How To Trade Options – Guide For Investors
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Options trading offers investors many ways to generate income. The fact is, a well-rounded portfolio will include a variety of assets such as mutual funds, exchange-traded funds (ETFs), bonds, stocks, and options.
Although it may seem as if options trading is mysterious, once you find out how it can boost the performance of your portfolio, you’ll realize how easy it is to confidently make them work to your financial advantage.
An Easy Definition of Options
An option is a contract in which the buyer has the right to buy or sell an underlying stock at a particular price by a specified date. Because options depend on another asset’s value, they are referred to as derivatives.
The strike price is the price the seller and buyer agree on. The buyer is not obligated to buy or sell by the expiration date of the option.
The amount of shares in a stock option contract is usually 100. To purchase the call, take the cost of the premium and multiply it by 100 to get the total price of the option.
Options contracts aren’t limited to stocks. Commodities, bonds, and currencies are examples of different types of underlying assets where stock options can be written.
Just like with any other stock exchange purchase, you’ll need to have a brokerage account to purchase options.
Buying Call Options
The buyer takes a long position which is called “going long,” “go long a call option,” or “be long a position,” by purchasing at least one call option. If the buyer takes a long position, then the seller is being short.
That’s because the seller stands to lose more if the buyer exercises the option to sell the stock back. The goal of the seller is to have the call option go down in value all the way through its expiration (also known as expiry) date. The goal of the buyer in a call option situation is to sell the underlying stock after the share price on the market goes up.
Examples of Call Options and Put Options
Call options and put options are best understood when examples are given to see it in action. Keep in mind, in a call or put option, the underlying stock’s value is a key motivator in your decision making involving options trading.
Buying Call Options – Scenarios
You have purchased a buy call option on $50 stock trades which are trading at $70 per share currently; therefore, your option’s value should be at least $20 per share. You can use your right to buy the stock for $50 per share. If you do, you just saved $20 per share on the trade.
Say that the 2Y1 company’s per-share trade is $50. A call option with a strike of $50 expires in 30 days and it costs $2. You have a strong belief that the 2Y1 stock will jump very high in the weeks after the financial statements are published.
Any day now, the report should appear. You paid $200 for covering 100 shares of a single call option of the 2Y1 underlying stock.
A few weeks later, you see that the 2Y1 stock rose to $60. The report came out and now you have netted $800.
How? Since you paid $200 for the call option for the underlying stock, you exercised your option to sell it at the open market price to another buyer. You did this instead of buying the full shares from the seller for $50 per share, your strike agreed-upon price.
You made a profit of $10 per share because of the $60 current market price – $50 strike price = $10. Your option contract grossed $1,000 and since you paid $200, you netted $800.
Because you didn’t actually buy stock, just the underlying asset, a derivative of the stock, your investment was smaller.
If you had planned on buying the stock and the price went down, you may have decided to buy it. The call option gave you options.
The underlying stock price went up and you profited the most by selling it back. Trading options can certainly provide substantial windfalls if executed properly.
Buying Put Options
The buyer purchases a put option when it’s perceived that the underlying stock is likely to go down. The buyer wants to exercise the right to sell shares at the strike price (the agreed-upon price on the option) by a specified date if that happens. If the stock market price goes below the strike price, then the seller has to honor the option agreement and pay the buyer more for the devalued stock.
Put options have limited profit potential because after it hits zero, that’s it. With a call option, the earnings are unlimited. Stocks are always going up and they don’t have a foreseeable endpoint.
But if you think there’s a good probability that a stock is going to go down, a put option may work for you in gaining quick profits.
An “in the money put” option is when the market price currently is less than the strike price. The option holder can sell stock at the strike price anyway if desired.
Buying Put Options – Scenarios
In this example, you want to protect your S&P 500 index portfolio from losing more than 10% in a bear market that you fear is straight ahead. The S&P is trading at $2700, so you can buy a put option with the right to sell the index at a lower price of $2295 within a year. ($2700 – 10% = $2430).
Over the next three months, a 20% crash occurs in the stock market and it’s equal a 500 point index drop. You sell your index for $2295 and lose only 10% because the index is selling for $2160.
You have a gain of 250 points due to your put option you held.
You paid for the put option, so you only lose what you paid for the down payment. The market could totally bottom out and you’d still have the put option giving you the right to sell the stock at a particular price. You could let the option expire or trade it to see what you could recoup.
In another scenario, the 2Y1 company is trading at $35. A put option has a strike price of $35 with a 30-day expiration date.
