Getting Acquainted With Trading Options (Guide)

Investor portfolios are usually constructed with several asset classes. These include stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot. It may seem overwhelming at first, but it's easy to understand if you know a few key points.

Options trading gives investors the opportnity to speculate on the future direction of the overall stock market or individual securities, like stocks or bonds. Options contracts give you the choice—but not the obligation—to buy or sell an underlying asset at a specified price by a specified date. Thus, options trading is when you buy or sell an underlying asset at a pre-negotiated price by a certain future date.

They are tradable contracts that investors use to speculate about whether an asset’s price will be higher or lower, without any requirement to actually buy the asset in question. While it is a little more complex than stock trading, options can help you make relatively larger profits if the price of the security goes up.

If you're looking to go beyond stocks, mutual funds or bonds in your portfolio, options could be a good fit.That’s because you don’t have to pay the full price for the security in an options contract. In the same way, options trading can restrict your losses if the price of the security goes down, which is known as hedging. Options give you, well, options for diversification. It gives you a great way to grow your income, limit your risk and hedge against market fluctuations at the same time.

Hedging with options is meant to reduce risk at a reasonable cost. Here, we can think of using options like an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. And while the risks can be high, so can the rewards. You may have heard that getting started with options trading is difficult, or it's only for the most advanced investors.

The reality is options are something virtually any investor can try — with the right know-how. Options strategies can range from quite simple to very complex, with a variety of payoffs and sometimes odd names. (Iron condor, anyone?) Regardless of their complexity, all options strategies are based on the two basic types of options: the call and the put.

Imagine that you want to buy technology stocks, but you also want to limit losses. By using put options, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short sellers, call options can be used to limit losses if the underlying price moves against their trade—especially during a short squeeze. Options can also be used for speculation. 

Understanding Option Terminologies

Many traders think of a position in stock options as a stock substitute that has higher leverage and less required capital. After all, options can be used to bet on the direction of a stock's price, just like the stock itself. However, options have different characteristics than stocks, and there is a lot of terminology beginning option traders must learn. To understand options, you just need to know a few key terms:

Derivative. Options are what’s known as a derivative, meaning that they derive their value from another asset.It is simply a financial contract that gets its value from an underlying asset. Take stock options, where the price of a given stock dictates the value of the option contract.

Call Option And Put Option. A call option is the right to buy a stock at a specific price by an expiration date, and a put option is the right to sell a stock at a specific price by an expiration date. This means that, while a call option gives you the opportunity to buy a security at a predetermined price by a specified date, a put option allows you to sell a security at a future date and price.

Strike Price And Expiration Date. An option's strike price tells you at what price you can buy (in the case of a call) or sell (for a put) the underlying security before the contract expires. That predetermined price mentioned above is what’s known as a strike price. Traders have until an option contract’s expiration date to exercise the option at its strike price. 

The difference between the strike price and the current market price is called the option's "moneyness," a measure of its intrinsic value.

Intrinsic Value And Extrinsic Value. Intrinsic value is the difference between an option contract’s strike price and current price of the underlying asset. Extrinsic value represents other factors outside of those considered in intrinsic value that affect the premium, like how long the option is good for.

Premium. The price to purchase an option is called a premium, and it’s calculated based on the underlying security’s price and values.

In-The-Money And Out-Of-The-Money. Depending on the underlying security’s price and the time remaining until expiration, an option is said to be in-the-money (profitable) or out-of-the-money (unprofitable).


How Options Work
One important difference between stocks and options is that stocks give you a small piece of ownership in the company, while options are just contracts that give you the right to buy or sell the stock at a specific price by a specific date. It is important to remember that there are always two sides for every option transaction: a buyer and a seller. 

So, for every call or put option purchased, there is always someone else selling it. In terms of valuing option contracts, it is essentially all about determining the probabilities of future price events. The more likely something is to occur, the more expensive an option that profits from that event would be. 

For instance, a call value goes up as the stock (underlying) goes up. This is the key to understanding the relative value of options. The less time there is until expiry, the less value an option will have. This is because the chances of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option is a wasting asset. 

If you buy a one-month option that is out of the money, and the stock doesn’t move, the option becomes less valuable with each passing day. Because time is a component of the price of an option, a one-month option is going to be less valuable than a three-month option. This is because with more time available, the probability of a price move in your favor increases, and vice versa.

How To Trade Options

Just like many successful investors, options traders have a clear understanding of their financial goals and desired position in the market. The way you approach and think about money, in general, will have a direct impact on how you trade options. 

The best thing you can do before you fund your account and start trading is to clearly define your investing goals. To start trading Options:

Open an options trading account. Before you can start trading options, you’ll have to prove you know what you’re doing. Compared with opening a brokerage account for stock trading, opening an options trading account requires larger amounts of capital. 

Investment objectives. This usually includes income, growth, capital preservation or speculation.

Trading experience. The broker will want to know your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year and the size of your trades.

Personal Financial Information. Have on hand your liquid net worth (or investments easily sold for cash), annual income, total net worth and employment information.

