Jan 9
The “Crucial To Read” Options Trading Guide for Beginners
If you’re new to trading and interested in taking the next step on your trading journey, this article will be a great place to start.
Learning to trade always reminds me of the process of getting in shape.
It’s one of those things where you can get so overwhelmed with all the technical details that all the “pros” talk about, that it’s easy to ignore the basics.
Years ago I played hockey and a big part of that involved weight training.
So, being the diligent little guy I was, I decided to research the best way to go about lifting weights.
I read all sorts of bodybuilding books, powerlifting books and even hockey specific training books.
The old interwebs were (and still are) completely jammed full of all sorts of tips & tricks to help you see gains and get jacked.
Unfortunately in reading all this stuff, it’s easy to lose focus.
And as the 80/20 rule states, 80% of your results will come from 20% of your efforts.
These results always come from a core group of actions that are focused on the basics.
When it came to weightlifting, I found that I got the best results from doing the 3 basic lifts: bench, squat and deadlift.
All the other fancy lifts were great, but they were only useful for tweaking a solid foundation of strength and muscle. And without that foundation, they were useless.
And it’s the same way when trading: unless you’ve got a solid foundation of the fundamentals, all the advanced tricks and tips will be worthless.
So with that in mind, I’ve put together this epic post on the basics of trading options.
I’ll go over all the basic terminology to give you an understanding of what’s up.
So without further ado, let the learning begin!
Options trading may appear intimidating initially, but it’s simple to grasp after learning a few basic concepts. Investor portfolios are typically made up of a variety of asset classes. Stocks, bonds, ETFs, and even mutual funds are examples.
Options are a different asset class that, when employed appropriately, may provide numerous benefits that stock and ETF trading alone cannot.
Important Keys to Keep in Mind
A call or put option is a contract that gives the buyer the right, but not the duty, to purchase (in the case of a call) or sell (in the case of a put) the underlying asset at a certain price on or before a specific date.
Options are used to generate revenue, speculate, and hedge risk.
Because they draw their value from an underlying asset, options are referred to as derivatives.
A stock option contract normally represents 100 shares of the underlying stock. However, options on any underlying asset, including bonds, currencies, and commodities, can be negotiated.
So Really, What Are Options?
Options are contracts that provide the bearer with the right, but not the responsibility, to purchase or sell a certain quantity of an underlying asset at a predetermined price at or before the contract’s expiration date. Like most other asset types, Options may be acquired through brokerage accounts.
Options are valuable because they can improve a person’s portfolio. They do so by increasing their revenue, providing protection, and even using leverage. There is generally an alternative scenario fit for an investor’s purpose depending on the occasion. A popular example is using options as a successful hedge against a declining stock market to prevent downside losses.
Optional revenue can also be generated periodically. They’re also frequently employed for speculative objectives, such as betting on a stock’s direction.
Investing in Options: The Basics
There is no such thing as free money or a free lunch with stocks and bonds. Options are no exception. Before placing a deal, the investor should be informed of the dangers of options trading. This is why, while trading options with a broker, you’ll normally have to read something like the following disclaimer:
Options come with risks and are not appropriate for everyone. Options trading is speculative and has a significant risk of loss.
Derivatives are options.
Derivatives are a bigger category of securities that includes options. The price of a derivative is determined by or derived from the price of something else. Options are financial security derivatives whose value is based on the price of another asset. Calls, puts, futures, forwards, swaps, and mortgage-backed securities are all examples of derivatives.
Option Building Blocks: Calls and Puts
Derivative securities, such as options, are a sort of derivative security. The price of an option is inextricably related to the price of something else, making it a derivative. When you purchase an options contract, you are given the right but not the responsibility to buy or sell an underlying asset at a certain price on or before a specific date.
A call option entitles the holder to buy a stock, whereas a put option entitles the holder to sell a stock. Consider a call option as a deposit for a future purchase.
Example of a Call Option
A prospective homeowner notices the construction of new development. That individual may desire the ability to purchase a property in the future, but only when specific projects in the neighborhood have been completed.
The choice of purchasing or not buying would benefit the potential home buyer. Consider purchasing a call option from the developer to purchase the home for $400,000 at any time in the following three years. They certainly can — know it’s as a non-refundable deposit. Obviously, the developer would not provide such a feature for free. To secure that right, the potential home buyer must make a down payment.