The price is $2. You have a strong belief that 2Y1 stock will plummet in a few weeks after the quarterly earnings are published. You purchased the put option for $200 because you covered 100 shares at $2 each.
Your beliefs came true. The earnings report for 2Y1 stock dropped and the stock price went down to $25. Your strategy paid off and netted $800 in profits.
What happens now is that you could use your rights to sell 100 shares os 2Y1 stock at $35 each. If you do, you’ll make $10 in profit on each share. Your put option covers 100 shares and you received $1,000. You originally paid $200 for the option. $1,000 – $200 = $800.
The long put strategy is what you used to make the trade. That’s where you think that before a put option expires, the price of an underlying security will drop below the strike price.
How Investors Benefit by Trading Options
Options help investors limit risk exposure, for determining if the stock will go up or down, and to generate income repeatedly. But options, just as with any type of investment, aren’t without financial risks. You can reduce losses in a market downturn with options trading.
Writers and Holders
Holders are investors (buyers) that buy options. You can buy options as a call holder or put holder. As stated earlier, as a buyer when you purchase an option, you’re not obligated to buy or sell.
Since you’ve already spent money on the option you purchased, it acts as an insurance premium on a future action you may or may not take at a later time. The risk is minimized due to the limitation of the cost of the option and the option is good until the expiration date.
Writers are the sellers that sell options. A seller can write an option as a call writer or a put writer. The obligation for the writer is great because based on the option chosen, they must either buy or sell the underlying stock if the holder wants to exercise their rights given by owning the option.
Consider that writers do get paid upfront for selling the option itself to the buyer. And if it works in their favor, the option will expire without further activity.
So while holders aren’t obligated to buy or sell an underlying stock, writers, on the other hand, make a promise to honor the options they sell to holders. When the holder pays a premium for the option, that amount is debited from the holder’s account at the time of purchase.
Strategies Deliver a Variety of Ways to Profit From Buying and Selling Options
A straddle is created when a buyer purchases a call option and a put option at the same time. Both must have the same expiration and strike price. The advantage of a straddle position is the underlying stock’s volatility.
If the price goes way up, it will be profitable for you. On the other hand, it could be risky as you could lose both premium investments. If the price moves a little or not at all, you could lose on both option purchases.
The key to winning in the straddle strategy plan is to find out which company’s underlying stocks are expected to make a big change. You might not know which way it will go up or down, but if you suspect a big change, consider covering both ends with a straddle.
The Strangle Strategy
A strangle is useful when you predict uncertainty (high volatility). Put and call options are purchased.
The strikes must differ, yet the options must have identical expiration dates. Remember you’re expecting some major moves up or down and that will likely bring profits.
It’s possible though to make a normally slow market profit with a strangle by being short. This should work with a straddle as well.
Hedging and Speculation are Two Reasons Using Options is Advantageous
Hedging lowers risk
Hedging is a way to lower risk. Hedging acts as insurance against a bear (downturn) market. Investing in a risky sector that shows volatility is a good example.
Say you really want to purchase stocks in the technology sector, but you want to minimize your losses just in case of a downturn. A put option would make sense here for hedging purposes.
The Possible Highs and Lows of Short Selling
Short selling can be tricky, highly profitable, and extremely risky. When an investor practices short selling, the investor borrows stock to sell on the market.
The goal is to buy it back when the price drops. Since the investor pays less because the stock was borrowed, the earnings are all profit, fewer fees of course.
How Speculation Works
Speculation is betting on a stock’s price direction, whether it will go up or down. An investor can perform various analyses on which to base speculation and then invest in a call option.
It works somewhat like insurance.
If the price of a stock indicates the speculation was the opposite of what the investor had thought, the losses can be drastically reduced. If the investment was only for the call option price, not the stocks increased price, there’s solace in that. The investor can trade up or let the option expire.
An Option’s Value is Relative
It’s the amount above strike and is the in-the-money figure. For instance, if the strike price on your put option is $25 and the market price is $20, you know that your option has an intrinsic value of $5 because that’s the difference between the strike and market.
Truth #1: When an underlying stock rises, so does its call value.
Time value and extrinsic value are the same. Taking the information from the intrinsic data above along with the knowledge that you paid $8 for your premium, you would subtract the intrinsic value from the premium to get the extrinsic value.
Truth #2: Options have a built-in feature called time decay.
Every day, an option loses a little value, bit by bit. You can relate it to purchasing a new vehicle. Once you leave the showroom floor, it’s used. The value is still good because it’s day one, but every day it gets older.
