This guide to options trading for beginners to help you understand what options trading is and better familiarize yourself with the terminology. We’ll cover all the basics you need to get started—from selecting an options brokerage to predicting the market’s movements.
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To get started with options, you’ll need to familiarize yourself with the terminology and trading tactics in this new world. When exploring options trading, you'll likely come to realize that it's a different, yet higher risk, beast than trading stocks.
However, options trading is a great way to diversify your investments once you figure out how everything works.
Whether you’re a new investor or refreshing your knowledge, you should learn some of the advanced strategies involved in trading options to maximize your profits and minimize your risks.
What Is Options Trading?
Options are a contract that allows you to buy and sell financial or other assets. Some of these assets include gold, stocks, exchange-traded funds (ETFs), and other investments. Every contract consists of a pre-negotiated price and a validity period.
When diving into this investment, you’ll need to understand some of these options trading terms to prevent yourself from confusion:
- Expiration. Time and date when the contract ends, at which point you will no longer be able to buy or sell.
- Premium. An option's purchase or sale price
- Strike price. An option contract's pre-negotiated price for the security when it is purchased or sold.
Options trading is when you trade options. You can trade these the same way you would with bonds and stocks. However, you'll notice that these trades call for different strategies.
Puts vs. Calls
When it comes to options trading, there are varieties that you might want to know about—puts and calls.
With call options, you have the right to buy a security at a pre-determined (exercise) price within a timespan. However, you're not obligated to make this purchase.
Call options are a fantastic option for short sellers because when an option is naked (not owned), it'll potentially give you a short position. Moreover, you also have the potential for long positions.
Conversely, a put option gives the buyer the same rights, except to sell a security at the exercise price or specific time.
Put options are great because you could limit your risk and cost-effectively. Also, you'll find yourself in a long position when you sell a naked put option.
Whatever weaknesses call or put options have, the opposite makes up for with their advantages.
Unfortunately, both call and put options suffer from similar weaknesses, price stability. You'll lose your premium on both the call and the put options.
Why Use Options
Options give you as an investor the following benefits:
- Potential to deliver higher percentage returns
- Greater cost-efficiency
- Less risk than equities
Hedging and speculation are usually the best use cases for trading options.
Hedging options reduce investment risks without breaking the bank. Using options as a hedge serves as a type of insurance and protects your investments from potential downturns.
When using technical and fundamental analysis, speculators might find options advantageous and have less risk due to some call options costing less than regular stocks.
How to Trade Options in Four Steps
While it might sound challenging to begin trading options, it’s not that bad. Like trading stocks, you’ll need to find a broker and figure out what investments are the best bang for your buck.
You’ll also need to predict your option’s strike price and what time frame you should target.
Open an Options Trading Account
Unlike establishing a brokerage account for stocks, you might find that setting up an account with an options brokerage could prove a lot more complicated. For instance, opening an options trading account calls for more initial investment capital.
Brokerage firms will screen you as an investor to better understand your risks, trading experience, and financial preparedness.
Here’s a list of what the Securities and Exchange Commission (SEC) says you’ll need before signing up for an options trading account:
- Financial information. Ensure you have information like your employment information, total liquid and net worth, and annual income.
- Objectives. Your goals for speculation, income, how you'll handle risk management, and growth.
- Desired options. Make a list of the options you want to trade. Whether they're puts or calls, covered—investors who own the asset—or naked.
- Trading experience. How many years you’ve traded stocks and options, the number of trades, and the size of each trade.
- Your knowledge about investing. Prove to them that you know how to invest.
Once you give the brokerage this information, they'll assign you a level based on your risk (one through five). One's the least risk. Whereas five is the highest. The grade will state how high of a risk you are as a trader.
The trading level the brokerage gives you will determine what options you can trade.
Pick What Options to Buy or Sell
We mentioned earlier that there are a couple of options to choose from when choosing options: call and put options.
Your choice of options will determine where you think they'll move:
- Price will decrease. Invest in a put and sell your call option.
- Price will increase. Get yourself a call and sell your put option.
- Market stability. Sell your call or put option.
Predict the Options Strike Price
For a profitable options trade, you'll need to ensure that the option's in-the-money as the expiration date approaches—under or above the strike price.
If you purchased a put option, the in-the-money price should remain under the strike. If you're familiar with stocks, you can think about staying in the money-for-put options like shorting stocks.
If you believe a price of an asset would fall under $50, you'll want to invest at a strike price above $50 to remain profitable.
With call options, it's ideal for you to find the price that exceeds the strike price. For example, you find an asset priced at $20, and based on your analysis, you think it'll rise to $40 later on. Therefore, you'd want to find a strike price that's less than $40.
Unfortunately, we can't choose whatever strike price we want.
Within options trading, there are standardized pricing increments throughout its industry. These are otherwise known as option quotes, matrix, or option chains.
Option quote values could range from various numbers and are determined by the asset's price.
When it comes to paying for an option, the prices (or premiums) you buy an option for have a couple of components:
- Time value. It contains several elements—for instance, the asset's volatility, the time before the contract expiration, interest, and more.
- Intrinsic value. The gap between share and strike price if an asset is over the strike price. For example, if you have an $80 call option and a $100 strike price, the intrinsic value is $20.
While intrinsic value's more straightforward, time value has more to take into consideration. If you used the intrinsic value that we mentioned and have an option premium of $15, the time value will be $10.
Decide the Option Time Frame
Each option contract comes with an expiration date that specifies the latest time you can put the option into effect. It is impossible to choose a date at random: you must choose from those offered by an option chain.
When it comes to picking options, you’ll have only a couple of styles available:
- American. It's possible to exercise these options up until their expiration date.
- European. It is only possible to exercise European options on their expiration date. Many options on stock indexes are of the European.
Option contract expiration dates have various ranges. Some don’t come for months—others for years.
Some increments go by day and week. However, we recommend that only experienced options traders use them.
If you're a long-term options trader, monthly and annual expiration dates are the best route for you. While they're more expensive, these dates give your investment more time to move.
Moreover, long-term expirations help preserve the time value of an option even when the assets trade under the strike price.
However, as an option's expiration date approaches, its time value declines. Because of this, your investment could fall under its strike price.
hat was options trading for beginners. After reading, you should better understand some of the terminologies in options trading, what types you have available, and how to start trading.
Although you do not receive any ownership rights with some options, there are definite advantages to having an option contract over other investment vehicles.
To succeed in this market, you need to predict share prices to make a profit. Because of this, you’ll need to perform a lot of research, which is a skill that’ll improve over time.
As you dive deeper into options trading, shop for the right brokerage firm, and develop a strategy, you'll find this means of income diversification as an excellent addition to your portfolio.
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