Compared to regular buying/ selling of stock, options trading can seem like a whole new world. And to a certain extent it is. There is new terminology you need to learn, new ways to make (and lose : / ) money, and a new way to look at the market and its participants as a whole.
There are some similarities however. The "Buy low, Sell high" rule still applies and where companies are concerned, a companies fundamentals will always be forefront (at least in my opinion).
Although options trading can seem pretty scary and like something only stock market professionals can do, there are some basics that even a beginner can learn to employ. You don't have to be a pro trader to do it. This Options Trading Guide is here to show you how.
First, we will cover the basics. Then we'll go over how you can start making money with options today.
Table Of Contents
The Derivatives Market
Just as the stock market is for stocks and the bond market for bonds, the derivatives market is for, you guessed it, derivatives. Derivatives are things that get, or derive, their value from another source.
In this case, they derive their value from the underlying asset: stocks, bonds, commodities, currencies, etc.
Just like the stock market, there is an over-the-counter derivatives market and a regular market exchange. The derivatives market is huge accounting for at least $12 trillion and upwards of $640 quadrillion. I can't even begin to tell you what a quadrillion is.
The derivatives market provides investors with the ability to make (and lose) a substantial amount of money. It gets a bad rap, though, as many say it played a role in the big 2008 financial crisis.
Futures, options, swaps, and forwards are the four main types of derivatives. We'll dive more into options below. This is, afterall, the Beginner's Guide to Options.
Futures vs. Options - What's the difference?
The two types of derivatives that you hear of most often arefutures and options. To not confuse the two. Let's go over them a bit.
Futures require the buyer to buy the shares and the seller to sell them. In contrast, options provide the investor with the right to buy or sell the shares if they want to. They are not obligated to do so.
Both futures and options are subject to the specified price of the contract as well as its expiration date. As an investor, you can use both futures and options to make money and to mitigate the risks of your investments.
Let's Talk About Options
There are two types of options: calls and puts. Buying call options give you, the investor, the right to buy an asset at a specified price by a specified expiration date.
On the other hand, buying put options give you the right to sell stocks at a specified price by the expiration date.
Call options are said to be a bullish strategy used by investors who believe that the market is going up. While put options are said to be a bearish strategy, used when you think the market will go down.
When you buy a call or put, you are said to be the 'holder'. And when you sell a call or put, you are called the 'writer'. As the writer of a call or put, you get paid what is called a premium.
The amount of the premium is determined by the market.
Interesting Fact: European options can only be exercised on the day of expiration. However, American options can be exercised at any time up to expiration. This makes American options more valuable.
How to Use Call Options
There are two things you can do with call options: buy or sell. If you believe that the market or the specific stock's value will go up, you will want to buy a call option.
This will give you the right to purchase the stock at the strike price, or the agreed upon price. (Note: Contracts are for a minimum of 100 shares.)
Thus, if the price does go up, you will profit by paying a price that is lower than the actual price of the stock. Keep in mind though that you do not actually have to purchase the stock to profit. You can instead sell the option and gain the profits that way.
On the other hand, you could write covered calls to earn a little income on the side while at the same time decreasing your cost per share (reducing your risk) of the stock you own. When you write, or sell, a call against stock that you own, it is termed a covered call.
As the seller, you receive a premium. And as long as the stock's price doesn't go higher than the strike price, you get to keep your stocks and the premium. A win-win.
However, should the price move higher than the strike price, the option will be exercised. This means you must sell your shares and you will lose out on the future gains of the stock.
You can prevent this from happening if you buy back the option you sold but you may lose money in doing so.
If you don't own a particular stock, you can still write calls for it. This is called naked call writing. It is a very risky strategy in which you could lose an unlimited amount of money.
As a beginner, you won't want to engage in naked call writing and most brokers will restrict who can write naked calls anyway.
Risks, Losses, and Rewards
If you are considering buying or selling calls, you should properly assess the risks and potential losses of each strategy. Don't fall into the trap of only looking at how much you can make without realizing just how much you can lose.
When buying a call, you must pay the required premium for the ability to purchase that stocks at your desired strike price. If the stock price never goes above your strike price, then the option you purchased will expire worthless.
