Did you know Warren Buffett uses options to grow his wealth?

Options are a powerful tool that can significantly boost your investment portfolio. Many investors overlook options, missing out on their potential to enhance wealth and manage risk.

Here are 3 key explanations you need to know to kickstart your learning journey on trading options.

1. What are Stock Options

Stock options are contracts. Having a contract allows you to decide whether to buy or sell a stock at a set price by a specified date. You can but you don't have to.

The technical explanation goes like this: you own the right to buy or sell a stock but not the obligation to do it.

You’re not buying a share of the company. You’re buying the right to trade its shares.

Think of it like you paid $1 for a coupon for the right to purchase a pen at $3 by the end of this week. The pen could be selling for $3 or $5 in the market right now. Why would you want to buy an option contract to do that?

There are essentially two kinds of option contracts – call and put options.

2. Call Options

Buying a call option is like betting a stock price will go up. You pay a small fee for the right (but not the obligation) to buy that stock at your chosen price on or before the expiry of the contract. If the stock goes up, you can buy it cheap and sell it for more.

Using the same coupon example, you’d be paying $1 to purchase the right – the coupon – to buy the pen at $3. The coupon will expire by the end of the week. If the price of the pen goes up to $10 tomorrow, you’d still be able to buy your pen at $3 with the coupon, or you can choose not to buy it.

And if you do buy your pen at $3, you get to sell that same pen in the market for $10. Profiting a grand total of $6 ($10 current market price – $3 your cost price – $1 fee you paid to buy the coupon) in this entire process.

3. Put Options

The opposite side of a call option is a put option. Buying a put option is like betting a stock price will go down. It gives you the right to sell a stock at a defined price before the option contract expires.

Now let’s say you own some of those pens at $10 each. If you anticipate that the price will decline soon, you buy a put option to sell your pens at $10 (the right to sell) before the expiry date.

If the price of pens do drop, your put option allows you to sell your pens at $10, saving you the loss you would have incurred if not for the put option. This can protect your portfolio from market downturns acting as a form of insurance.

There are many other ways to trade options. We’ll explore more of these later in another article.

Learning stock options can open new avenues for investment and risk management. By understanding the basics, you can make informed decisions, avoid the pitfalls and potentially enhance your financial returns.