Everyone understands how investing in stocks works. You own a small share in a company’s business. If the price goes up, you get a profit. If it goes down, you make a loss or wait until it grows. Trading options is a little less straightforward and can be a source of confusion for beginners. How do options work, and how are they different from stocks? How do options trade, who does it, and why? What is stock options trading? We’ll answer these and other questions in this guide.
Options are a type of asset that allows an investor to make a big profit with a relatively small investment budget. They can also protect an existing investment against losses.
This options trading guide is an overview of options trading for newbies. We’ll explain what options are and the benefits they provide. As part of our trading options 101, we’ll cover some basic option trading strategies for beginners and how to start trading options.
Hopefully, by the end, we’ll have all the basics of how to start options trading.
Stock Option Contracts
A stock option contract is a right to buy or sell a specific amount of stock at a specific price and for a certain period of time.
The holder of an options contract can benefit from the price movement of the underlying asset without having to own the asset itself.
There is a fee for such a contract, called a premium.
The right to buy or sell at a later date allows an investor to make a profit as long as the price moves in the direction they want. If it does, they can then exercise the contract, i.e., buy or sell the shares at the agreed price, called the option strike price.
If the price moves in the opposite direction, they can let the contract expire. In this case, all they lose is the premium paid for the option.
Options contracts are leveraged, meaning an investor is trading with more capital than they are actually using in a transaction. A standard option contract gives an investor the right to buy or sell 100 shares.
Options themselves can also be traded on the exchange market. That’s because this agreement to buy or sell at a fixed price can generate profit and be of interest to other traders. So instead of buying or selling the shares, the investor can sell the contract to someone else.
When you learn to trade options, it's useful to think of options as bets on whether the price will go up or down.
A stock option contract is a right to buy or sell a specific amount of a stock at a chosen price before it expires.
Here are some characteristics that every option contract has:
- Expiration: the time at which the contract will expire
- Leverage: how many shares the investor can buy or sell
- Strike price: the fixed price for which the investor can buy or sell
- Premium: the option’s price for the investor
There are two main types of options contracts — “call” and “put.”
Call and Put Options
A call option is a right to buy an asset at an agreed price or strike price. This is used when an investor expects the price of a stock to go up.
If it goes up, they can buy at a strike price. This is lower than the current market price, so we can buy the shares and make a profit.
A happy options trader who correctly predicted where a stock would go.
A put option is a right to sell an asset at an agreed price. This is useful when an investor expects the price of a stock to fall.
Then, if the price falls, the investor can profit the other way, i.e., sell the stock at a higher price than the new market price.
Call and put options are similar because selling or buying at prices that are different from the current market price allows investors to profit, whether the market moves up or down.
But it’s important to make a correct prediction about what is going to happen with the price. Otherwise, the contract becomes worthless.
It’s similar to renting an asset. You have a right to use it for a specific period and buy it if the price is right.
If you don’t use it, you lose money.
What is Options Trading?
Options trading refers to buying and selling options on the options market. The answer to “what is options trading?” is slightly more complex than traditional stock trading, but the underlying principle is the same.
The key thing to remember is that options can be traded just like any other financial instrument — stocks, mutual funds, and ETFs.
Stock Market Options Trading Strategies
Now let’s discuss some basic trade options strategies. These are essential to know for understanding option trading basics for beginners. These include buying calls, buying puts, selling covered calls, and buying protective puts.
A call option is useful when an investor expects the price of a stock to rise.
Let’s say a company stock is currently trading at $100 per share. If you’re confident the price will grow, you can get a call option to buy the stock at $100 (the strike price) for a premium of $10 per share and with an expiration time of 6 months.
A typical options contract is for 100 shares, so you’ll be paying $1,000 — that’s a $10 premium per share multiplied by 100.
Let’s say six months later the price goes up to $120. And we have an agreement that lets us buy 100 of these shares at the strike price of $100. Due to leverage, this difference is multiplied by 100.
Now the option position has a value of its own, and the investor has several options.
They can exercise the contract, buy 100 shares at $100 and sell them at the current price of $120.
They would be making 20% or $20 per share, which is $2,000 in total. But they had to pay the $1,000 premium for the contract, so they would end up with a profit of $1,000.
Not bad for a $20 change.
The other option would be to sell the contract itself because it has a positive value of its own. In this case, we say that the option is “in the money”.
If the price goes down, the investor wouldn’t be making any money, furthermore, the difference is also multiplied by 100 shares, but our losses are limited to the premium we’ve paid for the contract.
Any slight change is multiplied by 100. This is why options are similar to bets.
Options give you options. That’s where they get their name.
When an investor expects the price of a stock to go down, a good strategy can be to buy a put. This is a good way to use leverage to profit from falling prices.
A put is the opposite of a call option. It gains value as long as the price is falling. If the stock price goes up, the maximum amount we can lose is the premium. If you’re already familiar with short selling, put options work in a similar way. You borrow a stock to sell at a high and buy later at a lower price. The difference between short selling and put options is that with short selling the losses can be unlimited. With put options, your losses are limited to the premium.
