Options Trading 101: All You Need To Know

options trading

Written by Aryan Agarwal

November 24, 2020

Options trading was once viewed as an exercise best saved for experts, however, it’s gotten progressively well known for retail traders over the years.

In 2018, options trading saw average trading of more than 20 million contracts per day, which is a record-breaking number compared with earlier years.

New and beginning investors have the potential to profit by trading options and can utilize strategies to hedge themselves for the risk involved and increase the profit potential.

If you consider the time value, volatility, and interest rates, you can introduce a lot of flexibility in your investment strategy by trading options.

Before you get started, you’ll need to learn the lingo. Knowing what a strike price is and the difference between call and put options is critical to understanding what you’re getting into.

Options trading isn’t right for everyone, but it can enhance your portfolio.

To know whether it’s ideal for you, we should investigate what options are and how you can utilize them for trading.

What are options?

At the most essential level, an option is an agreement that permits you to buy or sell an investment, for example, a stock, an exchange-traded fund (ETF), or other assets.

Each option incorporates a pre-determined cost and an expiration date which determines how long the option is valid.

There are a couple of keywords to better understand options, and this is what you have to know:

Premium – The cost at which you can purchase or sell an options contract

Strike price – The pre-negotiated price of the security if it’s bought or sold according to the option contract

Expiration – The date and time the contract expires where you no longer will be able to buy or sell

Rather than purchasing or selling the stocks, the options contract gives you the choice to purchase or sell stocks or to sell it to another investor.

In any case, you’re not needed to do anything, and you could let the contract lapse without having any extra financial obligation.

Usually, an options contract is good for 100 stocks, though you can have more than one if you want to trade higher volumes.

For example, you could have ten options set up in case you’re hoping to purchase or sell 1,000 stocks.

What is Options Trading?

Options trading is actually what it seems like: trading options.

Trading options are pretty much the same as trading stocks or ETFs.

The thing that matters is that purchasing options doesn’t give you any ownership in the company since you haven’t bought any stocks.

What your contract does give you is a choice to buy the shares later, meaning you have the potential for ownership according to the terms.

When it comes to options trading, there’s more flexibility in your investment since they can include ETFs, commodities, and indexes in addition to the stocks and bonds you’d expect.

Prices fluctuate, and you can try to predict if the price will go up or down in much the same way that you try to predict stock prices.

At that point, you purchase or sell your options to increase your profit or lower your risk of loss.

Trading options are broken down into two types. Regardless of whether it’s a call option or put option depends upon whether you need to purchase or sell.

Call option – If you have a call option, you have the right to buy shares at the strike price before the expiration date. Having a call option obligates the current owner of those shares to sell them to you according to the option agreement.

Put option – Having a put option means you have the right to sell shares at the strike price by the expiration date. If you exercise your put option, the shares must be sold and you’ll collect the strike price for each.

Buying and Selling Options

You pay a premium when buying or selling an options contract.

The price of the premium is a relatively small amount of money that allows you the choice to buy or sell a certain number of shares at a fixed price (the strike price).

It’s similar in practice to how you’d buy stock. Except you’re not buying or selling the shares now, but are paying a premium for the ability to buy or sell in the future.

Depending on your prediction of how the values will change, you can buy or sell call options and put options.

For example, call options can be profitable if you were expecting the underlying asset to go up in value.

Then, you could presumably purchase shares for the strike price, which could be considerably lower than the market price.

But if you think the assets will go down in value, put options might make more sense. Since it gives you the right to sell at a price that’s likely to be higher than the market price, you could cash in on the difference.

Exercising Options

Most options traders tend to make money through buying and selling, but you do have the choice to act upon the terms in the contract. When you do, it’s known as exercising your options.

Options trading has many different strategies, and you can exercise options as part of your investment plan.

Whether you stick to buying and selling or also choose to exercise your options, there is an opportunity for versatility to increase profits and reduce loss.

Why You Should Use Options

Though their reputation is that of a risky investment that’s best left to the experts, options can prove useful to individual investors, too. Having options as part of your investment portfolio can introduce several strategic advantages.

Not only do they deliver the potential for higher returns, but they can also hedge against losses.

Options generally require less of a financial commitment than if you bought the asset outright.

That’s because you’re not paying full price to buy shares, but are paying less to for the choice to buy the shares at a later date.

This way, if the market price drops, you only lose the premium you paid to buy the options instead of losing a lot more money if you had bought the shares directly.

But if the market price skyrockets, you’ll have the opportunity to buy the shares at the lower strike price. When that happens, you can cash in by exercising your options or by selling your contract to another investor. Either way, you can profit from the transaction.

How to Start Trading Options

Though it sounds complicated and can include a wide variety of strategic approaches, it’s relatively simple to start options trading.

You need a broker and should compare fees and account minimums to pick one that is affordable and matches your investment style.

From there, it’s time to develop your options trading strategy. Like most investments, options trading strategies depend on your individual goals and risk tolerance, and can span from simple to quite complex.

Here are three strategies a beginner can use to get started.

The Long Call

Long Call options trading

When you hold call options expecting the price to rise, the value of the shares can increase beyond the pre-negotiated strike price.

When this happens, the strike price becomes lower than the market price, and you can make money because it appreciates at a faster rate than the underlying security.

The Long Put

Long Put

If you predict the rate will fall, buying put options can limit your investment loss.

In this instance, your put options give you the right to sell at the strike price which is presumably higher than the market price, meaning you might not lose as much money.

The Short Put

Short Put

The opposite of the long put, the short put is useful if you believe the price will stay the same or rise through the expiration.

This way, the option becomes worthless, and the put seller gets to keep the whole premium.

These are a few of the most simple strategies for trading options, but they could be worth considering if you’re just starting.

After you earn a little profit and are comfortable with these basic strategies, you can introduce more complex tactics. Just make sure you understand your approach and don’t invest more than you can afford to lose.

Conclusion

When you begin trading options, you’re buying the right to buy or sell shares of the underlying security.

You don’t have any ownership like you would if you had bought the stock directly, but there is value in having the choice of the options contract.

As with all investments, there is an inherent risk in options trading.

To make a profit, you need the ability to predict whether a share price will rise or fall, and that can require a significant amount of research (and luck).

Once you understand the ins and outs of how it works and find a great broker, there is an excellent investment potential if you implement the right strategies at the right time.

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