Trading in Options: A Guide for Beginning Investors

Joseph Meyer
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How to Trade in Options

The thought of losing more than you own may tempt many people to stick to investments they can hold onto the stock. But without some risk adjusted investment, their portfolios will not grow significantly in value in the long term. In this article, we explore a safe way to increase or decrease your investment in a stock while limiting potential losses.

Trading in options means that you have the right, but not the obligation, to buy or sell a stock at a specific price within a specific time frame. With this contract, you can gain leverage on a stock instead of buying it outright. If your bet goes south, you can always exit the contract for a small loss. Keep in mind, however, that this tool works best in a bull market. When the market becomes volatile, trading in options can also be risky.

What Is an Option?

An option is a type of financial security. In other words, an option is an agreement between the buyer and the seller of a certain amount of stock. The buyer pays the seller for the right to purchase or sell a certain quantity of the stock at a fixed price (the strike price) anytime before an expiration date that is pre-specified.

This is what’s known as “call” and “put” options. A put option is the right to sell a stock at a pre-specified price, while a call option is the right to buy a stock at a pre-specified price. A call option has an infinite strike price, or price of the stock, so the call buyer either exercises his or her option or lets it expire, which is known as an option owner’s “open option.” A put option has a finite strike price, meaning it has a maximum price you can buy the stock at before the option expires, so the put option owner has to exercise their right to purchase or sell the stock before it’s too late.

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The Two Types of Options

When you trade in options, you are either going long or short. The distinction between long and short depends on how you use options.

If you purchase a call option, you are going long. All you are doing is paying a premium to purchase the option. You aren’t obliged to exercise the option (you just pay for the option to buy the stock). But if the price of the stock increases, you can exercise the option and buy it for the agreed upon price. You can then sell the stock at a higher price and make profit.

If you sell a call option, you are going short. You are basically selling a contract that gives the buyer the right to purchase the stock from you. If the option expires worthless, you will lose the entire premium you’ve received, but no more. If the price of the stock increases, the buyer will exercise the option and you will be required to sell the stock at the agreed upon price.

If you sell a put option, you are going short. You are selling an option that gives the buyer the right to sell you the stock at a particular price. If the price of the stock decreases, the put option will be exercised and the buyer will sell the stock to you at the agreed upon price.

The Language of Options

An option is a financial derivative that allows the buyer to leverage a stock by gaining rights to buy (a CALL option) or sell (a PUT option) at a specified price. When you trade stock options, you must specify the assets, the strike price, the expiration date, and the price you pay for an option. The asset can be any major stock, index, commodity, or currency, but it cannot be bonds or futures contracts.

Strike price is the agreed upon price for which the contract holder may exercise the rights.

The expiration date is the deadline by which the holder of the contract must exercise the rights, or the contract expires. Most stock options expire in January, April, July, and October.

The last component is the price you pay, also called the premium. The price you pay is higher or lower depending on the stock price, the date of expiration, and how much time the option has before expiration.

And that’s it, the four basic components of an option. If any of these is changed, the contract is no longer valid and it ceases to exist.

Strike Price

The strike price is the price at which the underlying stock is expected to be traded at the time of the option’s expiration. The strike price is never part of the option’s price as seen on a financial sheet or quote. When analyzing strike prices, always remember that the higher the strike price, the more expensive an option will be. Strike prices will always be less than the stock price of the underlying stock.

When you are looking at an option quote two things will be listed: the intrinsic value (IV) and extrinsic or time value. The intrinsic value will be the same depending on the strike price paid if the option is a Call or a Put. The extrinsic value will be greater the further out the expiration date is as a result of the time value associated with the option (e.g. the chances of the stock being priced at the strike price by the option’s expiration rises with time). The extrinsic value will be listed as a percentage of the total option’s price. An option will never be worth less than its intrinsic value.

Exercising

The right to buy a stock for a fixed price is called a call option. When you exercise a call option, you the option buyer are buying (or going long) the stock at the fixed price. Buying a call option that’s "in the money" means that you the option buyer have the right to buy the stock at a price that is less than the current stock price. "Out of the money" option means the fixed price is higher than the stock price. It pays to check the option pricing.

There are two types of call options when covered call and cash covered call are concerned. The "cash covered call" or the "short call" is the types of call option when you buy the call option and sell the stock at the fixed price.

Expiration Date

Options are famous for their ability to increase the profit potential of a given trade. However, many traders don’t consider the expiration date which could effectively reduce your expected profit or turn you into a loser.

The ability to create options spreads that expire at different times allows you to isolate the risk of one strategy while taking advantage of another.

When an investor buys an option, she is exposed to all of the risk that comes with the position. The longer an option is allowing you to take advantage of the trade, the more risk is involved.

For example, the holder of a PUT option may see the price of the underlying stock fall. However, if the PUT option expires without the stock actually falling, the option holder will lose his entire investment … and maybe more. While this is a worst-case scenario, it is an important point to consider before buying long-term options.

Ask any options professional and he will tell you to avoid long-term options.

