Options Trading - The 10-Step Guide
What are options?
To start with, options are a form of derivative in the markets. Derivatives are a group of investments that derive their value from an underlying security. Think of it as a bet between whether that underlying security is going to go up or down.
Stock options are not that different from this analogy.
An option is a security sold from one investor to another with an agreement (in the form of a contract) between the two parties.
The buyer of the options contract pays a premium to the option writer/option seller. In exchange, the buyer will be given the right to buy a specific investment from or to the other party at a pre-determined price at some point in the future.
The right to buy the share from the option seller is known as a call, and the option to sell a share is called a put. We’ll get into this later don’t worry.
Did you know that one of the reasons why GameStop ($GME) went on an insane short squeeze is because of options? Well, today, you’ll be learning all about options trading for dummies and everything around it.
Key takeaways:
Terminology
Premium – The price of the option contract.
Strike price – The pre-agreed price at which the stock can be bought or sold depending on the terms of the contract. Commonly referred to as the “exercise price”.
ITM (In the money) – When the stock price is above the strike price of a certain options contract.
OTM (Out of the money) – When the stock price is below the strike price of a certain options contract.
Intrinsic value – The value of an option at expiration.
Extrinsic value – The value of an option at expiration plus the external factors of time value and implied volatility.
Buying call options
You buy a call option when you expect the stock price to increase. When you buy a call option, otherwise known as calls, you will be paying the option premium (price of the option) for the right to buy the shares of the underlying asset at a fixed price (strike price) on or before the expiration date of the contract.
Some traders prefer to buy calls instead of the asset itself because of the leverage it provides.
It can be an effective way to of increasing their exposure without tying up a lot of their funds.
However, there is also a higher possibility that traders can lose 100% of their position as the option expires worthless. Institutions, large investors, and funds often use calls to control large amounts of shares with relatively small capital or to hedge their position.
Buying put options
While a call option gives you the ability to purchase shares of a stock at the call’s strike price, a put option (puts) gives you the ability to sell shares at the puts’ strike price.
In simple terms, a call option will become more valuable when the stock price increase and a put option becomes more valuable when the stock price decreases.
Similar to call options, the value of put options will also fluctuate based on the stock’s price changes. Again, traders and investors buy put options as opposed to shorting the shares of a stock because it gives them much more leverage without risking too much.
A huge difference between this is that when you buy a put option, your potential loss is only 100%, assuming your option expires worthless. However, if you’re shorting a stock, your potential loss is actually infinite, because theoretically, there is no ceiling to how high the price of a stock can actually increase.
Selling call options
Selling options is a different concept altogether, but the fundamentals of it are that the call option seller will make money if the price of the stock remains under the strike price. For the best-case scenario, it would mean that the option expired worthless and the option seller/writer has realized their maximum profit (100%).
Note that selling a naked call option, which means writing the call option without owning the underlying security is an extremely risky strategy as there is no ceiling to how much you can potentially lose.
Selling put options
A put options seller takes the other side of the trade of a put options buyer.
This means that this seller will make his/her money when the stock price remains above the strike time. The maximum profit potential for this is, again, 100%. It is when the stock price is above the puts’ strike price at the expiration date, which means that this option contract has expired worthless.
One of the benefits that attract market participants to selling or writing options is that they can collect a premium from the buyers.
This gives them some sort of cushion even if they were to face a loss.
While the risks of having to take a huge loss due to the fact that the downside potential of selling a put options contract is theoretically unlimited, it is still a very strong alternative to just going long on the underlying asset itself.
Before we move on, here's an example of what it would look like:
Best option trading platforms
Searching for a good platform to trade options is definitely an area that has no perfect answer.
That’s because it will depend on your level of familiarity with options and the features that you want. In 2021, most brokers have already integrated at least some basic features that options traders are looking for, hence if you already have a brokerage account, it would be best to start there.
Beginners
If you’re a beginner, Robinhood and E*Trade is a good place to start as they both have a very simple user interface that looks less like the insides of a fighter jet.
The things you should and always need to look out for is to have it simple enough so that you can very quickly know whether you’re ITM or OTM. You never want to be caught not knowing what your average price is or unable to exit a position.
Intermediate
As you move into the intermediate level, the more sophisticated platform from TradeStation, TD Ameritrade and Charles Schwab will be your best bet. These are just some of the biggest brokers that most traders and investors use and all of them will have most of the indicators that you’re looking for already built into the platform.
These platforms also give you some of the sophisticated tools that take into account some of the values that are harder to calculate based on the Greek values.
Advanced
Okay, now that you’ve graduated from the intermediate level, it is time you hop on to Interactive Brokers or Tastyworks. These two platforms offer the most advanced tools an options trader can ask for.
Tastyworks is a platform dedicated to serving the options community, hence it is options focused throughout their entire platform. It even has a very simplistic interface on its app, which makes it even more appealing to those traders who want to manage their positions on-the-go.
