Investing » Stock Market » How to Trade Options: Full Guide For Beginners
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How to Trade Options: Full Guide For Beginners

Stock options are a great way for both hedging and speculation. However, since it's one of the riskiest tools of the financial market and you must understand the basics before jumping in. In this article, we've summarized stock options basics - What is it, how does it work, the different types and the various benefits
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Mann (Silvermann) is an experienced investor, financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Mann (Silvermann) is an experienced investor, financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Review & Fact Check: Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Financial Expert, The Smart Investor CEO

Experience

Baruch Mann (Silvermann) is a financial expert and founder of The Smart Investor. Above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

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Table Of Content

What Is An Option?

A stock option is an agreement between two parties – a holder (buyer) and a seller (writer). The buyer purchases the right (but not the obligation) to buy or sell stocks at a predetermined price for an agreed upon period of time. 

Why trade options?

Stock options are derivatives which means that their price derives from a security, called underlying stock. Companies and investors use them because of two main reasons – to hedge and speculate. Speculators like buying options because they offer a chance of much higher returns than the ones coming from the security they derive from.

The underlying assets could be stocks, stock indexes, commodities, precious metals, foreign exchange, and others.

For instance, a buyer purchases a stock option on shares of company A with a strike price of $15. The expiration date is 24 July. This means that you can, but it's not your obligation, buy Company A shares at $15 a share before or on 24 July.

In the article, you will find more details about the different types of options, their advantages, and other helpful information.

What Are Put And Calls?

Options have two different types: puts and calls.

  • Call options – Call options are contracts which guarantee the right of a holder to purchase stocks at a specific price and by a specific date. If the stock does not meet the price before the contract expires, the holder is not obligated to buy the stocks.
  • Put options – Put options give the holder the right to sell stocks at a predetermined price and a by a specific date. The seller must, by contract, buy the stocks at the agreed-upon price.

If an investor buys a call, it means they believe that the price of the underlying stock will go up. On the contrary, the seller of a call expects the price will go in the opposite direction. If the price does really increase, the holder of the call will buy stocks at a lower price than their current one on.

Sometimes investors think that the prices of a stock will decline, therefore they purchase puts. Assuming the price goes down, the seller must buy the stocks at a lower price than their current market value.

As we already mentioned, there are two main components in each contract: a fixed price and a fixed date (period of time). In stock options, the strike price is the predetermined value at which an option holder can buy or sell stocks.

Simulation For Beginners

In business, leverage is an investment strategy in which people use debt to acquire company's assets.

For example, if you want to buy 1,000 shares of a company and one share's price is $15, you have to give $15,000 to acquire them. However, if you purchase an option for the same number of shares but at a price $2, you can see that you'll have to pay on $15,000.

Therefore, for this $15,000 you can buy three options each giving you 1,000 shares. You will end up in control of more than 7,500 shares for the same amount of $15,000.

Now, there are 2 scenarios:

  • 1. Company share price increase to 20$

On the first option, you now have 1,000 shares with a total amount of $20,000  –>                              Total profit: $5,000

On the second option: you now have 7,500 shares with a total amount of $150,000. Since you have already paid $15,000 to buy the options + $112,500 to buy the stocks (7,500 shares in $15 each)  —> Total profit: $22,500

  •  2. Company share price decrease to 10$

On the first option, you now have 1,000 shares with a total amount of $10,000.  —>                           Total loss: $5,000

On the second option: In this case, you won't use the option, means you won't buy the shares, since the current price (10$)  is lower than the option you have to buy them in (15$). —>                         Total loss: $15,000 (the amount you paid for the option)

Remember: Always consider the risk. And even though options have many benefits, there are some drawbacks.  If the price does not reach the strike price within the agreed-upon period, then the holder can lose his initial investment.

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Options Carry Huge Risk

One of the things beginner investors need to know before trading options is the risk involved. Options are a seemingly complex way of trading stocks and as such require some in-depth knowledge. Failure to have requisite knowledge can lead to exponential losses for the investors.

Options have unlimited downside risk – unlike shares whereby your investment can go to zero, options on the other hand have unlimited downside risk. This means an investor can lose more than the initial amount invested.  For example, naked calls carry unlimited downside risk for the investor.

Only professional investors who has a long mileage in the stock market should consider trading options. If you are a conservative investor, this is not the right place for you.

Basic Options Trading Strategies

Here are the basic strategies for trading options:

  • Long call strategy – The long call strategy is purchasing a call option, or “going long.” This simple approach is based on the assumption that the underlying stock will climb above the strike price by the time it expires.
  • The long-put strategy – The long put is similar to the long call, except instead of betting on a stock's increase, you're betting for its collapse. By purchasing a put option, the investor is wagering that the stock will fall below the strike price before expiration.
  • Short put strategy – The short put is the polar opposite of the long put, with the investor selling or “going short” on the put. This strategy bets on the stock staying flat or rising until expiration, with the option expiring worthless and the put seller pocketing the whole premium. The short put, like the long call, is a bet on a stock growing, but there are several key distinctions.
  • Covered call strategy – Because there are two elements to the covered call, it becomes more complicated. To sell a call on a stock, the investor must first possess the underlying stock. The investor gives up all appreciation above the strike price in return for a premium payout. This strategy bets on the stock staying unchanged or slightly falling until expiry, allowing the call seller to hold the shares and pocket the premium.

However, there are many more sophisticated, complex options trading strategies. In fact, many professionals develop their own strategy, which usually combines both buying and selling options, as well as mix of some of the basic options strategies as described above.

Benefits Of Investing In Options

Below I will be looking at some of the main reasons why you should consider investing in options in detail. The three most notable are – hedging, speculation and spreading.