In addition to the point above, long-term options must be watched more closely to avoid having an unfavorable price move against you. The price of the option changes as each day passes, and each day you must review the price movement of every option that you are holding.

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At, In, or Out of the Money

An option’s price is determined by three things: – The price of the underlying stock

  • The time remaining until expiration
  • The volatility of the underlying stock

If you are bullish, you will likely trade a LEAP when the underlying stock will be trading above the option strike price. If you are bearish, you will probably want to sell an option when the underlying stock will be trading below the strike price.

Comparison of the option prices based on these three factors results in a graph shaped something like a bell curve (one look and you can tell I was a statistics major). Now, from a fundamental perspective, there are other factors that affect the pricing of an option; but, for the purpose of this discussion, it is important for you to understand that the main focus should be on the time remaining until expiration and, to a lesser extent, the underlying stock price.

Kinds of Value

Options are financial instruments which give the holder the right, but not the obligation, to buy or sell a fixed amount of a particular asset at a pre-agreed price on or before a certain date.

Options can be found in many varied forms and are based on a wide variety of underlying assets. These underlying assets can be from foreign exchange to commodities, equities, and precious metals. Options can also be created for phenomena such as interest rates and weather reports. It is the one of the most exciting investments you can make.

Writers and Assignments

The writers and the assignments have a number of features in common. For example, they may be either written or assigned. Another common feature between the two is that the number of writers and assignments can be very large.

The Differences between Writer and Assignment

The main difference is that, assignments are typically given on behalf of a third party hiring a professional to complete the task whereas a writer completes assignments for his/her own benefit.

Although it is somewhat true that assignments can be done for the benefit of the writer but this is not always the case. Other differences between the two include whether the assignments and the writers are always original and whether they are both students.

For example, the writer might be copying someone else’s work and the assignment might be copying someone else’s work.

Here, originality is a common feature. Neither of the two can be original all the time. For instance, on occasions, some assignments or writers may be given the same subjects to write about. In such cases, the quality of the works is what matters. When the works are of high standards, they are regarded as original.

Long vs. Short

When you buy an option, you essentially have the right but not necessarily the obligation to buy or sell a stock at a certain price on a certain date. There are different two types of options: calls and puts.

A call option is the right to buy a stock at a certain price (strike price or exercise price) A put option is the right to sell a stock at a certain price (strike price or exercise price).

The owner of an option must exercise the option at the expiration date. If he doesn’t, he loses the option, but the premium paid to buy it is forfeited. If the owner chooses to exercise the option, he is said to “call away the stock”; if the owner chooses to exercise the option, he is said to “put away the stock”.

When you buy an option, you are either a buyer or a holder. Holders know they have the right to buy or sell the stock and it’s not necessary to exercise the option to make a profit. Buyers, on the other hand, must exercise the option to realize any profit.

Equity vs. Index Options

Owning stock is the most common option trading. There are two types of stock options “ calls and puts. A call option gives the buyer the right, but not the obligation to buy 100 shares of a given stock at a specified price The put option gives the buyer the right, but not the obligation to sell 100 shares of a given stock at a specified price

Index options are more speculative in nature than stock options. Index options provide the right to receive the change in value of an index over a specific period.

There are two types of index options “ calls and puts. A call provides the right to receive the change in value of an index over a specific period. A put provides the right to receive the original value of an index over a specific period.

Before entering the options market, you should have a good understanding of the underlying asset, what you can gain from trading options in that asset, and how you can hedge risk. If you need an introduction to what options are, you can read our beginner’s guide to options trading.

Stock Options Quote

As a market-based economy, the stock market is a vital part of the United States’ economy. A free-market exchange, the stock market is at the heart of the U.S. financial system. The NYSE (New York Stock Exchange) and Nasdaq are the largest stock market exchanges. Large brokerage firms and banks manage approximately 50% of these exchanges in the U.S.

Buyers and sellers agree to buy and sell stock at certain prices, called the “bid and offer.” The sellers are willing to sell at the offer and the buyers are willing to buy at the bid. The difference between the bid and the offer is called the “spread.” This spread sets the trading price, or the “net.” After the net, a commission is added.

Volatility and Deviation

There are a lot of factors that cause option PEs to increase such as surprise news, seasonality shifts, and earnings announcements. As you can see, all of these things can have a positive impact on your options’ returns. Historically, one of the biggest movements in option prices is associated with events that are surprising to the market. This is why reading the news and understanding how news can impact the assets will be beneficial to you as an option investor.

Why Trade In Options?

Going all the way back to 1979, the CBOE (Chicago Board Options Exchange) introduced options trading. Before that, options trading was done over the counter, often on a one-to-one basis between the purchaser and the seller, and without any centralized market place.

In these early stages, options were traded as part of a financial portfolio toolkit, used to hedge against the risk involved with certain investments.

The introduction of options exchanges allowed investors to trade options individually, rather than in a bundle, and therefore also brought about the notion of short options trading. Now, in addition to being able to buy bullish options, investors could also buy bearish options and profit from falling stocks.

