Complete Options Trading Guide for Beginner-Level Traders
Options are one of the more popular choices for traders today. Here you’ll learn about all of the different aspects of options trading, along with some effective strategies that are great for beginners depending on the given circumstances. You can also take in-depth options trading courses here at Sheridan Mentoring.
Options Trading for Beginners
Options have become an appealing option for many investors today, particularly as trading volume continues to rise and investors have decided to try new types of investments. If you want to make the most of this type of investment and are interested in trying options in lieu of or in addition to other types of investments, you’ll benefit from gaining a full understanding of options and how they work.
What is Options Trading?
Simply put, options are derivatives, deriving their value from other parties.
While certain high-profile investors such as Warren Buffett have warned against using derivatives, they have also contradicted themselves in many cases and invested in options regardless.
The average retail investor can easily profit without ever buying or selling options at any point, but it’s important to keep in mind that options in and of themselves aren’t inherently bad.
Instead, issues may arise from options’ wide proliferations and the craziness that the accounting entails.
Like any other tool, options are only as beneficial or damaging as the person makes them. Well-informed investors may find them to be an incredible asset to their investing practices, while investors who are less educated may suffer from more damage to their holdings.
Options Trading Definition
Options trading consists of both “call” and “put” options. Call options entail the contract buyer purchases the right to buy the underlying asset at a future time at a set price, which is also called either a strike price or exercise price.
Put options, on the other hand, are where buyers purchase the right to sell the underlying asset at a predetermined price in the future.
Call and Put Options
There are also two different parties involved in call and put options: the party buying the option and the party selling the option. Both sides come with their own individual risk and reward profile and will use different strategies.
The option buyer traditionally has a long position, while the seller has a short position.
Tradable options are basically contracts between two different parties, and the companies with underlying securities in these contracts aren’t actually involved in the transaction at any point.
Instead, cash only flows in the parties actually in the market. In any option trade, the counterparty could be anything from another investor to a market maker who may offer to buy and sell a specific security to try and profit from it.
Why Options Trading?
A call buyer will want to make a profit as soon as the price of the underlying shares increases. The call price increases as the shares rise. However, the call writer hopes the stock price decreases, or at least rises less than the initial selling price of the call.
The put buyer will be able to make a profit when the underlying stock price declines. The value of a put will increase as the underlying stock’s value decreases. On the other hand, put writers want the option to expire with the stock price higher than the price of the strike, or are at least hoping the stock will decline to an amount that’s less than what they received to sell the put.
A majority of options never expire or see any transaction of shares, as options are tradable securities. Depending on the circumstances, investors can easily lock in profits or losses by buying or selling a contract that opposes their initial action.
Calls and puts, whether isolated, combined, or with positions in underlying stock, offer various levels of protection or leverage to portfolios. Option users can profit in bear, bull, or flat markets; options can function as insurance to maintain protection of gains in a shaky stock; options can generate steady income from an underlying blue-chip stock portfolio; or stocks are employable to help double or triple money overnight.
Regardless of how users utilize these options, it’s important to remember that insurance costs money that could come out of your own profits, and looking for a quick double or triple could potentially wipe out your entire investment.
Options Trading Basics
Now that we know what options trading is, it’s time to dig deeper into exactly how options trading is performed.
How Options Trading Works
If you want to make the most of options trading and get the best possible results, you’ll want to know how each type of option works, along with the various positions.
Types of Options Trades (USA and EU)
As we’ve mentioned, there are several different types of options calls and puts that you can work with in options trading. American options are exercisable at any time between the expiration date and the date of purchase. Most exchange-traded options are similar to this.
European options differ from American options in that they can only be exercised on the expiration date. Early-exercise is the only reason for this difference between American and European options. A majority of stock options are of the European variety, while American options often include a higher premium than their virtually identical European counterparts.
Options can also be categorized by duration until expiration. Short-term options will expire within a year or less, while long-term options with expirations more than a year are considered long-term equity anticipation securities (LEAPs). LEAPs are essentially the same as regular options, providing opportunities to manager or control risk. However, LEAPs allow these opportunities to last for far longer periods of time.
Options traded on exchanges are known as listed options. There are several electronic and physical exchanges in the U.S. where options are traded. Options are also tradable with counterparties through the use of an exchange, also known as over-the-counter (OTC) options. Oftentimes financial institutions will make use of OTC options to tailor specific outcome events that aren’t ordinarily available among listed options. To provide more liquidity to options markets, market makers exist to generate a two-sided market in an option when asked to quote. These market makers can take advantage of theoretical and arbitrage mispricings between the market price and value of the option, through theoretical pricing models.
Pricing of an Option
Consider a stock that’s selling shares at $40. This is for a company you particularly like, and you like the price. Because of the ideal price, you also decide to expand your opportunities by purchasing a few call options. If your predictions are correct, the price of those shares will increase and subsequently their value will also rise.
It can be a challenge to determine which options are worth buying, the strike price, and the expiration date, along with how the option price will react as the stock price increases or falls.
Options prices are the sum of two components: time value (TV) and intrinsic value (IV).