This fee is referred to as the premium for an option. It is the option contract’s price. The deposit in our home example maybe $20,000, which the buyer pays to the developer. Let’s assume it’s been two years, and the developments have been completed, and the zoning has been authorized. Because that is the contract price, the home buyer exercises the option and buys the house for $400,000.
That home’s market worth may have risen to $800,000. The buyer, however, pays $400,000. This is because the down payment is locked in a set price. Let’s imagine, in an alternate situation, the zoning permission doesn’t arrive until the fourth year. This option has passed its one-year expiry date. Because the contract has ended, the home buyer must now pay the market price. In any situation, the developer retains the $20,000 deposit.
Example of a Put Option
Consider a put option to be an insurance policy. You are probably aware of the procedure of acquiring homeowner’s insurance if you own a property. A homeowner purchases a homeowner’s policy to safeguard their house from damage. They pay a premium for a set time, such as a year. The policy has face value and protects the policyholder if their house is destroyed.
What if your asset was a stock or index investment rather than a home?
Similarly, if an investor wishes to protect their S&P 500 index portfolio, put options can be purchased. A bear market may be approaching, and investors may be hesitant to lose more than 10% of their long position in the S&P 500 index. If the S&P 500 is now trading at $2,500, they may buy a put option that allows them to sell the index for $2,250 at any time in the following two years.
Suppose the market drops 20% (500 points on the index) in six months. In that case, it will have made 250 points by selling the index for $2,250 while it is selling at $2,000, resulting in a cumulative loss of only 10%. In reality, if this put option is kept, even if the market collapses to zero, the loss will be only 10%. Purchasing the option carries a cost (the premium). If the market does not fall during that time, the option’s maximum loss is limited to the premium paid.
Options can be used in four different ways:
Purchase (long) calls
Calls to sell (short)
Puts to buy (long)
Puts to sell (short)
When you buy shares, you are taking a long position. When you buy a call option, you are potentially taking a long position in the underlying stock. A short position is created when you sell a stock short. You can take a possible short position in the underlying stock by selling a naked or uncovered call.
Purchasing a put option offers you the opportunity to short the underlying stock. You can get a prospective long position in the underlying stock by selling a naked or unmarried put. It’s critical to keep these four possibilities straight.
People who sell options are known as writers of options. The key distinction between holders (buyers) and writers is as follows:
Call and put holders are under no obligation to purchase or sell. They can choose whether or not to utilise their rights. This restricts the risk of option buyers to the premium paid.
However, if the option expires in the money, call and put writers (sellers) are compelled to purchase or sell (more on that below). This implies that a seller may be obligated to follow through on a purchase or sale agreement. It also means that option sellers are exposed to a greater number of risks and infinite risks in certain situations. As a result, authors risk losing far more than the cost of the options premium.
Why Should You Use Options?
Speculation
Speculation is a bet on the direction of future prices. Based on fundamental or technical research, a speculator may believe that the price of a stock will rise. A speculator may purchase the stock or a call option on it. Some traders speculate using a call option rather than buying the stock directly since options give leverage. When opposed to the full price of a $100 stock, an out-of-the-money call option may only cost a few pennies or even cents.
Hedging Options was created specifically for the purpose of hedging. Options hedging is intended to decrease risk at a fair cost. We can consider employing solutions such as an insurance policy in this case. Options may be used to guarantee your investments against a downturn in the same way that you insure your home or car.
Assume you wish to invest in technology stocks. You do, however, want to keep your losses to a minimum. Put options allow you to minimize your negative risk while still enjoying all of the gains in a cost-effective manner. Short sellers can utilize call options to reduce losses if the underlying price swings against their transaction, particularly during a short squeeze.
So How Do Options Really Work?
It all boils down to calculating the likelihood of future price events when it comes to pricing option contracts. The more probable something will happen, the more expensive a profit-generating choice will be. A call’s value, for example, rises when the stock (underlying) rises. This is crucial to comprehending the relative worth of choices.
The closer an option gets to its expiration date, the less valuable it becomes. This is because as we got closer to expiry, the odds of a price change in the underlying stock lessened. If you buy an out-of-the-money one-month option and the stock doesn’t move, the option loses value with each passing day. A one-month option will be less valuable than a three-month option since time is a factor in the price of an option. This is because the likelihood of a price change in your favor increases as you have more time available and vice versa.
As a result, an option strike that expires in a year will cost more than an option strike that ends in a month. Time decay is the cause of this option losing value. If the stock price remains unchanged, the identical option will be worth even less tomorrow than it is now at this moment.
