For every novice trader, the option markets can be an intimidating place. Options are complicated, and it’s easy to get lost in the weeds of what options do and don’t trade on paper versus which types of assets they’re paired with. This article is meant for new traders who want a clearer understanding of how trading options works so that you can make educated decisions about whether or not these investments are right for your portfolio.,
Options trading is a complicated topic. However, it’s not impossible to learn the basics of options trading. Options are contracts that give you the right to buy or sell an asset at a specific price before a certain date.
With the development of zero-commission brokerage companies like Robinhood, options trading has become a popular hobby among retail traders.
However, although these products frequently provide a better reward-to-risk ratio than trading the underlying asset directly, numerous factors may work against traders, including time, fluctuations in the instrument’s implied volatility, and liquidity.
In this essay, I’ll try to explain the most fundamental principles concerning options, such as what they are, how they function, which techniques are most often utilized when trading these instruments, and how you may get started trading these products.
What Are Your Alternatives?
A contract between a seller (typically referred to as the writer) and a buyer is known as an option (commonly known as the holder). An options contract tracks the price of an underlying item, such as a stock, commodity, or cryptocurrency.
These contracts provide the holder the option to purchase (call) or sell (put) a certain number of units of the underlying asset they track after the contract expires, rather than the obligation to do so. The Options Clearing Corporation (OCC) is the body in responsibility of issuing, standardizing, and ensuring the execution of these contracts in the United States.
Option contracts are divided into two categories. The American-style contract may be executed at any moment throughout the contract’s lifespan, but European-style contracts can only be exercised on the contract’s expiry date.
The price of options may be influenced by a number of factors, including the following:
- The underlying asset’s price
- Price of a strike
- Date of expiration
- Greeks (delta, gamma, vega, theta, rho) are risk factors for options.
- Volatility implied
Option contracts provide the buyer the right — but not the responsibility — to purchase (for calls) or sell (for puts) the underlying asset at a certain price on or before a certain date.
Optional Calls
A call option offers the holder the right, but not the duty, to purchase a certain number of units of the underlying asset — usually 100 in the case of stocks.
A holder of an 09/17 AAPL $170 call option, for example, has the right to purchase 100 shares of Apple Inc. once the contract reaches its maturity date, or prior in the case of American-style options.
However, if the underlying asset’s price is less than the total of the price plus the premium paid for the shares, the contract is usually worthless, and the buyer has no motivation to exercise his or her right.
Put Alternatives
A put option allows the holder the right, but not the responsibility, to sell a certain number of units of the underlying asset — usually 100 in the case of stocks.
A holder of an 09/17 AAPL $170 put option, for example, has the right to sell 100 Apple Inc. shares once the contract reaches its maturity date, or prior in the case of American-style options.
If the underlying asset’s price is less than the price less the premium paid for the option, the holder will have no motivation to exercise his or her right.
How to Invest in Options
Due to the enormous number of factors that may impact their price and the significant danger of losing money if appropriate tactics are not used, options are often regarded too advanced for traders who are just starting started in the investment industry.
If you think you’re ready to take your first steps into the exciting world of options trading, here’s a step-by-step tutorial to get you started.
Step 1: Open a trading account for options.
In the United States, most brokerage companies now provide access to the options markets. Due to rising competition, these providers have been gradually lowering the charges they charge for trading these securities.
Notably, Robinhood is the cheapest platform for trading options since it does not collect any fees or commissions for doing so. Other suppliers, on the other hand, often charge a flat cost per contract each transaction.
Traders who register an account with a US-based brokerage company will often have access to basic options trading tactics, sometimes known as Level 1 Options. Most providers may want more information regarding the trader’s history, understanding of how options operate, and past trading experience for more complicated techniques like vertical puts, straddles, and strangles – often referred to as Level 2 Options.
Furthermore, when using Level 2 options techniques, a minimum account balance is sometimes needed.
Step 2: Decide the options you want to trade.
You may now trade any options available utilizing Level 1 or Level 2 techniques after you’ve registered an account with a brokerage company.
By examining the security’s options chain, you may quickly determine which options are available for each of the instruments listed on your broker’s platform. These chains generally contain all of the options available by expiry date, as well as a list of all available strike prices for both calls and puts.
Some of the most frequent options trading methods are as follows:
Long Call
Buying a call option contract with a certain strike price and expiry date is referred to be a long call option strategy. If the price of the underlying asset is greater than the sum of the strike price plus the premium paid by the expiry date, these contracts profit.
With a long call option, the potential profit is infinite, but the maximum loss is restricted to the premium paid to acquire the contract. If the trader feels the price of the underlying asset will climb, he or she should use a long call strategy.
