A Starter Guide to Options Trading for Beginners

The stock market gives investors many opportunities to build wealth. While many people get started with trading stocks, some investors hear about options trading and may want to give it a try. Derivatives give traders the opportunity to use leverage without debt, generate cash flow and achieve other objectives. Options trading gives investors more capabilities, but it’s important to understand how these assets work before getting started. This guide will highlight the basics so you can feel more confident trading options.

What Is Options Trading?

Options trading is a form of leverage without debt. Every option gives you the right to buy or sell 100 shares at a strike price. Call options let the holder buy 100 shares at a set price, while put options let the holder sell 100 shares at an agreed-upon price. Traders buy options hoping that the underlying stock’s price will move favorably. Traders who purchase calls want the underlying stock’s price to increase, while traders with puts want the underlying stock’s price to decrease.

How to Read a Stock Option Quote

Reading a stock quote is simple. There isn’t much to it other than the ticket and market price. Stock options have more details in their quotes. Knowing what makes up a stock options quote can help you make trades that align with your portfolio goals and risk tolerance.

• Stock symbol: The 3- to 4-letter symbol that the stock trades under, also known as a ticker. The stock symbol for Amazon is AMZN.
• Strike price: The price that an options holder can exercise an order if they decide to do so. 
• Type: Options traders can choose between calls and puts. Buying calls and selling puts are bullish while selling calls and buying puts are bearish. The type and strike price determine if your option is in the money or out of the money.
• Expiration date: Every options contract has an expiration date. On this date, the contract either expires worthless or gets exercised.
• Premium: The amount you have to pay to buy an option. A seller receives the premium for incurring the risk of offering an option to a buyer.

How to Start Trading

Options trading can make sense for your portfolio. Traders can use these derivatives to generate positive returns and increase cash flow. These strategies will help you get started with options trading and become more confident along the way.

Research the Requirements and Open an Account

It’s easy to create a brokerage account, but almost none of them let you instantly trade options. You have to fulfill some requirements, which vary for each brokerage. You may want to look at several brokerages to determine if you can go straight into options or if you will have to prove yourself for a few months before you can start trading options.

Practice Paper Trading

Even if you can go straight into options trading, rushing into it doesn’t make sense for most investors. Paper trading can be a viable solution that removes risk and helps you learn about options. Stock simulators let you buy options during market hours with imaginary money. It’s okay to lose money in a stock simulator since there are no stakes. You can test your ideas in a simulator and get experience trading options before you use real money.

Decide the Type of Option

Each trader can choose between calls and puts. Long calls gain value as the underlying stock’s price increases, while long puts gain value when the underlying stock’s value decreases. A trader has to determine how they feel about a position before deciding on a call or put.

Predict Stock Price Movement

Technical analysis, fundamental analysis and news are factors that can help traders predict stock price movements. You have to feel confident about a stock’s price movement over the next few weeks or months before buying an option. No trader gets it right every time, but doing research before buying a call or put can increase your probability of making profitable trades.

Determine Expiration Date

The expiration date influences your premium and risk. An option expiring in a few days has a lower premium because the buyer takes a significant risk. Options with expiration dates several months in the future will be more expensive, but those lengthy expiration dates give options traders more time for their theses to play out.

Options Trading Strategies for Beginners

Options trading strategies can seem complicated if you look at trades that involve multiple positions. You can learn about advanced trading strategies and use them in the future, but it’s best to start off with a few basic options trading strategies to get more familiar with how these derivatives work.

Long Call

A long call is a bullish position. A trader with a long call hopes that the underlying stock’s price will increase. If a stock trades at $50 per share, and an investor buys a long call with a $55 strike price for a $1 premium, the stock must reach $56 per share before expiration to break even. 

Covered Call

A covered call is a potential income generating strategy. A trader with this position hopes the stock does not exceed the strike price. A trader may own 100 shares of a stock valued at $30 per share and decide to sell a covered call with a $35 strike price. If the stock price never exceeds $35, the call contract will expire worthless, allowing the trader to keep the 100 shares and the premium. Some traders repeatedly sell out-of-the-money covered calls to increase their cash flow. If the stock price exceeds the strike price, the trader must sell 100 shares at the strike price, regardless of the current market price.

