Options trading has exploded thanks to mobile brokers like Robinhood and Webull. Options are derivatives often used for hedging equity positions or executing complex trades, but retail traders are now using them as lottery tickets on their favorite stocks. While buying out-of-the-money (OTM) options isn’t a strategy for long-term success, many traders have cashed in huge gains thanks to short squeezes in meme stocks like GameStop (NSDQ: GME) and AMC Theaters (NYSE: AMC).
Access to options is more commonplace than ever, but that doesn’t mean trading derivatives is right for everyone. Options are complex and many factors go into their rise and fall. If you want to trade options with a small account, you’ll want to adhere to a couple guidelines to prevent your capital from eroding.
What are Options?
An option is a contract that provides the owner with the choice of purchasing (or selling) a stock at a certain time in the future for a predetermined price. This predetermined price is known as the ‘strike price.’ Each contract entitles the buyer to purchase 100 shares of stock at the strike price, but only if they choose to execute the contract. Options are bought and sold on exchanges just like the equities that underline them. The person selling the option (known as the writer) collects a premium from the buyer in exchange for the agreement. Call options appreciate in value when the underlying equity goes up, while put options appreciate during stock declines.
Let’s say you believe shares of DraftKings Inc. (NYSE: DKNG) are overvalued and will decline in price over the next six months. You could short the stock, but that involves borrowing costs and the potential to lose more than the original investment should the shares soar. Or you could buy a put option on DKNG shares, which allows you to profit off a share price decline without risking more than the premium paid for buying the put. If DKNG shares are priced at $50 on September 24th, you could buy the $45 put option that expires on November 19th. If DKNG shares decline below $45, your option will be “in-the-money” and you can execute it or sell it for a profit.
Option writers collect money up front, but are at risk of losing more than they earn if the stock makes an opposite move. Option buyers only risk the premium paid for the contract – if DKNG stock never declines below $45, the put in the previous example expires worthless. The closer the strike price is to the current price, the more expensive the premium will be. Ditto for options with expiration dates further out the calendar. An option is said to be “in the money” when the strike price is reached. “Out of the money” options have no intrinsic value and depend on the underlying equity hitting the strike price.
Why Trade Options
Options are popular because they allow traders to control a 100-share position through a single derivatives contract. This leverage creates great volatility, which allows traders to cash in large gains in relatively little time. The risk, of course, is that the option expires worthless and the entire premium is lost.
Trading options requires significantly less up-front capital, which is why small accounts can become big accounts quickly. To many retail traders, options are derivatives to YOLO cash into and shoot for the stars. But in reality, options can be used to hedge equity positions, create income streams, or simply leverage high probability bets.
Buying OTM options is cheap and mostly harmless. They cost little and offer large rewards, but the overwhelming majority will expire with a value of $0. However, options can become too much handle when buying AND selling come into play. In order to execute complex options trade, you’ll need to have a greater understanding of the factors that cause option prices to rise and fall.
Can I Trade Options with a Small Account?
Options trading with a smaller account can make sense in certain situations, but you have to understand the type of trading you’re engaging in. You won’t have the funds to hedge options positions with the underlying stock, or will you likely be able to afford the premium of options that are already “in the money.” This means buying OTM calls or puts and hoping for a large move – that’s pure speculation, not sound investing.
If your risk tolerance is high and you don’t mind throwing some capital into what are essential lottery ticket trades, here are a few things to keep in mind:
- Options can be sold before they reach expiration, so you can cash in as soon as your trade becomes profitable. Have a profit goal in mind so you know when to sell and aren’t tempted to hold on for bigger gains.
- To exercise an option, you’ll need to have enough funds in your account to cover the purchase of 100 shares of stock at the strike price. If you don’t have enough liquid cash in your account, your broker will often automatically sell your “in the money” option before the expiration date.
- Many brokers offer free stock and ETF trading, but options contracts often still carry commission. Make sure to understand all the costs and fees that will be extracted from your trade.
- Illiquid stocks are hard to trade; options based on illiquid underlying stocks are even harder to trade. Options spreads are often vast when shares are illiquid and you may not be able to exit your position at the preferred time. Stick to highly traded stocks so you’re stuck with high spreads or immovable securities.
- Don’t write “naked” options unless you know what you’re doing. In order to collect money now and hedge losses later, option sellers often purchase the underlying stock. This way, if the price goes up and the option is exercised, the seller can deliver the shares. Naked options are contracts written without ownership of the underlying stock. The writer collects the premium, but will be on the hook for buying the shares at the strike price if the option is exercised. For naked option writers, the potential losses are limitless, so only use this strategy if you’re an expert in derivatives.
Options are volatile, which creates plenty of chances to amass large profits. But volatility cuts both ways and an options position that goes up 25% in a day could be cut completely in half the next. Buying massive amounts of OTM call options on stocks like GameStop and AMC may have created a few millionaires, but most traders buying these types of derivatives will lose money.
Options trading in a small account can be exciting since one big win can often make up for a dozen losses. But understand that options are usually part of a larger portfolio position. Using them to gamble isn’t recommended if your risk tolerance is low. But if you have a small account and don’t mind losing a few hundred here and there in pursuit of a 2000% trade, dabbling in options isn’t the worst idea you could think of. Just don’t wager more than you can afford to lose.