Learning how to trade options can be complex for new traders, as it has multiple moving parts, which makes it even more challenging than stock trading.
The first step for anyone looking to become an options trader is to get permission. The amount of capital involved and the nature of trading means that each trader has to go through a screening process in which the brokerage firm determines your financial capability and trading experience, among other factors. Brokers ask traders to provide their annual income, net worth, stock or options trading history, the purpose of investment, etc. After assessing you thoroughly, the brokerage will provide you with your initial trading level.
What is Options Trading?
If you are new to trading options, then you should start by familiarizing yourself with the core elements of options trading. Like stock trading, you will have to decide whether you will buy or sell the stock. If you estimate the price to increase, then you should buy a call option. The call option contract gives you the right to buy a stock at a specific price within a certain time. Likewise, selling a call option obligates you to sell a stock at a specific price within a certain time.
If you think the stock price is likely to decline, then you should buy a put option contract. A put option gives you the freedom to sell the stock at a specific price before it expires. The seller of a put option has an obligation to buy the stock at that specific price. The price at which you will buy or sell an option is called the strike price or exercise price of the option.
Another variable you will have to consider is the amount of movement that will take place in the stock option price. An option can provide value to the holder if it closes above the strike price for call options and below the strike price for put options.
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For example, if you have estimated that the share price of an asset is going to increase from $50 to $60 in the next two months, you should buy at a strike price of under $60. On the other hand, if it’s looking like the price will go down to $40, then you should go for a put option having a strike price above $40. It’s important to note that the strike prices are not an ever-changing parameter: There are standards for strike prices, and the prices are directly related to the stock price in the options trade.
The premium you pay for an option has an intrinsic value and a time value. Intrinsic value is determined by taking the difference between the current market price, or share price, of the stock and the strike price of the option. Time value is the amount of time left until the expiration of the contract. Investors look for stocks whose intrinsic value will increase during the time remaining. Naturally, the more time available for the value to grow, the greater the value of the option.
To understand premiums, let’s consider the example of a $50 call option. With the stock price of $60, the option may have an overall value of $15. This means the intrinsic value will be $10 ($60 minus $50), and the time value will be $5, making up the total price.
Given the limited time frame for each stock option before expiration, you must estimate the time frame in which the stock will likely move. Similar to the strike price, the contract expiration dates are decided by others. You have a range of options with expiration dates, including daily, monthly, and yearly expiration dates. Of course, the longer the expiration date, the more the time available for the stock to move. Another benefit of having a more extended expiration date is that the time value does not decrease as rapidly. If the option has some time value left on it, the trader can still sell that value even if the trade has not gone according to expectations.
Where the Stock Trades in Relation to the Option
Some of the terminology related to stock options includes in the money, out of the money, and at the money. Here, in the money means that the trade is going in favor of the owner of the options because the stock price is higher than the strike price of the call option, or the stock price is lower than the strike price for a put option. The opposite is true for out of the money situations. At the money means that it’s a wash because the stock price is roughly equal to the strike price.
For example, if a trader anticipates a stock that is trading $50 is going to rise to $65 within the next three months, they could buy a 60-strike price call option going three months out for a price of $1. If the stock does trade up to $65, the trader could exercise the call option, buying the stock at $60, giving themselves a $5 profit on the stock. However, because they paid $1 for the option contract, their net profit would be $4. This would result in a 400% return on capital.
Likewise, if a trader anticipates the stock will trade down to $35 within the next three months, they could buy a 40-strike price put option for $1 extending the same time frame. Here, if the stock does trade down to their $35 forecast, the trader would be able to force the sale of the stock at $40, locking in a $5 profit. Because the trader paid $1 for the option contract, they would have a net profit of $4 and a 400% return on capital.
In either case, if the stock movement failed to reach the strike price, the option contract would expire worthless and the trader would lose 100% of their investment.
A trader does have the freedom to choose any strike price or time frame they wish to place to trade. The more an option is in the money or closer to being in the money, the higher the price of the contract. For example, a 60-strike price call option would cost more than a 65-strike call option, because the ability to buy the stock at $60 is better than the ability to buy the stock at $65.
Every trader should understand that time is a critical factor when deciding which option contracts to execute. Options contracts have an expiration date, which represents the last day a trader can exercise the contract. Monthly options contracts, the most popular, expire on the Saturday following the third Friday of the month. Weekly option contracts expire on the Saturday following each Friday. Some option contracts have midweek expiration dates as well.
Traders have the option to choose which duration works for them, which can range from days, weeks, months, or spanning multiple years. The more time a trader wants, the more the option contract will cost as he gives the trader more time to profit from the option contract. Think of it as insurance, you can buy one-month insurance policies every month, or you can buy a six-month policy, but the six-month policy will cost significantly more because it covers more time.
For example, having one month for the stock to trade over $60 is less desirable than having three months for the stock to trade over $60, so the three-month contract would have a higher cost. The more time a trader desires on their option contract, the higher the price of the trade.
Volatility is another crucial concept to grasp when trading options. Implied volatility (IV) indicates how likely it is, in the opinions market, that the stock will see a swing in its price between the high and low prices. The price of an option usually increases with an increase in volatility because volatility increases the chances of price moving favorably for the holder, the option owner. The person selling the options contract is called the writer. The holder gives the premium to the writer with the understanding that the writer will buy or sell the share at its strike price, in case the holder exercises the option.
Options offer huge advantages over other asset classes. For traders who understand how to mix different options, it allows them to limit their risk while maximizing their profit. This makes options arguably less risky than other similar investments. However, people new to options often have a rough time starting out, because they try to trade something they don’t yet understand. This is why it’s always smart to have a trading coach, especially with options trading.
Options may have a lot of moving parts, making them challenging to understand for new traders. Still, once they grasp the initial concepts, options enable traders the opportunity to make far above-average returns over and over again.