Afterall, if you really wanted the stock, you could just buy it for less than your strike price. Therefore, the maximum possible loss when buying an option is the premium you paid.
However, should the stock price take off, soaring well above your strike price, you now have the opportunity to buy that stock at a steep discount. Since there is no cap to how high a stock can go, your rewards, or gains, are limitless.
Buying a Call Example
Suppose ABC company is currently trading at $30 per share. You believe the stock is going to go up significantly so you purchase a call option with a strike price of $34. The option costs $1. So you pay $100 for the option (1 x100 shares).
To breakeven in this trade, you would need the stock price to rise to $35 since you paid $1 per share. Thus, the breakeven point is the strike price plus the premium you paid. Anything above this point is profit for you. However, if at expiration the stock price is below $35 you will have lost money.
When you sell a call, the exact opposite takes place. Your maximum profit potential is capped at how much you received from the premium plus however much the strike price is above your initial purchase price.
On the other hand, your maximum possible losses is equal to the price you paid for the stock minus the premium you received. This is a scenario when your stocks have dropped to $0 in value.
However, naked call writing losses are not capped. They are unlimitedas the stock's price could soar. Then you would be left footing the bill for the difference between the new high price and the low price you agreed to sell it for.
Selling a Covered Call Example
Suppose instead of buying a call you decide to sell a call for the same ABC Company. You don't think the stock's price is going to rise significantly in the coming weeks and you want to lower your cost basis for the stock you own. So you sell a $36 call and receive the $1 premium.
As long as the stock remains below $36 you keep all of your premium. If it goes higher, your profit is the same as this is your max potential gain. But below that you begin to lose your premium until you reach the breakeven point of $35.
*Not drawn to scale but to provide a general reference.
Don't be blinded by how much you can make! ALWAYS analyze the risk of each trade and how much you could lose.
How to Use Put Options
SImilar to calls, there are two things you can do with puts: buy and sell. When you buy a put, you are buying the option to sell your stock at a specified price at or before the expiration date.
This can limit the amount of money you would lose should the stock's price drop significantly.
Many investors will doprotective puts as a hedge to an unexpected drop in their stock's price. Even though they may be bullish on the stock, or believe it will go up, they buy a put as an insurance policy in the case that it suddenly goes down.
In contrast, when you sell, or write, put options, you are acting like the insurance agent. You are saying that you will buy the stocks at the strike price no matter what. Because you are taking on a risk and insuring these stocks, you get paid a premium.
Make sure though that when you are writing puts you have the money to buy the stocks should the option be exercised. As a beginner, most platforms will probably make sure you have the cash before they allow you to write puts.
I suggest before you sell puts for a specific stock make sure you are actually interested or wouldn't mind owning the stock in question.
Risk, Losses, and Rewards
Buying puts can provide protection and cap the amount of money you lose on stocks that you already own. The worse that could happen is that your option will expire worthless. This means that for buying puts your max potential loss is the premium you paid.
But should your stock's value increase and continue to increase, your gains will too. Thus, you max profit potential is limitless.
Buying a Put Example
You buy a protective put for your ABC stocks with a strike price of $36 and a cost of $1 per share. Your breakeven point is $35, or the strike price minus the cost of the option. Thus, if the stock's price goes below $35 dollars you would make money. Otherwise, you would lose money but such losses is capped at the $100 you paid for 1 contract.
Selling puts, however, gives you a maximum profit potential equal to the premium you are paid. Your maximum loss potential is the cost of the stock you would purchase if the option is exercised. This is the scenario when the stock you may have to buy falls to $0.
Selling a Put Example
You sell a put for ABC at a strike price of $36 and a premium of $1 which you receive as payment for selling the option. Your breakeven point is $35, or the strike price minus the premium you received. So, if the stock's price goes below $35, you begin losing money.
Option Spreads
There are more advance techniques that you may want to start using once you get the hang of the basics. They use different combinations of buying/selling calls and puts, doing so at various strike prices, and for varying expiration dates. Here are a few of these advanced techniques:
- The Straddle: Buying a put and a call for the same stock at the same strike price and expiration date.
- The Strangle: Buying a put and a call for the same stock and expiration date but with different strike prices.
