A lot of investors cringe when they hear of options trading and immediately say ‘It’s too risky’. While we believe that options don’t need to be part of every successful portfolio, they definitely can be excellent investment tools.

Using options, investors can generate income, hedge their positions, lock in profits and earn outsized gains. If you use options the right way, you can generate returns in flat markets, make things easier on your portfolio in bear markets and earn outstanding results in decent markets.

Now that we have your attention, we should discuss more about what these are and how you can profit by using them. What are options? An options contract is the right to buy or sell an underlying asset at a fixed price (called stock price) at a predetermined date in the future (called the expiration date). For this article, we’ll limit our examples to options where stocks are the underlying asset.

Ok, now we know what options are but how many different types are there? There are two types of options - calls and puts. A call option increases in value as the underlying stock rises. Conversely, a put option increases in value as the underlying stock price falls. So, as you have probably figured out - you buy calls when you are bullish and buy puts when you are bearish on a stock.

Buying Calls

Instead of buying the stock straightaway investors buy call options to obtain leverage and magnify returns. By owning a single options contract you control 100 shares of stock. The cost of owning a call option is only a fraction of the cost of owning 100 shares of stock but your returns on the option can be much higher than owning the stock. As with other investments, there are risks with options trading. The underlying stock could decrease in price making your option worthless and you lose your premium. One other risk is that your timing of the options purchase could be off and your stock rebounds significantly after the options expiry.

Buying Puts

What do you do if you want to benefit from falling prices? You buy the opposite of a call, a put. This is a great tool for profiting from highly priced or troubled stocks. Again as with calls, your losses are limited to your option premium. The other choice you have of course is to short the stock. This involves borrowing money on margin and your potential losses are unlimited. So, a put option can be a more attractive choice.