September 18, 2017

How to Trade Options

Read more about Options Trading
This article contains references to products from our partners. We may receive compensation if you apply or shop through links in our content. You help support CreditDonkey by reading our website and using our links. (read more)

Trading options is complex, but could be highly profitable. Educate yourself with this options trading tutorial for a simple introduction.

Diversify your portfolio by learning how to trade options. Options can help give you leverage. It gives you control over a larger number of shares with a lower initial investment. Proceed with caution though; options trading isn't for novice traders.

A Beginner's Guide to Options Trading

Options can be highly profitable when done right.

They also require taking plenty of risks, though. Options can go wrong. You could lose out on the money you put into it or even more. You have to decide the risks you are willing to take.

Ready to know more? Read our guide below to help you get started on this path to investments.

How to Start Trading Options

First Step: You Need a Brokerage Account

Before you can trade options, you'll need a brokerage account. If you are new to trading, consider an online options broker.

Tip: Ally Invest offers a good choice for beginners.

If you've never had a brokerage account, you'll need to break yourself in first.

Brokers want you to have a basic understanding of stocks and investments. In other words, they want you to understand the risks involved in trading. Some brokers may want to see your liquid assets and your total net worth too. Trading options is risky business. This is why you need a broker to get started.

As you shop for a brokerage firm, don't base your decision on commission fees alone. Instead, look at the big picture. As a beginning investor, you want a supportive brokerage firm. You need good customer service as well as plenty of education as you go along. While researching brokers, consider the following questions:

  • What types of support do they offer? Is it all online? Can you call a live person if you have questions?
  • Do they offer research on stocks and options?
  • What type of guidance do they provide? Will they walk you through your transactions?
  • Do they have platforms specifically for beginners?
  • Are they legit? Do your research before handing over your money to make sure you are using a reputable trading platform and that payment methods will be secure.

Finding the right broker can mean the difference between success and failure in options trading.

Securing Approval for Options Trading

Opening a brokerage account doesn't mean you can start trading options. You still need approval before you can even start coming up with a strategy. Brokerage firms rate their clients on a scale.

The typical scale runs 1 to 5. But some places, like Charles Schwab, work on their own scale. In general, the scales go from low to high in this method:

  • Covered calls
  • Buy calls and puts
  • Spreads
  • Uncovered calls/puts

Each level is cumulative. If you are rated at Level 2, you can also trade whatever Level 1 can trade. The higher you move on the scale, the more you can trade.

Your approved level depends on a variety of factors:

  • Financial objectives: Are you trying to grow your income or maintain your capital?

  • Experience in the market: Are you a seasoned trader? What types of securities have you bought/sold? Have you ever bought/sold options before? How many trades do you make per year?

  • Risk tolerance: Do you have solid employment? Are you risking all of your capital or just a fraction of it? Brokers may even ask about your annual income and total net worth. They need a solid idea of the risks you are willing to take.

This information helps brokers decide which option trading level suits you. Each trading level allows a specific type of options trades. However, the allowed trades at each level could vary by broker. Ask your broker for a list of each level so you can see where you stand.

How Do Options Work?

Defining the Options Terms

Before you exercise your right to trade options, you should become familiar with the basics.

Essentially, you want to know the two most basic option trades. They are the call and put.

You should also know that one contract equals 100 shares of the underlying stock. If you buy one call contract, you buy the right to buy 100 shares of that stock. If you buy five contracts, you have the right to buy 500 shares of the underlying stock.

You'll see the price of the contracts as a premium. For example, a $3 premium means $3 x 100 shares or $300.

Call Options Definition

A call is when an investor buys the 'right' to buy a stock at a specific price. This price is the strike price. If the stock's market value never passes the strike price, the contract expires and is worthless to traders. If you're the one who sold the contract - if you're the "writer" - you can make a profit from the premium. You benefit from this situation because you don't have to sell the stock, however, you made a small profit by collecting premium. If you're the buyer, you paid the seller that premium. His gain is your loss.

  • Holder: The person who buys the contract is the holder. You may also hear the holder called the investor or buyer. He risks the premium paid to buy the option.

  • Writer: The person who sells the contract is the writer. You may also hear the writer called the seller. He takes much higher risks than the buyer does. He stands to lose a lot more than just the premium paid. He could be on the hook for the market price of the underlying securities of the option sold.

If, however, the stock's market price exceeds the strike price, the buyer can exercise the right to call. The holder can then buy the stock at the strike price. Since the writer holds the stock, he simply sells it at the strike price. The writer loses the ability to make a profit based on today's market value.

Calls can be covered or uncovered (naked). Here's the basics:

  • Covered calls: This option signifies that the writer (seller) owns the stocks in the options contract. If you exercise your right, the seller has the stocks to sell. He is 'covered' if the transaction occurs. His risks are minimal.

  • Uncovered call: This type of option means the seller doesn't hold the stock. If you exercise your right to buy it, the seller must first buy the stock at the market price. Since the strike price is lower than the current market price of the securities, this usually results in a loss. How much the seller loses depends on the scenario.

