Trading options is more complex than simply buying and selling a stock in regular times, and in unusual circumstances like the current market, options may present even greater complexity if you don't fully understand how they work. However, with education and experience, it's possible to learn how these investments work, and in what ways they may help you invest the portion of your portfolio that you manage personally.
Every investment plan should include an assessment of your individual goals, risk constraints, time horizon, tax constraints, and liquidity needs. Options have unique characteristics and risks, and should be carefully considered within the context of your overall investing plan. Investors can trade options if they sign an options agreement and are accepted to trade options by a brokerage firm.
Before trading options, it's particularly important to know how much risk you are willing to take. For many investors, and especially those just starting out with options, it's vital to know what kind of investor you are. For instance, what type of risk are you comfortable with? And how thoroughly do you understand the way options work? The answers to these questions can help you decide if options are right for you, as well as the types of options strategies that might best align with your objectives and risk constraints.
With that said, here are a few tips when thinking about your next options trade: Consider volatility and dividends, and ways to manage your risk.
Use volatility to your advantage
Volatility can be an often overlooked aspect of options trading by many investors, but in today's market, it is vital to think about the impact of large price moves for underlying assets of options. Many options investors do not realize that, even if a stock for which you have bought or sold an options contract moves in the direction that you want it to, that option may not always reflect the stock's move.
The reason is oftentimes a change in implied volatility. As it relates to options, implied volatility is the market's expectation for future volatility. So, a stock might move in the direction that you want it to, based on your option position, but an increase or decrease in expected volatility that may have caused the stock to move could positively or negatively impact the price of the option—known as the premium.
You can help put yourself in position for success by getting familiar with how both implied volatility as well as historical volatility factor into the price of an option. Always remember to put an option's current level of volatility in perspective. For example, be careful when buying an option with current implied volatility at the high end of its past range, as well as when selling an option with current implied volatility at the low end of its past range. This will help you correctly interpret the impact volatility can have on options.
Moreover, implied volatility can help you find the right options contract among all of the available choices. One way to determine if an options contract is attractively priced is again by evaluating implied volatility relative to past ranges.
Suppose you expect there to be a near-term increase in implied volatility. The straddle is one of the more popular strategies that is designed to capitalize on the expectation for higher implied volatility and a relatively large move in either direction. A straddle involves buying a call and a put option with the same strike price; essentially, you are looking for an increase in implied volatility. This strategy offers limited risk and unlimited reward, and the breakeven is either the call strike price plus premium paid or the put strike price minus premium paid.
One tool that you can use to help generate investing ideas based on volatility is the Trading Ideas tab on Fidelity.com's options research page (login required).
Look for dividends
One pitfall that some new options traders can fall prey to is focusing solely on their expectation for the direction that an underlying stock of an option will move. While that is of critical importance, the potential impact of dividends upon the price of options is another one of those nuances that it's important to be familiar with—especially when selling options.
Before initiating an options trade, know if the stock pays a dividend as well as when it is payable if it does. If it pays a dividend, you have to examine if the option is in the money (which is to say that it could be worth exercising) or close to it as expiration approaches. If the dividend is greater than the time value of the option (see What is time value? sidebar), then the stock could be assigned (meaning the owner of the option could exercise the option in order to earn the dividend payment, and you would be forced to sell the stock).
Fortunately, you may not necessarily get stuck with being assigned in this scenario. You may have a choice in advance of that dividend payment. You could wait and see if the stock will be assigned, or, you could close the position and roll it out to a later month to potentially avoid assignment. In fact, almost two-thirds of all options are closed out before they expire. This is one of the many ways that you can manage your risk with options.
What is time value?
When it comes to options, it can be particularly important to manage your positions actively and change course as needed. And in times like these—when markets can turn on a dime upon an impactful news release—you may want to keep an especially close eye on any open position.
"An options trade is an actively managed strategy, which is to say that you don't want to set it and forget it," says Greg Stevens, vice president at Fidelity. "When an options trade is open, there are several choices you may make throughout the life of the contract—including closing out the trade, letting the option expire, and if you still want to be in the position, rolling it out." Of course, if you sell an option, assignment is out of your control.
- Closing out a trade can involve taking an offsetting position. For example, if you purchased a call option, you could sell an identical call option to effectively close the trade out.
- Letting an option expire is when an options contract reaches its expiration date without being exercised, and is possible if you purchase or sell a call or put.
- Rolling out an option involves closing out an option that is about to expire and simultaneously executing a similar trade with a later expiration date.
- Assignment can happen if you sell an option—meaning you might have to receive or deliver shares of the underlying stock.
Chart a path to trading options successfully
Options require an enhanced understanding relative to traditional investments, such as stocks, during any market conditions. Be sure to utilize the many tools and resources that can help you reach better outcomes. And remember to consider volatility and dividends, and most importantly, ways to manage your risk.