Option prices are also affected by volatility. This is because uncertainty raises the chances of a positive outcome. Larger price fluctuations enhance the chances of significant moves both up and down as the volatility of the underlying asset rises. Larger price fluctuations will enhance the likelihood of an incident occurring. As a result, the more the volatility, the higher the option’s price. In this sense, options trading and volatility are inextricably intertwined.
A stock option contract is a choice to purchase or sell 100 shares on most U.S. exchanges; this is why you must multiply the contract premium by 100 to determine the total amount you’ll have to pay to buy the call.
Holders typically opt to collect their winnings by trading out (closing out) their positions. Option holders sell their options on the market, while writers purchase back their holdings to close their positions. Only roughly 10% of options are exercised, 60% of options are exchanged (closed), and 30% of options expire worthlessly.
Intrinsic and extrinsic value, often known as a temporal value, can explain fluctuations in option pricing. An option’s premium is the sum of its intrinsic and time values. Intrinsic value is the amount of an option contract that is in the money, which in the case of a call option is the amount above the strike price at which the stock is trading. The additional value that an investor must pay for an option over its inherent value is time value. This is the temporal value or extrinsic value. As a result, the price of the option in our case may be calculated as follows:
Intrinsic Value + Time Value Equals Premium
$8.25 $8.00 $0.25
Options nearly always trade at a premium to their intrinsic value in real life since the likelihood of an event occurring is never zero, even if it is extremely rare.
Call vs Put Options: What’s the Difference?
Only by limiting losses and maximising gains can call and put options serve as effective hedges. Assume you’ve invested $100 in Company XYZ’s stock in the hopes of seeing it rise to $20. As a result, your total outlay is $1,000. You buy one put option (each options contract represents 100 shares of the underlying stock) with a strike price of$10, each worth $2 (for a total of$200) to hedge against the chance that the price would fall.
Consider the case when the stock price moves in your favor (e.g., it rises to $20). In this case, your put options will be worthless. However, your losses are restricted to the premium amount (in this example, $200). Your maximum earnings are likewise constrained if the price falls (as you predicted with your put options). This is because the stock price can never go below zero, and so you can never make more money than you do once the stock price falls to zero.
Consider the following scenario: you’ve staked $5 on XYZ’s stock, falling to $5. You’ve acquired call stock options to hedge against this position, believing that the stock’s price would rise to $20. What if the stock price moves in your favor (i.e., it drops to $5)? Your call options will expire worthless, resulting in a $200 loss. After it takes off, the price of XYZ has no higher limit. XYZ has the potential to reach $100,000 or more in theory. As a result, your gains are unrestricted and limitless.
Calls
-Buyers of call options utilize them to protect themselves against an asset or commodity’s price falling.
Hedge against a drop in their purchasing power, American importers, can purchase call options on the U.S. currency.
-Holders of American depository receipts (ADRs) in overseas corporations can hedge against a drop in dividend payments by buying call options on the U.S. currency.
-To hedge against their holdings, short-sellers employ call options.
Puts
-Put option buyers use them to protect themselves against a rising price for an asset or commodity.
-To hedge against a rise in their selling expenses, American exporters can utilize put options on the U.S. currency.
-Manufacturers in other nations can utilize put options on the U.S. dollar to protect themselves against depreciation in their home currency.
-Put option profits are restricted for short-sellers since a stock’s price can never go below zero.
What Types of Options Do Experienced Investors Use?
Traders utilize options to speculate and hedge, as previously stated. Traders watch option prices and use complex methods like a strangle or an iron condor to optimize their profits. Here’s a brief rundown of various money-making tactics that are quite easy but successful. More information on options strategies may be found here.
Long Calls
Going long on a call entails purchasing call options and wagering that the underlying asset’s price will rise over time. Consider a trader who buys a contract with 100 call options on a stock now trading at $10. The cost of each choice is $2. As a result, the contract’s total investment is $200. When the stock price reaches$12, the trader will recoup her losses.
The stock’s gains after that are profits for her. The stock’s price has no upper limitations, and it might go as high as $100,000 or even more. Because each option is worth$2, a $1 gain in the stock price doubles the trader’s winnings. As a result, a long call guarantees limitless profits. If the stock price moves another way (i.e., down instead of up), the options will expire worthlessly, and the trader will only lose $200. Long calls are a good strategy for investors who are confident that the price of a company will rise.
Covered Calls
When entering a short call, the trader is on the other side of the deal (selling a call option rather than purchasing one), wagering that the price of a stock will fall over a set time. A short call can have infinite gains because it is a naked call, which means that if the price moves in the trader’s favor, they can profit from call purchasers.