Long Put
Buying a put option contract with a certain strike price and expiry date is referred to be a long put option strategy. If the price of the underlying asset is lower than the result of subtracting the premium paid from the strike price after the expiry date has passed, these contracts benefit.
With a long put option, the potential profit is infinite, but the maximum loss is restricted to the premium paid to acquire the contract. If the trader feels the price of the underlying asset will fall, he or she should use a long put strategy.
Protected Call
A covered call is when a trader writes (sells) an options contract utilizing an open position on a certain asset. To write a covered call on a stock, a trader must own at least 100 shares. As long as the underlying asset’s price expires below the option’s strike price, this method may create passive income for the owner.
If the price of the underlying asset increases over that level, the contract holder may exercise his option, and the writer will be required to give up his collateral and forfeit the further profits. The maximum profit is restricted to the premium earned for writing the covered call, but the potential loss is infinite, though not necessarily significant, since the options seller would only lose out on the profits he would have achieved if he had retained the underlying asset.
Investors utilize options to make money through generating capital gains, speculating, reducing market risk, and generating income.
Equity Anticipation Securities (Long-Term) (LEAPS)
Contracts with an expiry date of more than nine months are termed LEAPS options, while the precise time necessary for a contract to be designated a LEAPS varies from one author to the next.
A LEAPS strategy is essentially the options counterpart of a buy-and-hold strategy. Because they have a long expiry date, they allow the underlying asset more time to increase (call) or fall (put) as planned.
Due to the high implied volatility ascribed to the contract, LEAPS tend to trade at large premiums since the future is very unpredictable. As a consequence, for a LEAPS approach to be lucrative, the price must generally climb or fall considerably.
The advantage of LEAPS is that they may produce bigger returns than purchasing and holding the underlying asset directly if the trader’s directional price prediction is true.
With a LEAPS contract, the maximum profit is infinite, while the maximum loss is the premium paid for the contract.
Step 3: Determine the strike price and the expiration date.
Now that you’ve learned about the most frequent options trading tactics, it’s time to decide which contracts you’ll be working with. You must choose a strike price and an expiry date for this.
Because of their cheaper cost, most traders will choose out-of-the-money (OTM) options. Options with strike prices above the market price (calls) or below the market price (puts) are known as out-of-the-money options (puts).
The risk of the contract expiring worthless is increased since the price of the underlying asset must move considerably for these options to be in-the-money (ITM). Furthermore, when the underlying asset’s price is volatile, the option’s price will be impacted by this aberrant price movement, and sellers may demand a greater premium, thereby reducing the probability of making a profit.
Finally, a trader must choose the options contract’s expiry date. Out-of-the-money options will see their price decline as the expiry date approaches, therefore the notion of time decay is significant at this stage. As a result, traders should choose an expiry date that provides ample time for the underlying asset to perform as planned.
In most circumstances, an expiry period 45 to 60 days from the time the option is purchased is flexible enough to allow the underlying asset to move in accordance with the trader’s estimate.
Step 4: Create a Trading Strategy
By their very nature, options are very volatile instruments. A position may be harmed by changes in the many factors that impact its price, such as the instrument’s implied volatility, Greeks, and time decay.
As a result, before initiating a position, options traders should have a strategy in place that includes a maximum loss, an exit price for the underlying asset at which they would end their position, and a maximum holding duration. They will be spared the losses caused by rapid time decay as a consequence of this.
Pro Tip: Options vary from stocks in that they have an expiry date and an exercise price; however, options do not have shareholder rights and do not pay dividends. In addition, options are merely a fraction of the cost of the underlying asset in general.
Terminology Used in Options Trading
You may have come across certain terminology that you are unfamiliar with since they were only spoken in the context of options trading. If you’re going to be navigating the complicated world of derivatives, here’s a glossary of terms you should be familiar with.
In-the-Money
Call options with a strike price below the market price and put options with a strike price above the market price are referred to as “in-the-money” or ITM. ITM options’ value should rise as their expiry date approaches, approaching the contract’s intrinsic value, which is the difference between the strike price and the market price of the underlying asset.
Consider buying a call option on Zoom Video Communications (NASDAQ: ZM) with a strike price of $280, while the current market price is $282. This option contract is in the money, and its intrinsic value should approach $2 ($282 – $280) as the expiry date approaches.
Also, the closer an option’s price gets to its intrinsic value, the deeper it is in-the-money, which means the strike price is much lower than the market price.
Out-of-the-Money
Call options with a strike price above the market price and put options with a strike price below the market price are referred to as “out-the-money” or OTM. The value of OTM options should decrease as their expiry date approaches.
Assume you’ve purchased a call option on Ford (NYSE: F) with a $14 strike price and the current market price is $12. This option contract is out-of-the-money, and its intrinsic value should be approaching zero as the expiry date approaches.
