Options trading can appeal to some investors because of the possibility of making significant returns in a relatively short period of time. What may be less appealing is that options can also magnify losses, require ongoing monitoring and involve risks that investors may underestimate.

An option is a contract that gives you the right, but not the obligation, to buy or sell a security at a set price before a set date. Used well, it can protect a position and help manage portfolio risk, generate income or speculate on future stock price movements. Used without a clear understanding of the risks, however, an option can quickly become an expensive mistake.

Trading options is not a requirement for building wealth, and for many investors, options may not be a fit at all. This guide is meant to help you figure out where you stand – that is, whether options belong in your toolkit or whether your time and money are better spent following a long-term, buy-and-hold investment strategy. Before you decide to use options, it may be worth running through a quick self-check on your investment experience, time horizon, liquidity needs, temperament and risk capacity.

Options trading: What options are and why people use them

Options contracts come in two basic forms: calls and puts. A call gives you the right to buy a security at a set strike price before the contract expiration date. A put gives you the right to sell at that price instead. Either way, you are paying for a right, not taking on an obligation – which is what separates options from simply buying or shorting a stock. But if you were to sell an option, you’d be taking on an obligation of performing on the right you’ve sold the buyer.

People turn to options for a handful of reasons – hedging downside risk, generating income or speculating on future market movements. The trade-off is flexibility versus complexity: Options can provide more ways to manage a portfolio, but they also introduce additional variables, including time decay, changing market volatility and expiration dates. Those factors mean an options position can lose value even if the underlying stock moves in the direction you expected.

For example, say you hypothetically own 100 shares of a stock that has appreciated over the years. If you're worried about a temporary decline, buying a put may help limit losses. Or, if you're comfortable selling those shares at a higher price, you could write a covered call to potentially generate additional income (while accepting that your upside may be capped and your stock called or sold if the stock rallies beyond your strike price).

Should you consider using options?

The honest answer for many people is likely no, or not with a meaningful amount of money. And as with any complex financial instrument, taking the time to gain a comfortable level of education and understanding is important. Before you place an options trade, conduct a self-assessment using these five questions:

• Experience level: Do you already understand options basics such as calls, puts, strike prices, expiration dates and concepts such as time decay?
• Time horizon and attention: Can you realistically monitor positions and track expiration dates as well as the risk and implications of a potential early exercise prior to the expiration date?
• Liquidity needs: Could the money you’re using to trade be tied up or lost without derailing a near-term goal, like a down payment on a car or a tuition bill?
• Temperament: Can you handle fast price swings and being wrong without taking additional risks in an attempt to recover?
• Risk capacity: What is the actual dollar amount you could lose without it changing your financial picture, not just how much risk you feel comfortable with on paper? Are you comfortable selling the underlying shares to cover option settlement or being called out of the underlying stock for covered call transactions, including the tax implications from doing so?

If your answers suggest you're not ready, that's a perfectly reasonable conclusion. Choosing not to trade options today doesn't mean you'll never use them. It simply means it isn’t the best investment strategy for you right now, and being able to recognize this is better than finding out the hard way.

Who may want to consider options

Options aren't appropriate for everyone, but there are situations where they can support an experienced investor's broader financial plan.

• The risk manager, or hedger: Already owns a stock position and uses options – often protective puts – to limit downside without selling the underlying shares. This strategy may fit if you have a concentrated or long-held position you want to protect through uncertainty. But don’t forget that downside protection comes at a cost. If the stock doesn't decline, the option may expire worthless, resulting in a full loss of the premium you paid.
• The disciplined income seeker: Holds stocks they are comfortable owning for the long term and sells covered calls against them to generate additional income. This scenario may fit if you accept capped upside on a portion of your holdings in exchange for regular income. Keep in mind the possibility of having shares called away in a strong rally, though.
• The experienced, rules-based trader: Utilizes small positions, defines exits before entering a trade, and understands volatility and assignment risk. This might apply if you have a track record of trading stocks and a plan you actually follow. Watch out for becoming overconfident after a few successful trades and abandoning the discipline that made them successful.

Who may want to avoid options

Other investors may decide not to trade options because they don’t fit with their financial goals and risk tolerance.

• The goals-first builder: Focused on retirement or another long-term goal and does not want deadline-driven decisions competing for attention. The expiration of an options contract forces a choice on a schedule, which runs counter to a steady, hands-off approach.
• The cash-flow-sensitive investor: Does not yet have a solid emergency fund, has near-term expenses on the horizon, or simply cannot afford to have money tied up or at risk.
• The stress-reactive trader: Tends to chase losses, panic sell or abandon a plan once markets start moving fast.

Options trading pitfalls

Options can amplify gains and losses relative to the money invested, which is why disciplined risk management is essential.

There are some “red flags” to be aware of if you’re thinking about investing in options. These include looking at options as a shortcut to getting rich, carrying high-interest debt that has not been paid off, and having little or no emergency savings.

Inexperienced options investors can be particularly susceptible to some common traps, among them buying short-dated contracts without fully understanding how they work, ignoring fees and taxes, and not fully understanding how implied volatility plays into options pricing.

If any of the above describes your situation, long-term investing typically wins out. Building wealth steadily, minimizing decision fatigue and staying out of time-pressured decisions can be a genuinely strong investment strategy on its own.

If you're on the fence: Safer alternatives and ‘starter steps’ before you trade options

If you are not sure that you’re ready, there are ways to move forward without jumping directly into options trading.

Some starter steps that don’t require a trade:

• Paper trading to see how options contracts behave without real money at stake
• Reviewing educational resources about options trading and how options contracts work
• Learning the mechanics of strikes, expirations, options contract sizing and premiums
• Reading your broker's risk disclosures
• Setting position size rules for yourself before you place a single trade

As you build your options muscle, safer alternatives worth considering include diversified mutual funds and exchange-traded funds (ETFs) that spread risk across many holdings. Automatic investing on a set schedule can help remove timing decisions from the equation. You may also want to rebalance periodically, setting your risk level through your mix of stocks and bonds rather than through derivatives.

The bottom line: To trade or not to trade options?

Options are one tool investors can use to manage risk, generate income or express a market view, but they aren't necessary for building long-term wealth. While options may make sense for experienced investors with a clear plan, they also require time, attention and the ability to manage additional risk.

A simple way to think about the decision is this:

• Consider using options if: You understand the risks, have investing experience, can actively monitor positions and are using options to accomplish a specific objective.
• Consider avoiding options if: You are still building your financial foundation, prefer a hands-off investing approach or are hoping options will quickly grow your wealth.

If you opt to move forward with options, there are a few parameters you can follow to help set yourself up for success.

• Use only money you can afford to lose.
• Avoid stacking multiple forms of leverage.
• Decide your maximum acceptable loss before entering the position.
• Consider longer time horizons when appropriate rather than relying on very short-dated contracts.

A J.P. Morgan advisor can help you determine the right investment strategy, including if it involves options.

Options involve a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through J.P. Morgan. Investing involves risks, including loss of principal. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.