Put options can also be used to protect an existing investment, also known as hedging. Say you’ve invested $5000 in a stock but you’re worried it might fall. In this case, you can buy a put option. Then, if the price falls, the put option will work in your favor because you can sell your stocks at $5000 any time before the contract expires. But our put option now has value so you’ll be able to sell the option to other options buyers to make up for the loss.
When an open option position has its own value, it’s referred to as being in the money.
This strategy is suitable when a trader expects the stock price to stay the same or rise slightly.
It works like this: you buy 100 shares of a stock and sell a call option for these shares. In this case, you’re the one being paid a premium, which provides some protection in case the price falls. You are also agreeing to sell the shares at the strike price.
Let’s say you buy 1,000 Coca-Cola shares (KO) at $50 per share. Then you create 10 call options at $0.50 per share with a strike price of $52 that will expire in one month. Each contract is for 100 shares, so you can charge $50 for each one and $500 for all 10.
The premium you’ve received reduces the cost basis of the shares, because you got some of the money back through the premium. It’s as if you got the shares for $49.50 each. If the price rises above $52, your counterpart will want to exercise the contract and you’ll have to sell the shares to them at $52.
Of course, if the price keeps going up, you’d be better off holding the stock rather than selling at a price that’s lower than the market price, so this strategy works best if the price doesn’t change significantly. In this case, you get to keep the premium and the shares.
Protective Put Strategy
This strategy is for investors wishing to protect their existing asset from downside movement. It makes sense when they expect the stock to grow over time but want to protect themselves in the short term.
This is done by buying a put option against a stock you own. This works like an insurance policy. If the price goes up, your initial investment is growing. If the price falls, you’ll have a put contract that has value, and you can sell it to another trader.
This type of insurance strategy is also known as hedging an investment.
It’s also a bit like betting against yourself in sports. If you win, you get the prize money. If you lose, you win the bet.
Other Options Strategies
The following option trading strategies are more advanced, and you need to know what you’re doing to try to implement any of them. But it’s useful to know all the different strategies that options trading offers.
Married Put Strategy
This strategy is similar to a protective put, and also works as an insurance for stocks you own. Here the investor buys the equivalent of put options at the same time as buying the shares.
The difference is that a married put is more like an overall insurance to offset the risk of the whole investment, while the protective put is more likely to be used to insure against a short-term decline.
Protective Collar Strategy
This strategy is a combination of a covered call and a protective put. Here an investor buys an out-of-the-money put option and writes an out-of-the-money call option at the same time for the same stock.
The protective collar can protect from big losses, but it also limits gains.
Long Straddle Strategy
An investor buys a call option at the same time as a put option for the same stock. This is used when the investor expects the price of a stock to move rapidly in either direction, e.g. in reaction to some news.
Both options need to have the same strike price and expiration date.
This way, if the market reacts to the news, they can profit from the price change no matter which way it moves.
This is another strategy that allows investors to profit from a big price change in any direction. This involves buying a call option that is out of the money (i.e. not in good standing) and a put option simultaneously. They should also have the same expiration date, like in the long straddle strategy, but the strike price for the put should be lower than for the call.
How much Money do You Need to Trade Options?
Now, there are few places for newcomers to options trading to encounter a limited threshold for entering the market. Traders can start with even the smallest amount of money. So some brokers offer to begin with as little as $100 capital. Indeed, in order to start earning start-up capital, it is not as important as skills and knowledge in this area. The most critical thing is that the amount of initial capital is enough to buy the lot and pay the commission. Unfortunately, you cannot find such favorable conditions everywhere, but there are more and more investment sites like that.
The experience of trading on a demo account will provide you with valuable information about the minimum required amount of capital. It's free and should be used to test your readiness before making trades on a live account.
But in the end, in order for the profit to make economic sense and compensate for your training costs and psychological stress, you should be ready to have a starting capital of at least $2,000 to start options trading.
How to Start Trading Options
You’ll need to do a few things before you learn how to trade options. The first is to open an options trading account. Then you’ll need to choose the type of option you’ll be going for and have an idea of what you expect to happen to the price of a stock, and decide on your strategy. These are the essential things to do when starting trading options for beginners.
Open an options trading account
The first step to trading options is to choose a broker and open an account with them. You’ll need to verify your identity and go through registration. A good broker will also guide you through the process of trading options.
Decide on your options strategy
We recommend that beginners stick to the more straightforward strategies in options: buying calls and puts.
You have to be confident about your prediction, at least to an extent. If you commit to a call option, you should be prepared to lose your investment if the price falls. Conversely, if you purchase a put option, any slight upward movement will be multiplied by 100 and you won’t be able to profit from it.
Determine the expiration date and set up your contract
Choosing the right expiration date is key. This is not about long-term growth like in stocks. It's about the difference between the strike price and the market price when the option is due to expire. So whether it’s 3 months or 6 months, put some thought behind it and try to analyze other factors that may come into play.
