A question we are asked time and again by students is, “Should I trade options if I have a small account?”
Options trading is not quite the same as trading stocks and carry some unique risks that we’ll cover below.
In this article, we are going to take a look at what options are, how they work, and why it can be difficult to trade them in a small account even though they are cheap.
What are options?
An option – also known as an equity option or stock option – is a derivative contract that gives the holder the right, but not the obligation, to buy or sell a particular stock or other underlying security at a given price (strike price) up to or on a certain date (expiry date).
When trading options, you can choose to buy (option holder) a call/put long or sell them (option writer) depending on your goals and trading strategy.
A call option is a derivative contract that gives the holder the right, but not the obligation, to buy an underlying stock/security at a specified price on or before a specified date.
A put option is a derivative contract that gives the holder the right, but not the obligation, to sell an underlying stock/security at a specified price on or before a specified date.
How Options Work
While many people are interested in trading options, they don’t know where to start and some see options as extremely dangerous. An option can involve any asset, a piece of land, a car, and a building to name but a few.
Every options trade has two sides. The seller of the option or buyer of the option. The seller or the buyer can decide to trade puts and/or calls.
Here is a simple example that will help you understand how options work.
Let’s say you want to buy a piece of land that is listed for $1,000,000. You want to lock in the price before it jumps higher. So, you reach out to the owner and reach an agreement.
Under the terms of the contract, (remember options are contracts), the owner will hold the land for you for five months. In the course of that time, no matter how low or high other offers may be, nobody but you will be permitted to buy the land. That contract is a call option.
If you buy a call option, you are expecting the underlying security to experience a rise in price. The key to call options is to buy them with low strike prices and hope that the stock price will increase by the expiration date.
With put options, you are hoping that the price of the underlying stock is going to go down. This means you will be able to sell the stock at a higher strike price back to the seller by its expiration date, although the shares are now less valuable.
Benefits of Trading Options
Options trading has several notable benefits. First, the leverage that trading options provides can allow you to control huge positions with relatively little money.
For example, if you think shares in Facebook (NASDAQ: FB) will jump from $120, for example, you might buy a May $125 call option on 100 shares for $5 or just $500 in total.
That is a substantially lower cost to take a long position in Facebook than the $12,000 you would need to buy 100 shares of the stock itself.
You can also use options to personalize your risk profile when trading in order to adapt to a particular market view. For instance, you can purchase a call option to take a bullish view on the underlying security while limiting your risk to the premium you originally paid.
You can also buy both a call and a put option with the same strike price if you believe the market will make significant moves, but you are not sure on the direction and want to limit your downside risk.
Why it can be difficult to trade options even though they are cheap
There are always opportunities for traders to earn money trading options due to the fact that they are cheaper than stocks. However, options trading is not an area for amateurs and they can be much more challenging for beginner traders because of a number of reasons that we are going to discuss below.
- Poor liquidity
Trading options is just like trading stocks in the sense that the liquidity experience can be completely different depending on the security. In financial markets, liquidity refers to how easily a trader can buy or sell a security without losing much value.
In other words, it is a measure of how many sellers and buyers are present, and whether transactions can happen easily.
Liquidity affects everything including trade execution and the bid-offer spread. The more liquid a security is, the easier it is to trade.
Unfortunately, some options don’t have much volume so spreads can be quite large. The larger the spread, the the less liquidity for those options. For instance, if the spread is $1.00/$1.50, it may be hard for a $1.25 order to go through. Instead, sellers may have to move down to $1.10 and buyers up to $1.40.
- Time is against you (theta)
Unlike stocks, options are “decaying” securities, which means their prices decrease over time and this can suck the life out of you. Theta is the Greek letter that expresses an option’s expected price fall with the passing of time. In other words, theta is a measurement of time decay.
When trading options, time decay increases as the contract moves closer to its expiration date. This means that with all other things being equal (implied volatility and stock price), then you can expect the price of an option to go down every minute as it nears expiration.
- You will also have to meet some margin requirements that are imposed by security regulators.
- It is also not easy to know when the significant moves are going to happen.
- You will also have to do more prep work every day when day trading options since traders need to look at bigger watch lists of stocks because they don’t know which names are going to be active on a given day.
There are a number of benefits to trading option – whether you want to hedge against existing positions, speculate on a wide variety of securities, or just get a little bit longer to determine whether a trade is ideal for you.
However, options trading is not really a good idea if you are an inexperienced trader with a small account because there are three essential decisions (direction, price and time) you must make, which makes options more complex to trade compared to stocks.
In addition, if you don’t fully understand how options work, they may present even greater complexity in unusual circumstances such as during the ongoing coronavirus pandemic.
Therefore, if you are a beginner trader and you want to jump into the stock market, it would be best to start out with stocks because they are much easier to understand and trade.
If you’re interested in learning more about options, then make sure to check our in-depth Options Trading Guide.