Can you make active income from passive income sources? Do you have a nice-sized dividend portfolio get sitting around, waiting to produce more revenue? Then you might want to research trading options in the stock market.
Options are contracts giving the owner the right to buy or sell an asset at a fixed price for a specific time. The fixed price is called the strike price. I will go more in-depth into the vocabulary of the options market in other articles.
I have not traded options before. I read the book “The Options Playbook,” and I had a plan to open a paper options trading account—giving me the ability to practice buying and selling options safely without real money involved. However, I have busy catching up on cryptocurrencies as of late.
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The great part about options is that they exist in the stock market world, the commodities world, and the cryptocurrency world. So learning the terms and techniques of options will carry over between the different worlds.
Trading options needn’t be risky. In fact, most people use them as a hedge against another position. A hedge is a type of insurance. Hedges are significant in the commodities markets for owners or producers of crops. If you would like to learn more about the commodities markets, read “A Trader’s First Book on Commodities.”
However, options can be perilous because you do not need to own the underlying positions. It can get confusing, so that I won’t go too deep into the methodology now. But understand that you can get yourself into trouble exceptionally quickly in the options world. These risky techniques are not what I am pitching today.
Today I want to talk about why it may be a good idea to give some attention to options trading. There are many reasons why the world of options can interest you, and I will lay out five solid reasons for you. Of note, options sell in lots of 100 stocks. So they can be very pricey.
Before we get into my five reasons, I want to give out a couple of definitions that will serve us well throughout the article.
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Buying a call option gives the owner of the option the right (but not the obligation) to purchase an asset at a fixed price. Buying a put option gives the owner of the option the right (but not the obligation) to sell an asset at a fixed price. These concepts are deep, so I will give real-world examples to explain them better, hopefully.
Call option real-world example. Let’s say that the price of Nintendo Switch consoles hovers around $300 at Walmart on an average day. From time to time, they go on sale for $250. However, these sales are unannounced and unpredictable. If I wanted to buy the console for $250, I would buy a call option for the strike price of $250. To purchase the call option would cost me an amount of money based on the time I want to keep the option valid. The more time, the more money. Let’s say the price of the option was $10.
Then I would go about my business. I am the owner of an option, not the Nintendo Switch console. If the Nintendo Switch price dropped to $250, Walmart would telephone me and ask me if I wanted to buy the console. I would have the “option” to accept the console, hence the name. Whether I buy the console or not, I still would have paid the $10.
If the price of the console never drops to $250, then the option will expire worthless. Most options contracts expire worthless—this is good to remember.
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Put Option real-world example. Continuing the above example, let’s say I receive the Nintendo Switch. I can now buy a put option for the right to sell it at the strike price. I will set my contract for a fixed price of $280. Again, I pay $10 for the options contract.
I want the price to recover to $300+, but $280 will be a reasonable price for someone to buy a Nintendo Switch if it doesn’t. So I will get a phone call asking me if I would like to sell my Nintendo Switch console. I have the option to sell it at this price, hence the name. With the put option, I covered my bet that that price would spike back up to $300.
Here is another example, this time from Investopedia. Remember, these are complex theories, so take your time to understand them. It won’t come all at once. I am writing this article to help you decide if this is something that interests you. I believe there is value in the world of options, so I continue to understand it the best I can.
1) Insurance. We can use options to hedge our risk against the market. If your Tesla stock is moving higher and higher, you may want to buy an option to limit your downside. Remember, you will have to pay for this insurance.
If you are a speculator, then using options as a hedge or insurance is a must. You may seek to get the highest capital gains possible and take profits at the peak of the euphoria. Others may be waiting for a 5-10% reduction in price before they buy. Options can satisfy both parties.
2) Make extra cash. If you have an extensive dividend portfolio, you may want to make some money by selling covered calls. A covered call means that you own the underlying assets. So you may have 100 stocks of T (AT&T) and would like to sell covered calls.
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Someone would buy your calls, hoping to buy at a particular price. Most options expire worthless, so you get to keep the premium. If the market reaches the strike price, then you may lose your stocks. However, with the correct strike price, you should have profited from the stocks and the premium.
3) Gauge market sentiment. If you follow the options market, you can see how the market feels about a particular stock. Most options are closed by taking the opposite position than what you bought. When you buy or sell an option, you are opening a position. So you will need to buy or sell to close your position.
The Options Clearing Corporation keeps track of all open positions and gives the “open interest” of a particular stock. The “open interest” of a stock provides a gauge of where the stock is headed in the future. Open interest is an excellent way to start your research on a particular stock.
4) Get stocks at the price you want. If you are deadset on buying the right stock at the right price, then options trading is for you. Remember, you will pay a premium for this luxury. And the further out you extend your option contract, the more expensive (and risky) it can become.
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5) Stay busy in retirement. Trading options is an excellent way to increase income on your dividend stocks and stay active throughout retirement. Yes, I believe that to trade options safely, you should own the underlying stocks. So, in this case, it takes money to make money. “Covered” means you own the underlying stocks, “Naked” means you do not own the underlying stocks.
But, I see this as a great way to earn income, stay engaged, and build some excitement during your retirement years. I look forward to retiring and being able to focus some of my attention on options trading.
Conclusion. I hope I was able to add some value to your knowledge of options. Again, if you are unsure about options, I would try paper trading first. That is my intent as well. I just became inundated with information on cryptocurrencies before I could get into paper trading.
The world of options trading can seem complex; however, I think once you get the hang of it, it can be lucrative. I think the people who don’t get emotional or carried away can make a good steady income from options. To learn more, read these books, and try your hand at paper trading. If I get to do it first, then I will report my findings. Good Luck!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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