How to Trade Options for Beginners

An option contract gives the holder the right, but not the obligation, to buy with a "call option" or sell with a "put option" an underlying asset at a given price (called the "strike price") up to or on a certain date (called the "expiry date").

If you already trade a particular asset and would like to branch out into other ways of viewing the market, then options trading may be for you.

What is Options Trading?

If you're trying to figure out if trading options is right for you, you should first understand what options are. An options explanation can turn into something complicated very quickly, so let's simplify. As with most investing products, an option is a contract. It is exactly how it sounds. This specific type of contract gives you the right to buy or sell an asset at a specific price by a specific date. It's essentially a contract that gives you the option to follow through.

How Do Options Work?

Again, as with most investment products, you're going to want to determine the probability of the future prices of certain assets. You can assume that the more likely it is that something will happen, the more expensive a related option would be.

The basic steps of trading an option are:

• Identify the asset you want to buy or sell.
• Enter a contract to determine a premium, cost and expiration date.
• If you're the buyer, you pay the premium cost.
• Monitor the asset and decide whether you want to follow through on the contract to buy or sell.

Here are some key factors to understand about options:

• Options are typically sold in increments of 100. So you should be sure to multiply the premium of your contract by 100 to get the total cost of your option.
• The more time you have in your contract, the more valuable your option could be. This is because the more time there is, the more chance there is for the price to change.
• If you're the buyer of an option, you are not obligated to go through with buying. However, you will not get the premium back if you choose not to follow through. The only risk to entering the options contract is losing the amount you spent on the premium. So be sure you're comfortable with losing the cost of your premium if it comes to that.
• On the other hand, sellers may be required to make good on the options contract to sell. Sellers have greater risk and can lose much more than the cost of the options contract premium.

7 Steps to Trade Options

If you want to get familiar with options trading and make money from this opportunity, you will have to follow these seven steps.

Step 1: Educate Yourself About Options

Before starting to trade options, you'll want to learn about the various options strategies you can use and their risk profiles so that you understand how options can help you encapsulate a market view. You can take an options trading course or read books on the subject to do this. You will also want to review the specifics and operational mechanics of any options contracts you plan on trading since missing an expiration date, not knowing the amount of risk you are taking or transacting the wrong type or style of option can be a costly mistake.

Step 2: Connect to the Internet

Since you will generally want to trade options online via a trading platform, having a relatively modern computer or mobile device connected to the internet is virtually a necessity.

Step 3: Select a Good Online Options Broker

Many online brokers will allow you to trade options. Select a well-regulated broker that offers options on the asset classes you most want to trade along with a good options trading platform and tight dealing spreads. Since options are more advanced trading instruments, you may also need to qualify to trade options via a particular broker.

Step 4: Open an Account

Review your chosen broker's initial deposit requirements and account types to see what will suit you best. Also, familiarize yourself with the broker's margin requirements for various types of options strategies so that you can have enough funds deposited in your trading account to cover the options you want to trade.

Step 5: Practice Trading Options

Rather than jumping right into trading options with real money, it makes sense to first practice trading options in a demo account. This helps you understand the mechanics of options trading and gives you a risk-free chance to learn how to use your broker's trading platform.

Step 6: Develop a Plan

It's time to develop and test one or more options trading strategies that have a decent chance of success given the risk you will be taking. You can then incorporate them into an overall trading plan that lays out how you intend to operate your options trading business and manage your risk capital.

Step 7: Fund Your Account and Go Live

Once you have prepared yourself for trading options by following these steps, you're ready to start trading options in a live account once you identify a suitable opportunity in the market. Always make sure you have placed enough funds on deposit with your broker as a margin to support your options trading strategies and trade only with money you can afford to lose.

Why Should You Trade Options?

Trading options can enhance your investment portfolio. Unlike traditional stock trading, options offer unique opportunities. They allow investors to take advantage of market movements without fully investing in the underlying asset. This guide will cover the benefits of options trading. These include potential for higher returns, risk management, and income generation through premium collection. By understanding options, traders can maximize profits while managing risk. Whether you are an experienced investor or new to the financial markets, trading options can be a smart choice.