- The Iron Condor: Buying and selling a put at different strike prices and buying and selling a call at different strike prices for the same stock and expiration date.
Why do people trade options?
There are many reasons why people find options trading very alluring. Check out some of these reasons below.
Income
One reason people trade options is because it can be used as a source of income. Buying an option at one price and selling it at a higher price is one way to earn some cash. The other, is by writing options. By doing so, you will be paid a premium that you get to keep no matter what.
Hedge / Mitigate Risk
Another reason to use options is to mitigate the risk of your portfolio. Many buy and hold investors use options as insurance or a hedge in case the market falls.
They may purchase a protective put for the stock they hold because, by doing so, they limit the amout of money they will lose should the stock's value drop. You may choose to cover some or all of your portfolio with protective puts.
Leverage
Many investors prefer options trading because, unlike just buying stocks, options provide leverage. With options, you are able to benefit from the movement of stocks without actually owning them.
This means you can invest with much less capital and still receive the same gain as the buy and hold investors.
Using the leverage that options provide, you can "own" stock you wouldn't otherwise be able to buy. Futhermore, with options, you can receive significant returns on your investments.
For instance, say you had $1000 to invest and you wanted to purchase 100 shares of Microsoft stock. Unfortunately, Microsoft is trading at $200. This would cost you $20,000. Money you do not have.
So you turn to options. You find that buying a call will cost you $5 per share which, when you multiply that by 100, is $500 per contract. You buy 2 contracts and now "control" 200 shares of the company you technically can only afford to buy 5 shares of.
Even though you don't actually own the stock, you can still benefit from its movement. Thus, should the stock price increase, your options price will increase as well.
If it increased by $10, you could potentially get $2000 for your two contracts; thereby doubling your money. That's a 100% return on your investment.
Leverage, however, is a double-edged sword. While on one hand, it magnifies your gains; on the other, it can and will magnify your losses.
Need Less Money to Start
One of the best things about options trading is that you don't need much money to start. You could literally get started with just $50 (even less with penny stocks but I don't recommend that).
Not only can you get started with less capital but you can have more range than if you buy a stock outright.
For instance, you may be able to purchase only one stock with $50 in regular stock market trading. But with options, you could use that $50 to purchase a contract for 100 shares of stock. You multiply your reach by 100!
So not only can you expand your reach with options trading but you can do so at a lower cost. This allows you to use your money more efficiently to multiply your gains or mitigate your risk.
Furthermore, all of your money is not tied up in a single asset because techniquely you don't own them...yet. This benefit is the result of the leverage that options themselves give you as an investor.
Less Risky?
Is options trading less risky? In certain circ*mstances, yes. In others, no. Leverage, usually considered a perk of options, can go both ways giving you substantial gains as well as substantial losses.
As it turns out though, buying options instead of selling options actually limits how much money you can lose in a trade. Essentially, by buying options your max loss potential is the premium you paid.
In this way, it is less risky than owning the 100 shares of stock outright. Should the stocks unexpectedly go to $0, you will have only lost your premium.
However, selling options is very risky. Especially if you decide to do naked call writing. This type of trading is extremely risky as your potential losses are uncapped.
Should the stock experience huge gains, you would have to bite the bullet and buy the stock at this new much higher price, then sell it at the much lower agreed upon strike price.
Speculation
Some investors like to use options for speculating which way the market is going to move. Options are great tools for speculators as they provide leverage which can be used to multiply gains (and let's not forget, losses).
If an investor believes the market will go up, they will buy call options. But, if they believe the market will go down, they would buy a put.
And if they are right, the profits they receive can be very rewarding for the little amount of money needed to enter into the trade. Of course, if they are wrong, the losses can be big.
Flexibility/ Versatility
Options offer the average investor lots of flexibility money-wise because they are leveraged vehicles. But in addition to that, options trading gives you greater flexibility overall as there is a wide array of assets that you can buy and sell options for (i.e., commodities, indexes, foreign currencies, etc).
Further increasing the appeal of options, there are many different ways that you can use options to take advantage of the movement of the market.
By using various strategies, you can profit whether the market is going up, down, or sideways. And this is virtually impossible to do in regular investing.