Truth #3: Options with short expiration dates are less valuable than those with a longer expiration date.
Expanding on the new car analogy, options are like a car warranty. A thirty-day warranty is less valuable than a 3-year warranty. You have a certain amount of time to use it or lose it.
Well, the price of a call option with a longer expiration date will be more pricey than a call option shorter expiration date. Often, prices won’t move much in a short time span. A longer expiration date puts time is on your side for the price of a stock to travel in the direction that you’re hoping it will go.
You’ll pay a premium for that.
Option Strikes and Stock Movement
The success of options depends on the stock movement. For either a writer or holder to profit, stock prices must go up or down, above or below the strike price. And the market has a limited time to move based on a limited expiration date.
A higher market price than strike is called an “in the money” call. The option owner has a right to call the strike price and buy the stock at that price instead of the higher current market price.
Tips on Selecting a Good Strike Price
Whether you’re ready to purchase an option, it’s important to take time to determine the correct strike price. Here are some tips to consider:
1. Know your options trading goals. Are you looking more to ultimately buy and keep the stock, sell the stock, or all of that? Select call options if you’re leaning towards buying call options.
Alternatively, pick put options for setting a strike at the best selling price. You may want to do both and customize your strategy for each underlying stock you’re interested in.
2. Use a probability calendar to help you determine pricing strategies. Some calendars are very general while others may be more detailed. Check for the basic or detailed fields where you can input the “Stock Price,” “Target Price,” “Calendar Days,” ” Percent Volatility,” and more.
3. Frequently traded assets are more liquid and it will be easier to buy and sell those stocks that have market liquidity. Be on the lookout for them.
4. Find stocks that have short bid-ask spreads. A bid-ask spread is the resulting figure after you take the highest bidder’s price and subtract the seller’s desired accepted price.
5. Check the stocks “moneyness,” because in-the-money options are pricey compared to at-the-money options and out-of-the-money options.
Liquidity and the Bid-Ask Spread
A very important measurement of liquidity in the marketplace is the bid-ask spread. The stock market works efficiently when liquidity is high because it saves buyers and sellers money while they trade. You always want to execute fast trades and avoid bottlenecks in the process.
For example, currency is highly liquid. It’s easy to transfer, spend, and manipulate. Let’s view an example of a bid-ask where liquidity is fluid.
If the bid price for a stock is $38 and the asking price is $40, the bid-ask spread is $2. Turn it into a percentage.
The formula is:
The above represents a low bid-ask spread. Either a buyer or seller could quickly close the trade.
How Volatility Affects Option Pricing
Stock volatility is how much stock prices change over a period of time. Low volatility indicates a more stable stock because it hardly has any movement. High volatility shows high variance in pricing over a period.
In other words, a stock indicates an unpredictable pattern. Having said that, volatility is not a bad thing when it relates to options. This is because during one of the large price spikes, an investor can cash in for a huge profit.
Volatile underlying stocks tend to demand a high call option price.
Guidelines for Global Options Vary by Country and Type
- American options – Holders have no limitations on exercising buy or sell rights until the expiration date, therefore premiums are higher than European options.
- European options – Holders must exercise rights on expiration date only.
- Exotic options – Hybrids of American and European options and are customizable, so guidelines vary. They typically trade on over-the-counter (OTC) markets.
- Binary options – A digital option that pays all at once, no incremental payments.
- Long-term equity anticipation securities (LEAPs) – American options with more than one-year expiration dates.
Tips for Reading Options Tables
Investors use a variety of tools to understand the statistical patterns of stock options and other financial security derivatives. Here are a few terms you’ll want to familiarize yourself with when planning your buying and selling strategies for options trading.
|Volume (VLM)||Contracted traded most recent session|
|Bid Price||Latest price buyer wants to bid on a specific option|
|Ask Price||The Latest price the seller offered for a specific option|
|Implied Bid Volatility (IMPL BID VOL)||Expected upcoming volatility based on an option's current market price|
|Open Interest (OPTN OP) number||Number of opened contracts on an option. The figure changes when trades close.|
|Delta and Gamma (GMM) (Greek)||Rate of change measurements.|
|Vega (Greek)||Expected change in option price if a one-point implied volatility change were to occur.|
|Theta (Greek)||Measurement of an option's value lost in a day.|
|Strike Price||The agreed-upon price for the option at which the buyer can execute the right to sell or buy the underlying security.|
The Spreads Option Call Strategy
Spreads typically have limited profit potential, but they are best used when in situations where you need to minimize risk. With a combination of speculation and hedging, spreads offer the best of both worlds when it comes to buying and selling options in a combination strategy for profits.