Furthermore, the farther an option is out-of-the-money, meaning the strike price is higher than the market price, the closer its price will be to zero.
At-the-Money
The term “at-the-money,” or ATM, refers to call or put options with a strike price that is identical to the market price. The value of ATM options should decrease as their expiry date approaches.
Assume you’ve purchased a call option on Uber Technologies (NYSE: UBER) with a strike price of $39, and the current market price is $39. This contract is at-the-money, and its intrinsic value should decrease as the expiry date approaches.
After-the-money options are not beneficial for purchasers since they will be worthless at expiry, resulting in the loss of the premium paid on the contract. Meanwhile, ATM options remain advantageous for sellers since they will retain the premium they earned from drafting the contract.
Premiums
A premium is the cost of purchasing an option contract. The minimum number of options contracts that may be purchased per transaction is 100, and premiums are stated per contract. As a result, if the premium for a certain option is $0.05, the buyer will have to invest $5 ($0.05 * 100 contracts) to acquire a position.
The Black-Scholes Model is a formula that is often used to compute option premiums. To price various contracts, this method takes into account a number of factors, including the implied volatility of the option, the market price of the underlying asset, the strike price of the option, the time until the expiry date, and the risk-free interest rate.
Spreads
Options, like stocks, have bid/ask spreads that are determined by their liquidity. The spreads on the most liquid options are narrow, while the spreads on less liquid contracts are greater.
Low liquidity is bad for options traders since it may lead to losses if a holder is unable to terminate her position at the price she wants because there aren’t enough buyers.
The Greeks are a people that have a long history
The letters of the Greek alphabet are used in options to demonstrate how various factors might impact the price of an options contract. Here are a few of the most popular:
- Delta: Indicates how much the contract’s price will move for every $1 change in the underlying asset’s price.
- Gamma: Indicates how much Delta will vary for every $1 change in the underlying asset’s price.
- Theta: Indicates how much the contract’s price will fall or rise (depending on whether the option is ITM or OTM) with each passing day.
- Vega: Indicates how an option’s price will respond to an one point change in the contract’s implied volatility.
Date of Expiration
The date on which the buyer may exercise his or her right to purchase (call) or sell (put) the underlying asset at the strike price is the expiry date of an options contract.
Price of a Strike
For American-style options, the striking price is the price at which the buyer will be able to purchase (call) or sell (put) the underlying asset at the expiry date or before.
Options Trading’s Advantages (Pros)
- If the option expires in the money, the gains are bigger than if you traded the underlying asset directly.
- Options are usually less expensive than purchasing the underlying asset outright.
- The selling of covered calls may provide a shareholder with a steady stream of revenue.
- Hedging may be accomplished via the use of options. This implies that an investor may buy put options to protect himself from potential losses if the price of the underlying asset falls.
- Traders with a limited account balance may leverage their bets without borrowing money by using options.
- An options trade’s maximum loss is usually restricted to the premium paid.
Option Trading’s Drawbacks (Cons)
- Options are a kind of financial instrument that is difficult to understand. Traders may not know the degree of the risk they are taking unless they completely grasp how options operate since they are priced using a sophisticated formula that is impacted by changes in various variables.
- Options prices may swing dramatically in a short amount of time.
- Certain options tactics, such as naked put sales, might result in limitless losses.
How to Trade Options: Frequently Asked Questions (FAQs)
The following are some of the most often asked questions on how to trade options that we get.
Investors trade options for a variety of reasons.
Options may be used to speculate on the direction in which the price of an underlying asset will move in a short period of time, and they can increase the profits generated by the operation when compared to owning the asset directly.
They may, on the other hand, be used for hedging (by purchasing put options) or for creating passive income (covered calls).
How Do You Make Money Trading Options?
The majority of the tactics used to earn money with options need a thorough understanding of how they are valued, as well as technical analysis abilities.
Stockholders, on the other hand, may easily profit from options by selling covered calls. However, if the contracts they sold expire in the money, they may be forced to sell their assets.
Is it possible to trade options on ETFs?
Yes. Although not all exchange-traded funds (ETFs) include options, there are several.
What Is Binary Options Trading and How Does It Work?
A binary option is a form of option in which the trader must estimate the direction in which the price of the underlying asset will move in a relatively short period of time. Despite the fact that these options are legal and accessible to traders in the United States, they are deemed riskier than standard options and are more akin to putting a casino wager.
Last Thoughts
Do you believe you’re ready to start trading options now that you know what they are, how they function, and how to trade them?
If you are, make sure you only trade with money you can afford to lose, and study more about the complexities of these sophisticated financial instruments before you begin to enhance your chances of success.
The “how to make an option trade” is a guide on how to trade options. Options are contracts that give the buyer the right, but not the obligation, to buy or sell an asset at a specific price by a certain date.
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