Once you have a hypothesis that makes sense, or you have an automatic personal investment guide (wink-wink), set up your contract.
Pros and Cons of Options Trading
Now let's find out what are the pros and cons of working with options.
- A simpler algorithm. When trading binary options, you do not need to monitor intermediate price fluctuations, calculate how much your profit can change, and choose the right moment to close the transaction before it becomes unprofitable. All you need is to make a prediction about the price direction movement and specify the time for the expiration of the transaction. If during the specified time, the forecast was justified, the profit is yours.
- Fixed income and losses. Before concluding a deal, the options traders already know what they can get upon its completion. There are only two options: with a correctly predicted change in the price trend, the player will receive a profit indicated in advance. If the trend goes in the opposite direction, then the worst thing that will threaten the trader is the loss of the transaction amount, no more and no less.
- Online trading. It is enough to use a mobile application to work with binary options. Thus, the need to install "heavy" programs and constantly sit in front of the computer disappears.
- Good selection of trading instruments. You can work not only with "standard" currency pairs. Traders face everything from global company stocks to precious metals and oil.
- No leverage. With binary options, you only rely on your own money. Here you cannot rely on the help of a broker. That is why you should get more information beforehand. Also, a limited budget often reduces a trader's chances of making good profits.
- Inability to close the deal ahead of schedule. You don't have to make a decision if you are in doubt, but it can be frustrating in situations where closing a trade early would mean making a good profit.
- Few timeframes. As a rule, when working with binary options, it is difficult to predict the movement of the exchange rate as accurately as possible. Because of this, trading on short time intervals is rarely used in work, which in its own way limits the trader's freedom of action.
Hopefully, this article covers all the basics of trading options for dummies. Here is a recap.
Options are an affordable instrument that allows an investor to make a big profit, due to leverage. This is possible if the investor can correctly predict if the price of a stock will rise or fall.
It’s a right to buy or sell, not the same as owning shares.
The key thing is to be able to use an option within the specific timeframe before it expires. If you don’t use it the contract expires worthless. This is not necessarily a bad thing and can be an intentional risk you’re taking when you use an option as an insurance against a downturn for a stock you already hold.
As an options trading enthusiast with a deep understanding of the topic, let's delve into the concepts discussed in the article about trading options.
Stock Option Contracts:
A stock option contract is essentially a right to buy or sell a specific amount of stock at a predetermined price within a specified timeframe. The holder of the option can benefit from the price movement of the underlying asset without actually owning the asset itself. This right, however, comes at a cost, known as a premium.
Key characteristics of an option contract include:
- Expiration: The date at which the contract will expire.
- Leverage: Options allow trading with more capital than invested.
- Strike Price: The agreed-upon price for buying or selling.
- Premium: The cost of the option contract.
Call and Put Options:
Call Option: Gives the right to buy an asset at an agreed price, suitable when anticipating a price increase.
Put Option: Provides the right to sell an asset at an agreed price, useful when expecting a price decrease.
Both options enable investors to profit from price movements, but accurate predictions are crucial; otherwise, the contract becomes worthless.
Options trading involves buying and selling options on the market, offering a different dimension compared to traditional stock trading. Options can be traded like other financial instruments such as stocks, mutual funds, and ETFs.
Basic Options Trading Strategies:
Buying Calls: Useful when expecting a stock price to rise.
Buying Puts: Beneficial when anticipating a stock price decline or as a hedging strategy.
Covered Call: Involves buying shares and selling call options, suitable for stable or slightly rising stock prices.
Protective Put: A strategy to protect existing investments by buying put options against owned stocks.
Advanced Options Strategies:
Married Put: Similar to a protective put, providing overall insurance for owned stocks.
Protective Collar: Combines covered call and protective put strategies to limit losses and gains.
Long Straddle: Involves buying both call and put options simultaneously, anticipating rapid stock price movements.
How Much Money Do You Need to Trade Options?
Newcomers can start with minimal capital, with some brokers allowing initial investments as low as $100. However, a starting capital of at least $2,000 is recommended to make options trading economically viable.
How to Start Trading Options:
Open an Options Trading Account: Choose a broker, verify your identity, and open an account.
Decide on Your Options Strategy: Stick to simpler strategies initially, such as buying calls or puts.
Determine Expiration Date and Set Up Your Contract: Choose the right expiration date based on your hypothesis and set up the contract.
Pros and Cons of Options Trading:
- Simplicity in predicting price direction.
- Fixed income and losses.
- Online trading convenience.
- Diverse trading instruments.
- No leverage.
- Inability to close deals ahead of schedule.
- Limited timeframes.
Options are affordable instruments providing investors with the opportunity to leverage their capital for potential profits. However, accurate predictions and a good understanding of various strategies are crucial for success in options trading. It's an intriguing financial realm that offers flexibility but requires careful consideration and analysis.