Options trading 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 familiarising 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 go for the call option. The call option contract gives you the right to buy a stock within a certain time. Conversely, the put option gives you the freedom to sell the contract before it expires. The price at which you will buy or sell during an options trade 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 is able to provide value to the holder if it closes above the strike price for call options and below the strike price for put options.
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 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 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 increase, 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. If the options premium is $10, then 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 expirations. Of course, the longer the expiration date, the more the time available for the stock to move. Another benefit of having a longer 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.
Volatility is another important concept to grasp when trading options. Implied volatility (IV) indicates how likely it is, in the opinion of the 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.