Uncovered Call Example:
You buy the right to buy a stock with an uncovered call. The premium is $3 per share. Options are sold in 100-share increments. You pay $300. The strike price is $35 and the current market price is $30. It's a 3-month option.

After 2 months, the stock's market price hits $40. You exercise your right to buy the stock at $35 ($35 x 100 = $3,500). The writer must now buy 100 shares of the stock at $40 per share ($40 x 100 = $4,000). He must then immediately sell it to you for $35 per share ($35 x 100 = $3,500).

As a buyer, you make a profit of $200: $4,000 - $3,500 - $300 (premium paid) = $200 profit

The seller loses $200: $4,000 (paid) - $3,500 (made) + $300 premium = $200 loss

Note: These examples are provided without commissions. You'll have to take these fees into consideration, though. Different brokerages charge different fees. It's common to find a flat commission fee, plus a per contract fee. You may pay this fee for every leg of the contract. For example, you pay a commission fee to buy a call and 'open the position.' If you decide to exercise your right to buy, you'll pay the fee again when you 'close the position.'

Put Options Definition

A put gives you the right to sell a stock at a specific price. Again, the price is the strike price. If the market price of the stock never drops below the strike price, the contract expires worthless. If you buy a put, you buy the "right" to sell the stock. You don't have to sell it. Again, your risks are limited to the premium paid for the option.

You can buy a put on a stock you hold in your portfolio. This is a great strategy to help you hedge against potential loss. Since you own the stock, you are susceptible to the market's performance. If it drops suddenly, you stand to lose money. With a put strategy, though, you protect that loss by reserving the right to sell at the higher strike price of the purchased option.

You can also buy a put on a stock you don't own. If you exercise the right to sell it, your broker will buy the stock at the market price. He will then immediately sell it at the strike price. This is a riskier strategy, but may be more profitable in the end.

If you sell a put, you must buy 100 shares of said stock at the strike price. This only occurs if the buyer of the put exercises his right. In the meantime, you keep the premium paid until expiration. If the buyer never exercises his right, you make the premium and walk away, never trading any securities. If the buyer does exercise his right, you must buy 100 shares of the stock at the strike price.

Buying a Put Example:
When you buy a put, you buy the right to sell a stock. You may not even own the stock. If you do own it, you use the protective strategy. If you don't own it, you buy the right to make a profit without putting up a large initial investment for the securities.

Let's say you buy a put at a strike price of $50. You pay a $3 premium. It costs you $300 right away. You now have the right to sell the stock at $50. You have a 6-month expiration.

In 4 months, the stock drops to $40 per share. You exercise your right to sell it at $50. Your broker buys the stock at $40 per share, or $4,000. He then exercises your right to sell it at $50, making $5,000. Your profit then equals:

$5,000 (profit from selling) - $4,000 (cost to buy the shares) - $300 (premium paid) = $700 net profit

How to Invest in Options

How to Conduct a Trade

You'll have one of two positions when you trade options. You either enter a trade or exit a trade.

Viewing Available Options: You can view a detailed listing of the available options on FINRA. You can choose an individual stock as well as specific option expiration date to get pricing, volume, and historical information on an option.

Entering a trade means you start the process. You "open" the trade up for possibilities. In trading terms, you'll hear traders say that they "buy to open" or "sell to open." If you are the buyer of a call, you enter a buy to open transaction. If you write the call option (you'll sell the stock), you enter a sell to open transaction.

The exact opposite occurs when you exercise your call option's right. You now want to close the transaction. As the buyer of a call option, you'll now "sell to close." If you were the writer or seller of a call, you'll want to "buy to close." Basically, either transaction ends the contract.

Here's an easy way to understand the basics:

  • If you are the buyer of a call, you want to buy to start the process. You buy the right. When you want to exercise your right, you sell to stop the process. So you buy a contract. When you execute the contract, you sell your right. The contract is then complete.

  • If you are the seller (or writer) of a call, you want to sell to start the process. You sell the right to buy the stock. After the buyer exercises the right to buy the stock, you end the buyer's rights. Your position now ends.

Types of Options

The majority of options traded on the market are index or individual security options. The options predict either how a major index, like the S&P 500 will do or how a specific underlying stock will perform. These are the basic trades.

However, it's also possible to trade ETF and forex options. ETFs track a specific market segment, for example, diamonds. If you have an interest in the diamonds market, you could trade ETF options in this market segment. You can also diversify your risks and buy options on the forex market.

Put Your Predictors' Cap On

Once you understand the basics of options trading, it's time to make decisions. It starts with predicting a stock's direction.

There are three core elements you should consider.

  1. What do you think the stock will do?

    You must determine if you think the stock will go up or down. This will help determine the right strategy for options trading.

    • If you predict the stock price will increase, you'll buy a call. This gives you the right (not the obligation) to buy the stock at the strike price. Once the stock's market price exceeds your strike price, you are in the money. You'll buy the stock at the lower strike price and sell it at the higher market price. You profit is the difference minus any commissions paid.