Hedging as a business term is a type of investment strategy which tries to mitigate the potential risks a company can encounter. Even you, without knowing, are hedging – for example, you insure your house in order to minimize the risk in case of a fire or an earthquake. Risk management is a crucial part of any business so it's only logical that they have a whole strategy regarding this.

Many people claim that you need to use hedging (“insuring” yourself) then options are not a good investment. However, especially if we talk about large businesses, risk management is paramount. The safer you are, the better. That concerns individual investors, too.

Usually, they don't have the financial resources large corporations have, therefore options are very suitable. At the same time, investors want to take advantage of a very attractive stock and protect themselves from potential losses. Therefore, the buy options – low-cost and easy investment that offers risk protection.

Short sellers also use options to hedge while short selling. This is a process in which someone sells an asset he does not own or has borrowed.

Initially, options were not intended for speculation. However, throughout the years, many speculators have started using the niche.

What is speculation?

When investors bet on future prices of, for example, a stock, then they speculate. Often they do not have any data or research proving that this price movement might happen. It's just what they feel or wants to happen. The purpose is clear – to make a short-term profit.

In this regard, options are very suitable for speculators since, as we discussed, they provide leverage. Traders see them as potentially lucrative because a call option can cost a few times less than a share's price. This, on the other hand, is what increases the risk in trading options.

Don't forget:

In an option, you have to preliminary define the number of shares, their price movement and the specific period, which is very similar to gambling. If you fail only with one the components, then your option will expire leading to no results whatsoever.

This is yet another advantage of investing in options. It is a strategy that combines both hedging's (limiting the risk) and also speculation.

When you spread options it means that you trade with more than one-two, three, etc. Spread options' value comes from the difference between two or more assets.

Things to Know When Start Options Trading

Here are some things to keep in mind when you start your options trading journey:

  • Options Give You Options When Trading Stocks

Options are merely another way to trade equities, but with a broader range of possibilities. You can only initiate bullish exposure by buying shares and bearish exposure by shorting shares through stock trading alone. Your ability to properly predict the path of the stock is your ticket to a profitable transaction,

however with options, you may wager long or short with less total risk and capital outlay. These perks are only a small part of what's accessible when trading options. But the essential point to remember is that options are just more tools in a trader's toolkit for expressing an investing concept.

  • You Can Profit Both Ways

Trading options can put the odds in your favor if you know how to optimize them. This implies that you can place trades where you have a half chance of being profitable. And these are not trades that add extra risk compared to stock trading alone. You can gain in stocks in one direction.

For example, if you are long, you can only profit from an increase in price. If you are short, you can only profit from a decline in price. With options you can trade both directions of a stock which increases your ability to make profit and also hedge against potential losses.

Styles of Options

Even though the expiry date is individual for each option contract, it is always on a Saturday. If we have to be more specific, this is the Saturday which follows the third Friday of the last month.

Option holders should exercise their right before the Saturday since exchanges do not operate on weekends. Brokers prepare all the documents related to the end of the contract on the next Saturday.

There are different styles of options; the main are:

  • American-style options – they give the holder of the option the right to purchase the stock before the expiration date. Equity options are this style.
  • European-style options – this type gives the owner of the option the right to buy the stock only a short period of time before the contract expires. Foreign currency and stock index options are this styles. Despite these options being limited, the holder can sell them anytime.
  • Capped-style options – there are options with an established cap price. The cap price exists to limit the potential profit for the option owner and mitigates possible losses for the writer. The owner of such a contract has the right to buy the stock only for a specific period of time before the expiry date. If the cap price is reached prior to that, the option is exercised automatically.
  • Standardized options – each of this contract is for 100 shares of the underlying stock. These options are traded on most US exchanges unlike some of the other options (employee stock options).
  • Plain vanilla options – standard puts and calls with no specific characteristics. If options have some unusual features, then we call them exotic options. For example, they are different than American- or European-style options because of the underlying assets. Also, the time when the option holders receive a payoff. Unlike plain vanilla options, exotic ones are not that easy to trade with.
  • Binary options – For example, are also known as all-or-nothing options. Why? The payoff is either fixed if the asset reaches the strike price within the fixed period or nothing at all.

Where Are Options Trade?

Some options, called listed options, are traded on registered exchanges. For example, Euronext, Boston Options Exchange and International Securities Exchanges. It's typical for all listed options to have a strike price and expiry date. The underlying stock can be – market indexes, stocks, commodities, ETFs.

People can buy and sell the so-called over-the-counter option too. These are not traded directly on formal exchanges but rather between the counterparties.

Here, it's good to mention two terms and explain why they matter. Market makers are broker-dealer companies which make sure there is enough liquidity of stock in the market. The Nasdaq is an example of a market maker. 

 

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Bottom Line

Now that you have read the article, you know some of the basics about options – how they work, reasons to invest and types and styles of options. They are cost-effective and flexible investments with the potential for high return.

On the other hand, options are very time sensitive and speculative. Each investor should determine whether they are right for them or not.

FAQs

Stock options give investors the right to buy or sell stocks or other investments at a prearranged price in the future. But in most cases, options can only be bought or sold during regular trading hours.

As such trading in options ceases at the close of a market session. Options don't trade in extended hours because there is not enough interest or volume.  This is unlike stocks which can be traded during after-hours due to high interest from investors.

There are various platforms that beginner investors can use to practice trading in stock options.

Investopedia: Though Investopedia is popular due to its vast informational resources in finance and investment, one lesser-known feature of this website is its stock simulator. With $100,000 in virtual money, traders can practice options trading on this platform.

Thinkorswim: This is arguably the most unrivaled options trading simulator platform online. The app is a favored choice for traders who want to learn about options.  After your registration, users are granted $100,000 in virtual money to practice options trading