Writing a call without holding actual stock, on the other hand, might result in huge losses for the trader because if the price does not move in the expected direction, the trader will have to spend a big amount of money to acquire and deliver the stock at inflated rates.
They can minimize their losses by using a covered call. The underlying asset is already owned by the trader in a covered call. As a result, if the asset’s price moves oppositely, they won’t have to buy it. As a result, a covered call restricts both losses and gains because the maximum profit is restricted to the number of premiums received. When the options are close to being in the money, covered call writers can buy them back. Experienced traders use covered calls to make revenue from their stock ownership while also balancing off tax benefits from other deals.
Long Puts
A long put is similar to a long call, except that the trader would buy puts instead of selling calls, wagering that the underlying stock price will fall. Assume a trader buys a single 10-strike put option for a stock selling at $20 (indicating the right to sell 100 shares for $10). Each choice comes with a $2 charge. As a result, the contract’s total investment is $200. The trader will recoup his losses when the stock price falls to $8 ($10 strike — $2 premium).
Following that, the stock’s losses turn into profits for the trader. However, because the stock’s price cannot go below zero, these profits are limited. The trader can also let the options expire worthless if prices go the opposite direction, limiting the losses. As a result, the trader’s maximum losses will be restricted to the amount of premium paid. Long puts are handy for investors who are relatively confident that the price of a stock will move in the direction they wish.
A Short Put
In this case, a trader will sell a put option, banking on a price increase. In this situation, a trader’s maximum profits are restricted to the amount of premium collected. However, because she will have to acquire the underlying asset to meet her commitments, the potential losses might be limitless if buyers choose to exercise their option.
Despite the possibility of endless losses, a short put may be a profitable strategy if the trader is confident that the price will rise. When the option’s price comes close to being in the money, the trader can purchase it back, and profit from the premium received.
Specific Types of Option Classes
Options from the United States and Europe
Between the date of purchase and the expiration date, American options can be exercised at any time.
1) Unlike American options, European options can only be exercised at the end of their life, on their expiration date.
2) The differential between American and European alternatives is based only on early exercise and has nothing to do with geography. Many stock index options are of the European variety. Because the right to exercise early has some value, an American option often has a larger premium than a European option that is otherwise equal. This is because early exercise is preferred and demands a price.
There are also exotic alternatives, which are unique because the reward profiles may differ from the ordinary vanilla possibilities. Alternatively, they might evolve into separate goods with “optionality” built-in. Binary options, for example, offer a basic reward structure that determines whether the payoff event occurs regardless of the degree.
Knock-out, knock-in, barrier, lookback, Asian, and Bermuda choices are other unique possibilities available. Exotic options are usually only used by expert derivatives traders.
Options for the Short Term vs Options for the Long Term
The length of the option term can also be negotiated. Options that expire in less than a year are known as short-term options. Long-term equity anticipation securities, or LEAPs, are long-term options having an expiration date of more than a year. The only difference between LEAPs and normal options is that they last longer.
The expiration date of an option can also be used to differentiate it. Sets of options now expire weekly on Fridays, monthly on the last day of the month, or even daily. Quarterly expirations are occasionally available with index and ETF options.
Reading Option Chains & Charts
Options data is increasingly being obtained from online sources by traders. Even though each source has its unique way of presenting the data, the following variables are usually present:
- The volume (VLM) indicator simply indicates how many contracts of a specific option were traded during the most recent session.
- The “bid” price is the most recent price when a market player seeks to purchase a certain option.
- The “ask” price is the most recent price a market member has offered to sell a certain option.
- The future uncertainty of price direction and speed may be conceived as Implied Bid Volatility (IMPL BID VOL). An option-pricing model, such as the Black-Scholes model, calculates this number, which indicates the degree of projected future volatility based on the option’s current price.
The total number of contracts of a certain option that have been opened is indicated by an Open Interest (OPTN OP) number. As open deals are closed, open interest diminishes. - Delta can be compared to the chance of something happening. A 30-delta option, for example, has an approximately 30% chance of expiring in the money. The option’s sensitivity to quick price changes in the underlying is also measured by delta. If the underlying security’s price moves by $1, the price of a 30-delta option changes by 30 cents.
- Gamma is the rate at which you may move money in and out of your account. The movement of the delta can alternatively be conceived of as gamma.
- Vega is a Greek figure that specifies how much the price of an option would be expected to fluctuate if implied volatility changed by one point.