How to make money with options
The beauty of options trading is it's, well, options. There are many different ways you can make money trading. It doesn't matter if the market is going up, down, or sideways, as was previously mentioned.
Selling Calls and Puts
For starting out, you may want to consider selling calls and puts as these have a higher probability of making you money. This is because when you sell an option, you collect a premium.
And all you need to keep that premium is for the market to do nothing (assuming you sold an at-the-money or out of the money option, more on this below).
Further, in selling options time is on your side. The closer it gets to the expiration date the more your options extrinsic value decreases and the more of your premium you'll be able to keep.
Although you have a higher chance of making money selling options, remember that the potential loss is unlimited and that your gains is capped at the price of the premium. Weigh your risks carefully before deciding whether you want to sell options or not.
General Rule of Thumb
- When selling calls, you make money when the stock's price goes down.
- When selling puts, you make money as the stock's price increases.
- You don't have to wait until expiration to get out of a trade. If the trade isn't going favorably, you may want to get out to limit losses.
Buying Calls and Puts
While buying calls and puts may have a lower probability of making you money, the rewards could be huge should things go in your favor. Not to mention your risk is limited to the amount you paid in premium.
When you buy options, the only way you make money is if the markets changes drastically. You need large movement in the market and fast because over time the option that you purchased will lose its value. Time is not your friend when you buy options.
Should the market move in your favor, you do not have to exercise the option reap the rewards. As a rule, the gains are built into the options pricing.
So, if you bought a $2 call option for ABC Corp at a strike price of $20 and now it is priced at $24, that $4 gain per share would be included in the sell price. Therefore, you would be able to sell your call option for at least $6.
General Rule of Thumb
- When buying a call option, you want the stock's value to dramatically increase within a few days of purchasing.
- When buying a put option, you want the stock's value to dramatically decrease within a few days of purchasing
- You don't have to wait until expiration to get out of a trade.
Remember options trade with a minimum of 100 shares. Prices are quoted on a per share basis so don't forget to multiply by 100!
Factors that Affect Option Pricing
The Strike Price (Exercise Price) - The higher it is (or the farther it is from the current stock price), the lower the value of the option.
The Stock Price - The higher the price, the greater the option's value.
Expiration Date - Typically, the longer the time you have till expiration, the more valuable it is to the trader as the underlying asset has more time to move up or down. This equates to a higher price.
The Volatility of the Stock - The more volatile the stock is the higher the price of the trade. This is because higher volatility equals more risk. But also the potential for huge gains. So they will sell for higher premiums.
Interest Rates - Since rates tend to change marginally and not very often. It doesn't affect options as much as the other factors. An increase in the interest rates increases call options prices but decreases put option prices and vice versa.
Dividend Yield - Since the value of stocks decrease by the amount of the dividend, call option prices decrease as the ex-dividend date gets closer. In contrast, put option prices increase as it approaches the ex-dividend date.
* Ex-Dividend Date is the cut-off date for receiving the upcoming dividend.
Options trading can be very rewarding but also extremely risky! Make sure you fully understand your risks before investing.
Key Terms with Options Trading
Here are some key terminology that is often used for options trading. Please note that the terminology usage differs for calls and puts:
For Call Options
In-the-money: The strike price is below the actual price of the stock. So, the option has some inherent (or intrinsic) value at purchase.
At-the-money: This is when the strike price is equal to or very close to the actual price of the stock.
Out-of-the-money: The strike price is above the actual price of the stock. This option has no inherent value only extrinsic or time value.
For Put Options
In-the-money: This is when the strike price is abovethe stock's actual price. So it has intrinsic value.
At-the-money: When the strike price is equal to or very close to the actual price of the stock, it is considered at-the-money.
Out-of-the-money: This is when the strike price isbelow the stock's actual price. It has no intrinsic value only extrinsic.
Call Example
ABC Corp is currently trading at $100. If you choose to buy or sell a call option for ABC Corp with a strike price of $95, you are trading an "in the money" option. This option would have an intrinsic value of $5 per share.