The types of options you want to trade. For instance, calls, puts or spreads. And whether they are covered or naked. The seller or writer of options has an obligation to deliver the underlying stock if the option is exercised. If the writer also owns the underlying stock, the option position is covered. If the option position is left unprotected, it's naked.

Based on your answers, the broker typically assigns you an initial trading level based on the level of risk (typically 1 to 5, with 1 being the lowest risk and 5 being the highest). This is your key to placing certain types of options trades.

Pick which options to buy or sell.
  • If you think the stock price will move up: buy a call option, sell a put option.
  • If you think the stock price will stay stable: sell a call option or sell a put option.
  • Call options and put options can only function as effective hedges when they limit losses and maximize gains.

Predicting The Option Strike Price

When buying an option, it remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for put options, it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.

For example, if you think the share price of a company currently trading for $50 is going to rise to $60 by some future date, you’d buy a call option with a strike price less than $60 (ideally a strike price no higher than $60 minus the cost of the option, so that the option remains profitable at $60). If the stock does indeed rise above the strike price, your option is in the money.

Similarly, if you think the company’s share price is going to dip to $40, you’d buy a put option (giving you the right to sell shares) with a strike price above $40 (ideally a strike price no lower than $40 plus the cost of the option, so that the option remains profitable at $40). If the stock drops below the strike price, your option is in the money.

Determine The Option Time Frame
Every options contract has an expiration period that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

If you think the stock price will go down: buy a put option, sell a call option.


 How To Trade Stock Options

There are various online brokerage outfits that allow you to trade stock options. For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling naked/uncovered calls), you generally need to sign up for a margin account and agree to risk notifications.

How is options pricing determined?

The relative price of an option has to do with the chances that an event will happen. But in order to put an absolute price on an option, a pricing model must be used. The most well-known model is the Black-Scholes-Merton​ model, which was derived in the 1970’s, and for which the Nobel prize in economics was awarded. 

Since then other models have emerged such as binomial and trinomial tree models, which are also commonly used. Options pricing can be calculated using different models. But at its core, options trading prices are based on two things: intrinsic value and time value.

An option's intrinsic value represents its profit potential, based on the difference between the strike price and the asset's current price. Thus, Intrinsic Value is the difference between the cash market spot price and the strike price of an option. It can either be positive (if you are in-the-money) or zero (if you are either at-the-money or out-of-the-money). An asset cannot have negative Intrinsic Value.

Time value is used to measure how volatility may affect an underlying asset's price up until the expiration date. Thus, Time Value basically puts a premium on the time left to exercise an options contract. This means if the time left between the current date and the expiration date of Contract A is longer than that of Contract B, Contract A has higher Time Value.

The stock price, strike price and expiration date can all factor into options pricing. The stock price and strike price affect intrinsic value, while the expiration date can affect time value. The price of an Option Premium is controlled by two factors – intrinsic value and time value of the option. 

This is because contracts with longer expiration periods give the holder more flexibility on when to exercise their option. This longer time window lowers the risk for the contract holder and prevents them from landing in a tight spot.

At the beginning of a contract period, the time value of the contract is high. As the expiration date of the contract approaches, the time value of the contract falls, negatively affecting the option price.

The Different Types Of Option

You should be aware that there are two basic styles of options: American and European. The distinction between American and European options has nothing to do with geography, only with early exercise. Many options on stock indexes are of the European type.

Because the right to exercise early has some value, an American option typically carries a higher premium than an otherwise identical European option. This is because the early exercise feature is desirable and commands a premium.

American options can be exercised at any time between the date of purchase and the expiration date. European options are different from American options in that they can only be exercised at the end of their lives on their expiration date.

An American-style option can be exercised at any time between the date of purchase and the expiration date. Most exchange-traded options are American style, and all stock options are American style. A European-style option can only be exercised on the expiration date. Many index options are European style.

Most option traders use options as part of a larger strategy based on a selection of stocks, but because trading options is very different from trading stocks, stock traders should take the time to understand the terminology and concepts of options before trading them.

It is also interesting to know what Options traders borrow from the Greeks. We’re not talking about Aphrodite and Zeus. Options traders use the Greek alphabet to reference how options prices are expected to change in the market, which is critical to success when trading options. The most common ones referenced are Delta, Gamma, and Theta.

Although these handy Greek references can help explain the various factors driving movement in options pricing and can collectively indicate how the marketplace expects an option’s price to change, the values are theoretical in nature. In other words, there is never a 100% guarantee that these forecasts will be correct.

Why Trade Options?

While options are normally associated with high extra money on investing in the short term. And so even risk-averse traders can use options to enhance their overall returns. As with any other type of investing, it’s best to educate yourself thoroughly before you begin and use online simulators to get a feel for how options trading works before you try the real deal.

When you’re ready to begin options trading, start small—you can always try more aggressive options strategies down the road. In the beginning, it’s best to focus on an asset you know well and wager an amount you’re comfortable losing. By easing into options trading, you can quickly expand your knowledge and make better decisions in the long round.

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