Long Put

A long put is a bearish position where a trader hopes the underlying stock’s price will fall. If a trader pays a $3 premium to buy a put with a $100 strike price, the trader needs the stock to fall below $97 per share to profit from the put at expiration. A long put gives you the right but not the obligation to sell 100 shares at the strike price at or before expiration.

Short Put

A short put is a bullish position where a trader hopes the stock will continue to gain value. You receive a premium right away and will collect some of that premium if the put decreases in value before closing, or all of the premium if it finishes out of the money and worthless. You will have to secure cash in your account that may be equal to the amount you would have to pay to buy 100 shares at the strike price. For instance, if you short a put with an $80 strike price, your options trading broker will lock away $8,000 from your cash position. You can only access that cash again by closing the position or waiting for it to expire worthless.

Married Put

Traders use married puts to protect their portfolios from short-term downside. The investor already owns 100 shares of a company but believes the stock price will fall for a few months. This individual may choose to buy a put for that position. Puts minimize your portfolio losses because every cent below the strike price gets canceled out between the 100 shares losing value and the put gaining value. You can also choose to walk away from your position if the stock price falls below the put's strike price.

7 Tips When You Start Trading Options

Options trading gets easier as you get into it. These seven trading tips can accelerate your learning curve and make you feel more comfortable with derivatives.

Develop a Trading Plan

Identify what you will look for in an option. Some traders use technical analysis to determine entry and exit points. Other traders prefer to use fundamental analysis and buy contracts that expire in a few months to give these theses more time to play out. As you trade options, it’s a good idea to monitor your performance and see how you can improve.

Match Your Trading Strategy to Your Outlook

It’s important to determine if you are bullish or bearish about the stock market and individual investments before buying options. Getting the direction right is critical for trading options successfully. Bullish investors should look into long calls and short puts, while bearish investors should look at covered calls and puts.

Choose the Right Position Size

Options prices are volatile and can move sharply in either direction. You don’t need a large options trading position for it to have a sizable impact on your portfolio. Every investor should assess their risk tolerance and portfolio objectives to determine what percentage of their funds should go into options.

Choose the Right Expiration

Every option has an expiration date, and when that date hits, a contract either gets exercised or becomes worthless. Picking a further expiration date gives you more time, but it also results in a higher premium. A higher premium makes breakeven more difficult but can provide enough time to become profitable. Options contracts that expire in 1 to 2 weeks have lower premiums, which makes them more affordable. However, short-term options contracts give traders less time to realize profits, as a single flat day on the stock market can meaningfully reduce the option’s value.

Use Probability 

Every trade has a probability of being profitable. Many brokerage accounts and online tools can help you determine the likelihood of a position becoming profitable. Options trades with higher probabilities of becoming profitable tend to have higher premiums and less payoff. Some traders prefer to string several small wins together, while others prefer to buy an option contract with improbable odds and then record a significant profit if that option surprises the market.

Consider Volatility

Options contracts are volatile as it is, but the underlying stock market can also be quite volatile. Volatility doesn’t necessarily mean stock prices go down. During high volatility, an asset’s price may jump 3% on one day and fall by 2% on another day. Higher volatility increases potential profits for options traders but also results in higher premiums. Some traders buy during low volatility and anticipate that volatility will ramp up in a few weeks.

Avoid Focusing on the Expiration Graph

Expiration graphs help traders see how an option’s value changes as the expiration date gets closer. While this graph can help traders, you should look at additional resources to make decisions. An asset’s fundamentals and technicals can reveal additional insights.

Things to Consider 

Before you get into options trading, it’s important to consider that you can lose money with any investment, including options. Investors should assess their portfolio goals to determine how options trading can make sense for them and to avoid taking excessive risks. Options trading can help your portfolio, but if you go into this type of investing with no plan, you can put yourself in an unfavorable situation.

Getting Ready to Explore Options Trading

Options trading provides versatility for investors seeking gains and cash flow. While it can seem complicated at first, every options trading strategy revolves around calls and puts. When you become familiar with these options contracts, it becomes easier to interpret and harness other options trading strategies. Finding the right options trading app can put you in a better position to master this type of trading.

Frequently Asked Questions