Investing in stock options can prove to be a highly lucrative form of investment. Stock options provide investors with several advantages, including a way to enhance their portfolio as well as to hedge against inflation and a declining stock market. Here we discuss several tips to consider when investing in stock options so you can make the most informed decision and the greatest profit.
Research the Different Types of Stock Options
Stock option investments come with risks that other types of investments don’t, so knowing this and being prepared for it is essential. The first step in investing in options is to determine the types of stock options you’re interested in. The two primary types of stock options are nonqualified stock options (NQSOs) and incentive stock options (ISOs).
NQSOs are the most common type of options and do not qualify for special tax treatment. Thus, this type of option requires you to pay taxes, which will be withheld by the company when you exercise the NQSO. ISOs receive special tax treatment and are not subject to taxes.
Understand Technical and Fundamental Analysis
Understanding technical analysis, or how to analyze the stock market’s behaviors, is essential if you want to be a successful options trader. This will provide you with the information and tools needed to develop a successful strategy you can use when buying and selling options.
Additionally, you should understand fundamental analysis, which is the study of a business’s financial health, for the companies whose options you plan on buying or selling. You should have a clear idea of whether a company is a good investment and where that company is headed in the future.
Determine Your Investment Goal
It’s best to identify your overall investment goals first. What do you want to achieve by investing in options? Do you want to earn income from options, or are you trying to hedge against downside risks on other stocks? Knowing your objective will be a foundation for your options trading and guide you in making the best investment decisions.
Research the Volatility of Each Option
Implied volatility is what you want to look for, as this will provide you with the most accurate read on how the option will perform. You can check the option’s historical volatility and compare it to the stock market’s general volatility at the time.
Additional Stock Option Investment Tips
Here are some additional tips to keep in mind when investing in stock options:
- Decide on what your risk-reward payoff will be. This means establishing your risk tolerance and setting parameters around that.
- Determine events. There are two events you should look at — market-wide and stock-specific events. Each type of event can drastically impact the implied volatility before it happens as well as have a large impact on the stock price when the event does occur.
- Create a strategy: Once you’ve done the previous steps, you can now sit down and devise a strategy for investing in options.
- Set option parameters: After creating a strategy, you’ll now need to set the parameters of the options. These include strike prices, expiration dates, and option deltas.
Taking time to understand stock options and develop a well-thought-out strategy can significantly improve your chances of profiting from option investments.