Leverage

Options trading provides significant leverage. This allows investors to control large positions with a smaller investment. For instance, if you expect Apple Inc. (NASDAQ: AAPL) shares to rise from $118, you can buy a December $120 call option. This option gives you the right to buy 100 shares. At a cost of $7 per option, your total investment would be $700. This is much less than the $11,800 needed to buy 100 shares directly. Using options, you can increase your potential gains with less capital. However, it's important to consider that the risks are also greater due to the speculative nature of options trading.

Customized Risk Profiles

Options trading allows you to adjust your risk profile based on market expectations. Buying a call option indicates a bullish outlook while limiting your risk to the premium paid. For instance, if you buy a call option for Apple and the stock rises to $140 by December expiration, you would make $1,300 after deducting the $7 premium. In contrast, if you had purchased 100 shares outright, your profit would be $2,200. However, if the stock falls to $110, your maximum loss on the option would be the $700 premium. In comparison, buying the stock would lead to an $800 loss. Strategies like a "straddle" involve buying both a put and a call option at the same strike price. This allows you to profit from significant price movements in either direction while limiting potential losses to the premiums paid.

Additional Income

The "covered write" strategy helps generate additional income. It involves selling call options against a stock position you already own. For example, if you own 100 shares of Apple at $118, you can sell a December $120 call option for $700. If Apple's stock price rises above $120 by expiration, the option will be exercised. You will deliver your shares and earn $200 from the stock's price increase, along with the $700 option premium. This results in a total gain of $900. If the stock price falls, the $700 premium offsets some of your losses. This lowers your breakeven price to $112 per share instead of $118, providing a cushion against declines in the market.

Considerations Before Trading Options

Before starting options trading, you should consider several key factors. Options trading offers unique profit opportunities, but it also carries risks that are different from stock trading. It's important to understand how options work, the related terminology, and possible market scenarios. Additionally, you should evaluate your risk tolerance, investment goals, and market knowledge. This guide will discuss the main considerations for traders before they begin options trading. Being well-prepared will help you make smart decisions that match your goals and financial situation.

Options Expiration

Options contracts have a limited lifespan and expire on a specific date. Timing is crucial when trading options. You need to predict both the market direction and the option’s expiration date. If your options expire "in the money," they will often be exercised if you own them. If you sold the option, it may be assigned to you. This could mean acquiring or delivering the underlying asset. If you're not prepared to manage that position, it could require significant capital. Therefore, monitoring expiration dates is important. Be ready to adjust your strategy or exit the trade before expiration, especially if you cannot take on the underlying asset.

No Dividends on Long Positions

When you hold a long call option on a stock, you do not receive dividends. Dividends are paid only to actual stockholders on the record date for dividends. To receive the dividend, you must exercise your call option and own the stock before the ex-dividend date. The ex-dividend date is usually set several weeks before the dividend is paid. It is important to consider the timing. If you do not exercise your option before the ex-dividend date, you will miss the dividend. This can affect the overall return on your options strategy, especially for stocks with high dividend yields.

Added Complexity

Options trading adds complexity beyond just buying or selling assets. It differs from simple stock transactions. Options involve various strategies. These include covered calls, straddles, and spreads. Each strategy has its own risk-reward profile and technical details. To trade options successfully, one must understand key concepts. These include time decay, implied volatility, strike prices, and expiration dates. Without proper education and experience, traders may face significant losses. Therefore, it is important for traders to learn the mechanics and strategies of options. This knowledge can help minimize potential risks.

Types of Options

If you want to trade options, you'll need to understand the different types of options. Even though the options we talk about below seem like they're related to geography, understand that geography has nothing to do with it.

American Options

American options provide significant flexibility, enabling exercise at any time from the purchase date up to the expiration date. As a result of this flexibility, American options usually have a higher premium. Traders prefer these options because they can respond to price changes throughout the duration of the contract.