- Theta is a Greek figure that reflects how much a certain option will lose in value over one day.
- If the option is exercised, the “strike price” is when the buyer of the option can purchase or sell the underlying securities.
Market makers make their income by buying at the bid and selling at the ask.
Long Puts and Calls
A long call (or put) on its own is the most basic options position. If the underlying price increases (falling), this position profits. Your downside is restricted to the loss of the option premium paid. A straddle is established when you buy a call and a put option with the same strike and expiration date at the same time.
If the underlying price rises or falls drastically, this strategy pays off; but, if the price stays relatively consistent, you lose premium on both the call and the put. If you foresee a huge move in the stock but aren’t sure which way it will go, this is the technique for you.
Put another way, you need the stock to move outside of a range. Buying a call and a put with separate strikes and the same expiration, known as a strangle, is a similar technique that bets on an outsized move in the assets when you foresee significant volatility (uncertainty). A strangle more costly than a straddle since it requires significant price swings in either direction to benefit.
Shorting a straddle or a strangle (selling both options), on the other hand, would profit from a market that doesn’t move much.
Combinations and Spreads
Spreads combine two or more option positions belonging to the same class. They mix the ability to form a market opinion (speculation) with limiting losses (hedging). Spreads frequently restrict potential gains. Nevertheless, these tactics might be appealing since they generally cost less than a single choice leg. Vertical spreads entail the sale of one option in exchange for the purchase of another. The second option is usually the same kind and expiration as the first, but with a different strike.
Buying a call and concurrently selling another call with a higher strike price and the same expiration creates a bull call spread or bull call vertical spread. If the underlying asset rises in value, the spread is beneficial. Still, the upside is limited owing to the short call strike. However, selling the higher strike call lowers the cost of buying the lower strike call.
A bear put spread, also known as a bear put vertical spread, is purchasing one put and selling another with a lower strike and the same expiration date. A calendar spread or time spread occurs when you buy and sell options with various expirations.
Trades containing both a call and a put are known as spread combinations. A “synthetic” combination is a unique form of combination. The goal of a synthetic is to build an options position that mimics the behaviour of an underlying asset without really controlling it. Why not simply purchase the stock? Perhaps you cannot acquire it due to a legal or regulatory restriction. However, you may be permitted to use options to construct a synthetic position.
Butterflies
A butterfly is made up of three evenly spaced out strikes and are all of the same type (all calls or all puts) and have the same expiration date. The centre strike option is sold, and the outside strikes are bought in a 1:2:1 ratio in a long butterfly (buy one, sell two, buy one).
It is not a butterfly if this ratio does not hold. The outside strikes are generally referred to as the butterfly’s wings. In contrast, the inner strikes are the butterfly’s body. A butterfly’s value can never go below zero. The condor is similar to the butterfly, except that the middle options do not have the same strike price.
Risks of Options: The “Greeks”
Many of the hazards associated with options may also be analyzed and understood since option pricing can be described mathematically using the Black-Scholes model. This aspect of options makes them arguably less dangerous than other asset classes, or at the very least makes the risks associated with options understandable and evaluable. At times, individual dangers have been given Greek letter designations and are referred to as “the Greeks” at times.
What Does It Mean to Exercise an Option?
Exercising an option entails carrying out the contract terms and purchasing or selling the underlying asset at the agreed-upon price.
Traders use options for a variety of reasons.
Traders utilize options to speculate and hedge their positions. A trader may, for example, purchase put options to hedge an existing bet on the price growth of underlying securities.
What’s the Difference Between American and European Alternatives?
European options can only be exercised at the specified expiry date. Still, American options can be exercised at any time before they expire.
How are options used to assess risk?
The “Greeks,” or four separate dimensions, are used to assess the riskiness of options. The Delta, Theta, Gamma, and Vega are some of them.
What Are the Three Most Important Options Characteristics?
The following are the three most significant properties of options:
- The strike price of an option is the price at which it can be exercised.
- The date on which an option expires and becomes worthless is known as the expiration date.
- Option premium: This is the cost of purchasing an option.
What Are the Taxes on Options?
Call and put options are typically taxed, dependent on how long they are held. They are subject to capital gains taxes. Beyond that, the details of taxable options are determined by the length of time they are held and whether they are naked or covered.
Final Thoughts
Look, I know that some of this technical stuff can make things seem really confusing.
When you know the fundamental ideas of options, everything becomes that much clearer and easier to understand.
