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The stock market may have struggled over the last year but stock market options are booming.
Options contracts give investors the right, but not the obligation, to buy or sell an underlying asset like a stock at a specified price. This type of trading can be risky and speculative, and it doesn’t have a place in all investors’ portfolios.
At the end of December, for instance, one measure of options activity reached a record high. Separate data analyzed by Bloomberg showed that the trade volume of contracts allowing investors to sell stocks at a given price surged more than 30% in 2022 compared to 2021 as stock prices fell.
How do options work, and should everyday investors get in on the action? Here’s what you need to know.
What are options?
An option is a contract that gives you the right to buy or sell an asset like a stock at a particular price, called a strike price. You can buy them and sell them like shares, but you aren’t buying the actual stock — you’re buying the right to buy or sell the asset.
There are two types of options: call options, which give you the right to buy an asset at a certain price, and put options, which give you the right to sell an asset at a particular price. Investors tend to buy call options and sell put options when they believe the price of a stock will rise. When investors believe the price of a stock will fall, they tend to sell call options and buy put options.
You can buy and sell options through a traditional or online brokerage or a registered investment advisor, though your ability to trade different types of options may be limited by your investing experience.
Why are options so popular right now?
“The bear market has forced a lot of investors to think about downside,” Callie Cox, a U.S. investment analyst at eToro, tells Money. “They're more aware of the risks, so they're more likely to hedge.”
That hedging comes in the form of options contracts — especially put options. When stock prices fall, investors who hold put options can limit their losses if the option’s strike price is higher than the current price of the stock.
Cox also points out a few trends that have made it easier for average investors to access options over the past few years. These include the growing confidence of retail investors and the advent of short-term options contracts that let investors trade options around particular economic events like inflation and employment reports.
“There are more options in options than ever before,” she says. “People are getting smarter and more precise with their money because they have the knowledge and tools to do so.”
Should retail investors buy options contracts?
If you’re right about how the price of a stock will move, options trading can bring returns that are far larger than if you bought the stock itself. But that type of speculation comes with risk.
“You really need to know what you're doing,” Matt Dmytryszyn, chief investment officer at Telemus, tells Money, “or go to somebody that does….it's a sophisticated market. It can be challenging to understand.”
It’s also very easy to lose a lot of money very quickly, especially if you’re buying multiple contracts.
“You buy one option and if it doesn't pan out, it's not the end of the world,” Dmytryszyn says. “But if you continue to do that and continue to be wrong, it's death by one thousand cuts.”
That said, Dmytryszyn adds that options contracts be a smart move for some people. For an investor who wants to maximize income from their portfolio, for instance, options contracts may be one way to boost income regardless of how the stocks in the portfolio are performing.
Options are also a way to minimize portfolio losses. They allow investors to lock in a sale price that might be higher than the stock’s market price, but keep in mind that committing to a particular sale price means you might forgo better returns if the stock recovers.
Remember: Options contracts come with a lot of risk, and they’re definitely not the best move for all investors — especially not beginners.