For Hedging

There is a saying that options are not for everyone. The truth is that options can be used for a wide variety of trading strategies. Many options beginners believe that all they need to do to profit using options is to buy calls or puts until they expire and collect the expiration date as profit. Options beyond this basic strategy allow you to collect premium and keep it because the underlying stock has NOT moved as far as you thought, or, you can sell the option early and make a tradeoff between time and premium collected.

You can earn a profit using options in either a bullish or bearish market. You will want to use options to protect a long stock position or to speculate on a stock that you believe will have a large move up or down.

There are two basic strategies you can use in trading options.

As Spreads

Increase, Are You Betting on Talent or a Likely Sack?

If you watch a lot of football, you’ve probably noticed that the spread has changed over the years. In most cases, it’s just a few points, but it’s worth noting that spreads are increasing.

The spread is the point difference in a game. For example, a team might be favored by five points. They are the favorite. The team on the other side of the spread is the underdog. That team might be a five-point dog. Either way, the point spread gets the losers pretty worked up – even if the game is being played by kids. But the increase of the spread has nothing to do with the kids taking the field.

The spread in football games is increasing for one reason – the odds being offered by football betting sites. The sportsbooks, including Bovada, Las Vegas, and a number of offshore sportsbooks, are offering better representations of the odds being offered by the NCAA and the NFL.

At one time, the favorite in a game was 10.5 points. A 15-point spread is now common, and you’ll see 20-point spreads, too. And, if the trend continues, the spread will be even higher next season.

In Combination

Straddles are an investment strategy thatÕs usually used for gaining long or short exposure to the underlying stock of a company for a brief period. As you can tell, they are completely opposite of puts or calls, which are used for long-term investment in the underlying stock.

A straddle involves putting in two contracts for either call options or put options, usually around the same strike price and expiration date. To make this strategy work, you must use stock options. Options on indexes do not work in this situation due to the fact that index options expire on the third Friday of the month. This means that you do not have as long to work with as you would with regular stock options.

Straddles can either be done on the same day or up to a week before the expiration date. Many beginners like to use the same-day opening multiple contracts opposite of each other to create a straddle because it is very fast and easy.

More Advanced Options Strategies

If you’re a beginning investor, you may have already heard about “options” and are wondering how exactly they can help you with your portfolio. Options are one of the most versatile investment vehicles available, and as a beginner, they’re fairly easy to understand. Think of an option as an agreement between two people to buy something at a set price. In the case of options trading, the thing you’re buying is shares of a stock … the stock price at the time the option is exercised is measured by a complex system of moving averages.

Instead of buying a stock outright, you enter into an agreement with a broker to purchase shares at the strike price. If the market moves in the direction you predicted, the option can be exercised and you can buy the stocks at the agreed upon price. If that option is not exercised, it expires and becomes worthless.

Options can be used as components in more complicated strategies. Here are two that you should know about.

Where to Trade Options

It is important when learning how to trade options, it is important to choose your brokerage services wisely. Many beginning investors are unaware of the different fees involved in trading, which can make an enormous difference on your win percentage.

Beware of hidden fees, which can be found in more expensive trading platforms and software, and sticking to most reputable online brokerages. Not all platforms are created equally. Some platforms have additional fees beyond the trading fee, which can add up over time.

With the technology available today, it only seems fair to avoid brokers who charge additional fees. As a beginning investor, it is important to seek out the best platforms available and avoid hidden fees.

Your brokerage is critical for your success as an options trader. If you are not sure how to trade options, I highly recommend seeking out a good online broker.

Here are some of the likely fees and fees to expect when investing in options:

Commissions. This is a flat fee that will be charged to you upon placing the trade. This fee will be listed on your order confirmation. This is the fee you will pay for placing an options trade.

How to Get Started

Options trading can be an excellent method for beginning investors to learn trading and investing methodologies and strategies without risking all of their money. While you’ll never make money if you don’t take risks, options’ versatility allows you to reduce the amount of money at stake while still benefiting from greater opportunities and increased buying power.

Options are a contract between a buyer and a seller that gives the buyer the right, but not the obligation, to trade a set number of shares within a pre-determined time frame. The seller of the option, called the “writer,” will either fulfill the option at the agreed-upon price or can decide not to assign the option, which means relinquishing any rights to make a trade.

When beginning to trade options, the most important thing is to choose a method that is suitable for your personality as well as your investing goals. While you might start out with one method of trading, you may find the need to obtain more information as your investing capital grows and you become more serious about trading.

Bottom Line

Is Trading Options More or Less Complicated Than Buying and Selling the Underlying Security?

Trading options does require a little effort on your part beyond simply placing the trade and awaiting the expiration. While the actual mechanics of trading options are less complicated than trading the underlying security, the rules are a little more complicated.

While the hands-on mechanics of simply buying the call or selling the put are easy to describe, every option has a whole host of variables that affect the cost and benefit, which are somewhat more difficult to interpret.

They include the month of the option, position of the underlying security relative to the strike point, volatility, and so on. After all, the price of an option shouldn’t be as simple as the put or call premium; it should also be affected by factors such as time until expiration and the direction of the underlying security.