If you want to invest in the stock market without spending a large amount of money initially, you may consider options trading. A way to speculate as to which way you think the market may move in the future, options trading has its pros and cons. Before getting started, here are five things you need to know to increase your chances of success.
Options are Contracts
When you purchase an option, you are buying a contract. Once you own an option, you then have the right to either buy or sell a certain amount of an asset at a price that has been predetermined before your contract expires. However, unlike most types of traditional contracts you enter into, buying an option does not automatically obligate you to buy or sell the asset. Instead, you can simply let the contract expire if you wish.
Options Reduce Your Risk
When you invest in the stock market or anything else for that matter, there is always the risk you will lose money in the process. However, one of the best things about options is that they can be used within your investment portfolio to reduce the risk of you losing thousands of dollars. In reality, options trading was created exactly for this purpose.
An easy way to think about any options you purchase is to view them as insurance policies for your investing. Since you are essentially using options to speculate on the market’s direction, they help to ensure your investments should the market take a downturn. In essence, options trading can give you not only added income to your portfolio, but also financial protection and increased leverage when buying or selling.
Dollars and Cents
If you are a trader who has a limited amount of money to spend on your investing, options trading can let you spend only a few dollars or even a few cents on whatever asset it is you wish to buy. However, this is usually done only if you are using what is known as a call option when working with the best brokerage for options trading.
When you use a call option during trading, this means you have not bought a stock outright. Instead, you are gaining leverage on the future price direction of the stock. Should you decide to use an out-of-the-money call option for a stock, it is conceivable you can purchase a $100 stock for only pennies on the dollar.
You Need Broker Approval
While you may think options trading is something that just any investor can get into immediately, it is actually not quite that simple. To do options trading, you will first need to be approved for it by your stockbroker. To gain access to this specific type of trading, your broker will need to approve you for both options and margins. Once this occurs, you will be able to use your options to either buy or sell long or short calls or buy or sell long or short puts. Whichever you choose during options trading will depend on whether you want to stay with a stock long-term or try to get a quick profit and then sell.
Options Do Get Taxed
When you are involved in options trading, don’t assume that just because it differs from other forms of investing that you will be able to avoid paying taxes as you would in traditional trading situations. Whether you have a call option or a put option, these options will be taxed based on their holding duration, which of course will vary based on the options you purchase and trade.
Also, keep in mind that options of any kind are subject to capital gains taxes, which in some cases may be substantial if you are experiencing trading success. Since you should always know how these taxes will impact your portfolio, you should speak to your broker as well as a CPA to make sure your trading decisions impact your finances in the best possible manner.
Though initially sounding complex and confusing, options trading is much easier to understand than you might imagine. By working with your broker and understanding the goals you have for your portfolio, options trading can be a useful and profitable investment tool.