Anytime you purchase a short call, its purpose is to generate income quickly, while the long call is to limit risk. The makeup of a spread indicates that two or more options are traded at the same time making it a one-trade event instead of two separate trade instances.
Another benefit of spreads is that they are typically less costly compared to buying a call option which may have several different components.
While you may or may not utilize spreads as a beginner trader, it’s good to be aware of them to increase your knowledge about trading and many ways to generate income.
- Options are of the same class, the underlying security
- Established with a net credit, net debit or money
- Can be bearish, neutral, or bullish
- Have sides called “legs” where the short-option is the short leg and the long option is the long leg
- May have the same or different strike prices
- All calls, puts or a mixture of both
- Same or different expiration dates
- May require a trader to be approved for trading spreads since spreads are giving credit on options purchases and a debited account for losses.
A horizontal spread is also known as a calendar spread. Simultaneously, the investor buys and sells two options for an underlying with the same strike price; however, expiration dates differ.
The benefit of using the horizontal spread is to minimize risk by selling the option that will expire soon and then buying a longer-term option. This is called a long-horizontal spread.
But a short horizontal spread works in the opposite way. You would sell the long-term option and buy the shorter-one because you’re counting on making money in the near-term. Horizontal spreads are useful to make money fast or slow.
No matter how low the stock price drops, your risk is limited to the amount you paid for commissions when you make trades. And with horizontal spreads, you want the price to drop so you can profit.
When your long-term option value decreases, sell it and buy back the short-term option. Repeat the process of watching for volatility. You risk only what you paid for the option.
Your account is debited for the cost of each trade so track your true earnings. Minimize losses by limiting the amount of horizontal spread you open at once.
In a vertical spread, you would purchase options of the same class, meaning they should be of the same type (calls or puts), the underlying asset, style and contract size, and expiration date. The strike prices differ and these types of spreads can be either bullish or bearish.
Bear Call Spread
The bear call spread is a vertical spread. If you believe that an underlying stock’s market price will go down soon, the bear spread might be a good strategy.
In a bear call spread, you’ll buy one in-the-money call (OTM) and sell one in-the-money call (ITM). The expiration dates should have the same expiration date. The stock price must be lower than the strike price (the price you agreed to pay for the stock in your option purchase, should you decide to buy).
Bull Call Spread
The bull call spread is a vertical spread type of strategy to use in options trading to try if you think the underlying stock will rise at an average level in a few weeks.
For the same underlying stock, you would purchase one at-the-money call option and write an out-of-the-money call option that has a higher strike price. Both options must expire on the same date.
Bear and Bull Put Spreads
Bear put spreads are vertical spreads that allow you to profit and limit risks. If you feel moderately bearish about a stock, you could try a bear put spread. Buy a put and sell a put with a lower strike price at the same time.
Now, just to refresh, “Put” as an option means you are given the right to sell the underlying stock at the strike (price) back to the seller who sold you the option by the expiration date of the option. In verticals, your maximum potential profit is the net profit of what you sell your spread for minus commissions and fees.
The diagonal spread is a vertical and horizontal spread combination. This means the diagonal will consist of different expiration dates and strike prices.
The elements of the options for diagonals are practically endless. They can be long, short, bearish, bullish, use puts or calls.
A strategy for bullish long call diagonal is:
- Buy 1 – The long-term option with a lower strike
- Sell 1 – The short-term option with a higher strike
Close the trade at the expiration date of the short-term option or replace it by purchasing another one, hence, rolling it over and repeating the process.
Long Butterfly Spread
The butterfly spread works best when you believe that the underlying stock won’t change much by the time the option expires. It consists of a combination of bear spread and a bull spread. It’s limited profit potential but also limits risk.
- Buy 1 – In-the-money (ITM) call – It has a lower strike than the market price
- Sell 2 – At-the-money (ATM) calls – Its strike is equal to the stock market price
- Buy 1 – Out-of-the-money (OTM) call – It has a higher strike than the market price
Note that the buy call option is in-the-money (ITM) when the strike price of the option is lower than the market price. This means that the holder of the underlying stock can purchase the stock below the market price.
In Conclusion: Should You Trade Options?
Options trading offers stock market earnings flexibility for beginners and skilled traders alike. Start small and learn you’ll learn more from each trading experience.
Use this guide as a resource and motivation tool. Begin trading options today, and you’ll likely find it fun and profitable.