value immediately after you purchase it due to the impact of time decay, assuming that the price and volatility remain the same. You can also lose your entire investment when purchasing an option if the price doesn’t reach the strike price.
The riskiness and utility of options depend on how you’re using them. If you’re buying call options ahead of an earnings announcement, you’re making a binary bet on an earnings beat and it’s usually a very risky strategy. If you’re selling out of the money call options to generate an extra income on stock you already own, your only risk is opportunity cost.
If you’re interested in trading options, you may need to meet certain requirements. Most brokers have different levels of option trading that require approval since they involve margin and a high risk of loss. You may need to provide your annual income, trading experience and net worth (liquid and illiquid) depending on the types of strategies you want to use.
Different Option Strategies
There are many different option strategies and some of them are riskier than others. The best way to avoid losses is to start simple and expand within your comfort zone.
Covered call option diagram. Source: The Options Bro
The lowest risk strategies include:
- Selling Covered Calls: A covered call is constructed by holding a long position in a stock and then selling (writing) call options on that same asset, representing the same size as the underlying long position.
- Rolling Covered Calls: Rolling up a covered call involves buying to close an existing covered call and simultaneously selling another covered call on the same stock with a future expiration date or a higher strike price.
- Buy-Writes: The buy-write strategy involves buying a stock and writing a call option against the stock position at the same time.
Other option strategies include:
- Buying calls: Buying calls is a bullish strategy that involves buying a call option with the risk of complete loss and a leveraged reward.
- Protective puts: Protective puts are designed to help protect a long stock position from downside by offsetting losses with a gain in the put option’s value.
- Selling cash-covered puts: Selling a put option provides an immediate premium income while committing to purchase the shares at a lower price. This is nearly identical to selling covered calls.
- Long straddles/strangles: Straddles and strangles are option strategies that involve purchasing call and put options with either the same strike price and expiration or the same expiration but different strike prices.
- Spreads: Spreads involve purchasing one option and selling another option at a higher strike price.
At Snider Advisors, we focus on low-risk strategies designed to help investors generate an income while maintaining a diversified portfolio of high-quality stocks. The Snider Investment Method chooses stocks solely based on their option income potential and risk factors, using a proprietary SIM Score for volatility, RapidRatings Score for bankruptcy risk and diversification tools.
There are many high-risk option strategies out there. For example, selling uncovered calls or puts is very high risk since there’s unlimited loss potential that’s leveraged beyond a traditional short sale. Even experienced traders can and do blow out their accounts with these high-risk strategies, so you should use them with extreme caution if at all.
How to Get Started
Most brokerages offer option trading as part of their services. Robinhood is a popular retail trading app that offers commission-free options trading, while platforms like TradeStation have unique features for advanced traders looking for a little more power.
At Snider Advisors, we recommend Ally Invest since it offers an easy-to-use platform with low costs. The platform includes a probability calculator, option chains, research and market data, profit-loss diagrams and anywhere access via a mobile app. With no commissions and $0.50 per contract, it’s also cheaper than other major brokerage providers.
Lattco’s automated trading platform. Source: Snider Advisors
We also provide an automated trading platform, called Lattco, that works with Ally Invest to help implement the Snider Investment Method. The platform automatically tracks your portfolio, stock allocations, generates new positions, tracks performance, and handles a lot of the time-consuming parts of the option trading process for investors looking for income.
The Bottom Line
Options trading opens the door to a variety of strategies for everything from speculation to income generation. Almost anyone is eligible for low-risk option strategies, such as buy-write or writing covered calls, but most advanced and riskier strategies require broker approval. The best approach to trading options is typically starting low-risk and moving up as needed.
Snider Advisors has an economic incentive for recommending that clients open an account with Ally. Specifically, Snider Advisors receives a flat referral payment for each new account it refers to Ally. More detailed information about the relationship and our fiduciary responsibility can be found in our ADV Part 2A. Clients may contact Snider Advisors with any questions about the terms of the agreement with Ally.