However, if you choose a strike price of $105, you would be trading an "out of the money" option as there is no intrinsic value. Furthermore, if at expiration your option is still "out of the money," it will expire worthless as you could simply purchase the stock at market price and it will be cheaper.
Put Example
Taking the same ABC Corp, you decide to sell (or buy) a put with a strike price of $110. Because it is $10 above the stock's market price, it is "in the money".
This means, as the seller, you are promising to buy the stock from the buyer at $10 abovethe current price.
In contrast, if you decide to trade a put option with a strike price of $90, it will be "out of the money". It will have no intrinsic value as the stock could be sold for much higher ($100) at the current price.
There is extrinsic value though as the stock price can change over a period of time.
Related: How to Make Money with Simple Options Trading
How to Read an Options Table
Options tables can be confusing at first to a beginner. There is just so much going on and you may not be sure what the heck you are looking at.
To start, there are two parts to an options table: a call and a put section. Usually, the call section will come first. In addition to the strike price and the expiration date, here are some of the common items you'll find in an options table.
Volume |
Open Interest (OI) |
Bid |
Ask |
Last |
Change |
The number of contracts that have been traded. |
The number of open positions that have not yet been filled. |
The maximum price an investor is willing to pay for the option. |
The lowest price investors are trying to sell the option for. |
The price of the last trade. |
The change in price compared to the previous close. |
Typically, you'll want to look for contracts with a high volume and open interest as this indicates that there is a lot of interest in that option. This will make it easier for you to get in and out trades quickly.
Furthermore, to maximize your premium will you sell a stock option for, try to aim for the Mid price between the Bid and Ask or slightly higher. If that doesn't work, then start lowering your price until it goes through.
Likewise, to lower the purchase price of options, aim to buy at the Mid price or slightly lower. Then, if that doesnt work, incrementally increase your price.
The Greeks
If you do any type of research into options, you are bound to come across what are called the 'greeks'. As a beginner, you don't really need to know about this per se, so if it is confusing don't worry about it too much. It's a bit more advanced.
- Delta: measures the change of the options pricing due to the change in the stock price. With a Delta of 50% (or 0.5 x 100%), should the stocks price go up $10, the options price would only go up $5. Delta is higher for in the money options and lower for out of the money options. At the money options are usually 0.5.
- Gamma: measures how much Delta changes for every $1 increase or decrease in the stock's price. Gamma is higher for at the money options and decreases the further you go in/out of the money.
- Theta: measures the time decay of an option or how much money you will lose as time passes. Theta increases with time for at the money options but decreases over time with in and out of the money options.
- Vega: measures the affect changes of a stock's volatility has on the options price. As the volatility increases, options pricing will increase and as it decreases, so too will the options price.
- Rho: measures the affect of the risk-free interest rate on option pricing. The amount of Rho tells you how much the options price will change for each 1% change in the interest rate. For calls, an increase in the rate equals an increase in the options price. However, for puts, such an increase would cause the options price to decrease.
Things to Note
- Options trading is done on a 100 share basis. So the minimum amount you have to trade is 100 shares of a particular asset.
- There can be great rewards but also great risk. Be sure to look at both.
- Throughout this post, I've used stocks as examples but options trading can be for commodities, currencies, indexes, and more.
- There are commission fees for trading options. Be sure to factor this into your cost analysis.
All in All
Trading options may sound complicated but once you get the hang of the basics everything becomes much easier. Hopefully, now that you are fully grounded in the basics of options trading you can use that knowledge to start making some money like I did.
Start out slow and easy. Don't try to be too fancy too soon. You want to make sure you understand how this market works real time and not just in theory.
Make sure you fully understand how options work before you start playing around with big money. Happy Trading!
Related Questions
What are good platforms for options trading?
Starting out you could probably stick with a simple discount brokerage like Schwab to start doing a few easy trades. Once you get more advanced or want access to more tools, I recommend Tastyworks.
Their platform is specifically geared toward options trading. They have training tools and videos as well as all the fancy metrics to help you trade with ease and confidence.
*DISCLAIMER: The Information provided in this post is simply the opinions of the blogger and is given in the spirit of educational fun. It is not investment advice. Please do your own research and decide what is right for you before investing in any asset. If necessary, seek the help of a certified professional in discussing your options.
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