European Options

European options differ from American options in that they can only be exercised at one specific time, which is near or at the expiration date. Although these options have more limitations regarding timing, they typically have lower premiums than American options, making them a more budget-friendly option for certain traders.

Exotic Options

Exotic options offer greater flexibility and customization. They can have complex structures with different expiration dates and payment models. These options are designed for more advanced traders who seek tailored strategies. Exotic options allow adjustments to the strike price and the creation of unique payoff structures. This versatility is not available with standard American or European options.

You'll also need to understand the difference between call and put options:

• A call option gives you the right to buy a stock.
• A put option gives you the right to sell a stock.

Call Option Example 

This example will help demonstrate how call options work. Let's say there's a new business opening up in your town. It seems like it's going to be a profitable business with a lot of potential. You're considering offering to buy the business with the hopes of getting in at the start of something big. Of course, this is a risk on your part.

Even though the business shows a lot of potential, there's no way to know how things will turn out. This is where call options would benefit you. If you could buy a call option on the business, you could offer to purchase the business at $500,000 sometime in the next five years.

Now, the current owner of the business would want to know you're serious. So imagine that they would require a down payment of $50,000. If this were an options contract, that down payment would be referred to as the premium. The premium is the price of the option contract.

Now let's fast forward two years. The business is booming, and it is now worth closer to $1 million. You decide at this point that you want to go ahead and exercise your option to purchase the business for $500,000. You can do this even though it is less than the current value of the business because you locked in the price with your down payment.

Put Option Example 

You might want to have an option to sell your asset at a set price if you fear that your asset's worth might plummet. This will allow you to protect yourself from losing a larger amount of money.

So how do put options work? Let's say that you fear that your stock in Apple is about to become much less valuable. So you decide to take out the option to sell it, just in case. It's currently trading at $3,000, so you decide to take out the option to sell it at $2,700 at any time in the next three years.

You'll have to pay the premium. Let's say that's $300 in this case. So if you decide not to sell, you'll lose this $300 but you've probably gained much more by keeping your stock. If you're right and the stock plummets, you can sell it for the $2,700 you locked in, even if it's only selling at $2,200 when you sell it.

Options Tables

Though an options table might look intimidating, the truth is that they're relatively easy to read once you know what each abbreviation means. Here are a few of the most common sections you'll see on an options table:

Symbol

The ticker symbol for the underlying asset the option represents.

Last

The most recent posted trade price for each share of stock.

Change

Shows how much the last trade varied from the previous day's closing price.

Bid

The latest price at which you can sell an option.

Ask

The latest price at which you can buy an option.

Volume

Tells you how many contracts of an option were traded during the current session.

Open Interest

Indicates the total number of contracts for a particular option that have been opened. This number decreases as open options are closed out.

Strike Price

The strike price is the price at which you can buy or sell the stock if you choose to exercise the contract after purchase.

Most Profitable Option Strategy

There are many different options trading strategies and the strategy that will be best for you may vary depending on your position and the stocks you're trading. One of the most popular strategies is the "covered call."

When you structure a covered call, you sell a call option against shares of stock that you already own. For example, you might sell one call option for every 100 shares of stock that you own. You may even use the premium from your sold calls to accumulate more shares of stock.

This is a very popular strategy because it allows you to receive income from your investment portfolio. If the price of the stock increases beyond the call option's strike price, your long stock position covers the losses from the short option position. If the price of the stock falls, then your losses are buffered somewhat by the premium you received for selling the call.

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Knowledge is Power in Options Trading

Options provide traders with a greater choice of ways to express a market view. Since options can add considerable complexity to your trading activities, however, you will want to educate yourself thoroughly about how to best use them so that they boost your bottom line as a trader.

You may want to take an options trading course, read relevant articles, watch related tutorial videos and even hire an options trading mentor. Your online options broker could also provide you with guides and tips to train yourself, so check to see what it offers.

Frequently Asked Questions