    • If you predict the stock price will decrease, you'll buy a put. This gives you the right (not the obligation) to sell the stock at the strike price. Once the stock's market price is below your strike price, you are in the money. You could buy the stock at the lower market price and then sell it at the higher strike price. The difference minus commission paid is your profit.

    • If the stock's market price doesn't move like you thought, the option could expire "out of the money." If you bought a call and the stock's market price didn't exceed the strike price at expiration, it's out of the money. If you bought a put and the stock's market price exceeds the strike price, it's out of the money. These are the major risks involved with buying options.

  2. How much do you think the stock price will change?

    This will help you determine the right strike price.

    Choosing the right strike price isn't as overwhelming as it seems. The strike prices are standardized. You'll see a variety of available strike prices, but they will always be in specific increments. The typical increments include $1, $5, and $10. Occasionally, you may also see $2.50 increments. This takes some of the pressure off of you. The standardized increments take a little guesswork out of the process.

    • A call is "in the money" when the market price is higher than the call's strike price.

    • A put is "in the money" when the market price is lower than the put's strike price.

  3. How long do you think it will take the stock's price to move?

    This is where looking at the stock's historical patterns pays off. Knowing the stock's history can give you an idea of when/if you think the stock's price will change.

    • You can only choose from the available expiration dates. But, you can generically determine how long you think a stock will take to change.

    • If you think a stock will change in the short-term, you could consider a monthly expiration, whether 1, 3, or 6 months.

    • If you think a stock will take longer to change, you could consider a yearly expiration.

Technical Analysis

Predicting an option's future requires a bit of technical analysis. You'll want to understand the following:

  • Support levels: This is the stock's common "low point." Relying on the stock to go below this point could be risky.

  • Resistance levels: This is the stock's common "high point." Relying on the stock to go above this point could be risky.

  • Volume: As you track the stock's history, you'll want to look at the volume behind it. The more shares traded at a particular price, the more likely it's a trend. Relying on low volumes could lead you in the wrong direction.

You can learn these levels by reading the stock's chart patterns. Look at its history, focusing on specific patterns. Your brokerage firm should help you learn these factors and more, especially as a new options trader.

Focusing on these factors will help you determine if you should buy/sell a put or call; the strike price; and the expiration date.

For example, if you think stock prices are going to increase, you want to buy a call. This gives you the right to buy the stock of the underlying securities at the strike price. This should be below the market value. You would then make a profit.

On the other hand, if you think stock prices might fall, you'd buy a put. This gives you a contract to sell the stock at a higher price than the market value.

Predicting the increase/decrease requires research and knowledge, though. This is where the right broker comes in handy. They'll provide you with the research you need to decide. What did the stock do historically? What are the general feelings towards the stock today? You'll also want to understand the stock's implied volatility. Your broker can help you understand the risks involved.

Implied volatility: This volatility, while a bit hypothetical, affects options pricing. The more volatile a stock is, the higher the premium. A higher volatility means the stock has a higher likelihood of changing, whether up or down.

Finally, you'll need to choose an expiration date. The further out the expiration date, the greater the time value of the option. In other words, the longer the stock has to increase or decrease, depending on what you're hoping for to make a profit. Remember, the longer the expiration, the greater the premium.

The Final Word

Trading options can be a profitable investment for traders, but you must know what you are doing. If you are just starting out, use a supportive brokerage firm. Take advantage of the tools they offer and do your research. Options can help you hedge against loss. But they can also cause serious losses if you aren't careful.

We encourage you to balance your portfolio with a variety of investments. This helps you minimize your losses while investing.

Disclaimer: Opinions expressed here are those of the author's alone. Please support CreditDonkey on our mission to help you make savvy financial decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

More Articles in Money Tips

Next Page:

Options Trading

Covered Call

Making an extra premium while you wait for a stock to increase sounds like a dream come true. That's what a covered call does for you. It's not an exact science. There are no guaranteed profits. There are also no limits to your losses. It can be ...

Leave a comment about How to Trade Options?

Name
Email (won't be published)


Best Options Broker

The best options broker offers great service, low prices, and a user-friendly trading platform. Find the top options brokers to consider.
More Articles in Money Tips







About CreditDonkey®
CreditDonkey is a stock broker comparison website. We publish data-driven analysis to help you save money & make savvy financial decisions.

Editorial Note: Any opinions, analyses, reviews or recommendations expressed on this page are those of the author's alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.

†Advertiser Disclosure: Many of the card offers that appear on this site are from companies from which CreditDonkey receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). CreditDonkey does not include all companies or all offers that may be available in the marketplace.

*See the card issuer's online application for details about terms and conditions. Reasonable efforts are made to maintain accurate information. However, all information is presented without warranty. When you click on the "Apply Now" button you can review the terms and conditions on the card issuer's website.

CreditDonkey does not know your individual circumstances and provides information for general educational purposes only. CreditDonkey is not a substitute for, and should not be used as, professional legal, credit or financial advice. You should consult your own professional advisors for such advice.