IV is the difference between the option’s price and strike price, but it can’t be less than zero as an option holder wouldn’t work with a call that has a strike price of $40 and a trading price of $25. IV is calculated by looking at the underlying stock price and how it moves along with the option stock price.
TV is the premium that people want to pay for the potential upside of the stock until the expiration date. Options can be considered “wasting assets.” As the expiration date approaches, TV will decrease until there’s no more time left and the TV equals zero. Therefore, at the end of the expiration date, all that will be left of the option’s value is IV. Even if it’s small, TV will always be positive prior to the expiration date.
Options Trading Example
Consider the $40 option we discussed for this hypothetical company. There are some observations you are likely to notice when looking at the options table for it, including:
- Whenever the strike price is higher than or equal to the current stock price, IV will be zero. In these cases, the value of the option is only attributable to TV and the expectation that the price will rise above the strike price by the expiration date.
- The less time there is before the expiration date, the lower the TV will be. If the strike prices are identical, IVs will also be identical to each other. However, if an option expires earlier, one with a later expiration date will have a higher TV, as more time means higher value.
- Options that share a common expiration date will have maximized TV when the stock price and strike price are the same. As the stock price increases or decreases, the TV will fall.
How to Trade Options
Now that you have a clearer idea of exactly how trade options work and the different aspects and types of options, we can cover the different strategies you might want to consider.
Option Trading Strategies
Here are some of the best options strategies for beginners to consider.
Buying Calls (Long Call)
This type of position is preferred among traders who are either bullish on a specific index or stock and don’t want to risk capital in the event of downside movement, or want to take leveraged profit on a bearish market.
Because options are leveraged instruments, they enable traders to amplify the benefit by risking smaller amounts than would otherwise be required if the underlying asset traded itself. Standard options on a single stock has the same size as 100 equity shares. Investors can take advantage of leveraging options by trading options.
The main risk of this strategy is that the trader’s potential loss is limited to the premium they pay. Potential profit has no limits, which means the payoff will increase as much as the underlying asset price rises.
Buying Puts (Long Put)
This strategy is ideal for traders who are either bearish on an underlying return but don’t want to risk any adverse movement in short sell strategies, or wish to take advantage of leveraged position.
If the trader is bearish on the market, they can short sell assets such as Microsoft (MSFT), for instance. However, purchasing a put option on the shares is another alternative strategy. A put option will enable the trader to benefit from the position if the stock price falls. If the price increases, on the other hand, the trader can allow the option to expire worthless, solely losing the premium.
is the price of the option multiplied by the size of the contract. Since payoff function of the long put is defined as the max, the maximum profit from the strategy is capped, as the stock price can’t decrease below zero.
This is the preferred position for traders who either expect no change or only a slight increase in the underlying price, or want to limit the upside potential of an option in exchange for limited protection for the downside.
This strategy consists of a short position in a call option, with a long position in the underlying asset. The long position makes sure that the shortcall writer will deliver the underlying price if the long trader exercises the option. Using an “out of the money” call option, traders collect a small sum of premium, which also allows for limited upside potential. The collected premium covers the potential downside losses to an extent.
The risk that comes with this strategy is that if the share price goes over $45 by the expiration date, the short call option will be exercised and the trader will need to deliver the entire stock portfolio. Shares whose prices drop below $39 will make the option expire worthless, but the stock portfolio will also lose value.
This position is good for traders who own the underlying asset, and also want protection for the downside. The strategy involves a long position in the underlying asset, along with a long put option position.
An alternative strategy would entail selling the underlying asset, but the trader might not want to liquidate the portfolio, which could be because they expect high capital gain over the long term and subsequently wants protection for the short run.
If the underlying price increases at maturity, the option will expire worthless and the traders will lose the premium, while still having the benefit of the increased underlying price that they are holding. However, if the underlying price goes down, the trader’s portfolio position will lose value, but this loss is largely covered up by the gain from the put option position that’s exercised under the circumstances at the time. This essentially makes the protective put position an insurance strategy.
The one risk that comes with this strategy is if the underlying price drops, the potential loss of the overall strategy is limited by the difference between the strike price and stock price, plus the option’s premium.
Options Trading Tips
Want to make sure your options trading strategies result in success? Here are some tips to consider when trading:
- Use options as risk-reducing investment tools rather than gambling instruments.
- Manage risk carefully, avoiding holding positions that can potentially result in significant loss.
- Don’t invest in too many option contracts when trading, as it’s easy to over-trade with affordable option contracts, particularly when selling.
- Don’t overspend. Instead, stay within your allotted budget to avoid having your account wiped out by an unexpected event.
- Limit losses by buying one option for every option sold, which means selling spreads instead of naked options, which leads us to our next point.
- Selling naked options is considerable less risky than buying stock, but it isn’t without its downside risk. Ultimately, it’s reasonable to sell naked puts, but only if you want to buy the shares
These tips can help make options trading go more smoothly, with minimal mistakes along the way.
If you would like additional information about options trading and become an expert trader through comprehensive courses, contact Sheridan Mentoring today.