When searching for brokers and platforms, it comes down to your personal goals and preference. But what we would say is that you have to make sure that your broker has client protection policies in place. The stock market is a capitalist’s world and somebody on the other side is always trying to take your money. Ergo, it doesn’t matter even if your broker offers $0 commission in trading if our funds are at risk of never being seen again.
Think of it like a long-term relationship rather than just a fling.
Time decay
If you’ve never heard of this or don’t know what it is, time decay basically means that your options contract is slowly dying. Just like us. And you can’t do anything about it.
Okay, but seriously, it is the reduction of value of an options contract as it gets closer to its expiration date.
Without putting in too many jargons and having you scroll up to the terminology section, time decay happens because it makes sense that an option would get cheaper and cheaper if there is less time for the underlying security to move in price.
To illustrate this, let’s say that you bought some calls with the strike price of $30 at the cost of $2, you will then need this stock to go to $32 in order to breakeven. If you have enough time, you can wait for the stock to bounce around a little bit and not be as worried if it can reach $32 before the expiry date.
However, if there is not much time left, let’s say 5 days left until that contract expires, how confident are you that within these 5 days, that stock will go to $32?
This is essentially how time decay works and why options are considered and will always be a depreciating asset.
How time decay may affect the profitability of your trade depends on how long you’re planning to hold that contract.
If you’re planning to hold this contract all the way until its expiry, the extrinsic value will have completely eroded at that point and the time decay wouldn’t really matter.
However, if you’re planning on closing out your trades before the expiration date, time decay will play a huge factor because of how it directly diminishes the value of your options contract.
A possible way to neutralize this is to also be writing/selling options at the same time.
An example of this would be to buy ITM calls (with a bit of intrinsic value) while simultaneously selling OTM calls (with no intrinsic value) on the same stock. You either make a profit if the stock moves in your favour, or you reap the rewards when the time decay causes the options to expire worthless. Often, this will also be known as a credit put spread.
Option Greeks
Delta – How much an option is expected to change per $1 of change in price of the underlying security. For instance, for a 0.2 delta, it means that the option’s price will move by $0.2 when the underlying stock moves $1.
Gamma – The rate of change of Delta. It measures how much the Delta changes when the underlying stock moves $1. We would describe Delta as the speed and Gamma as the acceleration as to how fast the option will change.
Theta – Measures how much the price of an option will decrease as it gets closer to the expiration date. In other words, time decay in a numerical format.
Vega – The rate of change of an option per 1% change in the implied volatility of the underlying stock. How sensitive if the option to the volatility of the stock.
Option strategies
Well, you’ve finally come to this meaty section of the post.
To be brutally honest with you, trading options is mostly a number’s game. You just have to calculate how much you’re going to pay for one side of the trade and find a way to offset that with another trade. Although these options strategies might be a little hard to grasp, for now, we are pretty confident that over time, you will be on the profiting side of it.
- A straddle option is essentially a neutral strategy in which you simultaneously buy a call option and a put option on the same stock with the same expiration and strike price.
- A straddle option strategy makes you the most money in a volatile market because the more the underlying stock moves from the strike price, the greater the value of both the options.
- A strangle option is an options trading strategy in which the trader holds a call and put option with the same expiration date but a different strike price.
- A strangle option is usually deployed when a trader expects a large move in the short-term.
Both the straddle option and strangle option is used in very similar circumstances except for the strike prices of it. Both of these option strategies are the simpler ones that can be easily grasped. But it is definitely not limited to these two.
There are so many strategies out there, including covered call, married put, bull call spread, protective collar, iron condor, and iron butterfly. You don’t need to understand all of these, you just need to find one that makes the most sense to you and focus on that.
Futures vs options
There are many people who confuse futures and options. Although both of these are derivatives, their fundamentals actually differ a lot.
An options contract gives an investor the right, but not the obligation to buy or sell the shares of a specific stock at any time before the expiration.
A futures contract, however, requires a buyer to purchase shares and a seller to sell them on a specific date in the future.
Both of these products have their own specific risks as they tend to be fairly complex in nature.
When a trader buys an option contract, the most that they will lose is the premium that they paid for it; when a trader sells/writes an option contract, that seller is exposed to the maximum liability of the underlying stock’s price.
In some cases, as we have discussed above, the maximum losses an options trader can take is 100% while in others, the maximum losses can be unlimited. For futures contracts, however, it involves maximum liability for both the buyer and the seller.
That’s because as the stock moves, futures positions are marked to market daily and the change in value will be transferred between the accounts of the two parties at the end of every trading day.
However, both of these products also have specific applications that traders can take advantage of. It can be for arbitrage or hedging purposes. So, choose your financial products well for your own situation. Don’t compare it with another person’s situation.
Conclusion
Options trading greatly varies from stock trading. However, one of the greatest benefits that it can provide is having limited risks. Simply having limited risks in your trading can often be the best insurance you can have in the markets.
It may seem overwhelming at first, trying to grasp the concept of it. But getting to know how options work is a great tool to have in your arsenal, even if you don't plan to trade it now.
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