Are you a novice at trading? Do you have experience trading physical commodities and want to expand your skills further?
Trading is a skill that people have been perfecting for thousands of years. It involves making complex and calculated decisions based on experience and intuition. Getting into trading can be hard, especially if you’re a beginner, and options trading is no exception.
For that reason, we’ve decided to write a complete guide about options trading for beginners and help you easily overcome options trading and eventually master it.
Let’s get started!
Options Trading for Beginners - Let’s Get You Into Trading
Does trading with options seem like an intimidating feat to you? Are you unclear of the terms, unfamiliar with the process and don’t know much about options trading?
All of these questions are natural and normal. The main important thing is to be determined and have a positive mind. You can approach anything and succeed if you’re determined and optimistic, options trading is no exception.
Our task in this article is to help you understand:
- The fundamentals of options and options trading
- The different types of options
- The different trading options terms
- How to begin trading with options (including several important strategies)
By the end of this article, you will have all the knowledge and skills required to get into options trading with confidence, and we will even advise you where to begin your trading journey.
Let’s get into it!
Learning the Basics of Options and Options Trading
The most basic question that any beginner would ask is - what exactly are options, and what does it mean to trade options?
What are options?
You can think of options as a type of derivative contract that grants the buyer the right to buy or sell an asset or security at a given price in the future.
The value of options is derived from the assets they represent. This value is called “the option premium” and depends on two factors, the intrinsic value, and the time value. We will take a look at these a little later in this article.
What is options trading?
The process of buying and selling options is called options trading. It involves both the buyer (holder) and the seller (writer) of the options.
When the holder pays the writer an option premium, they’re paying for the right to buy and sell an asset or a stock at a given date.
This is the most basic explanation of how options and options trading work.
They may sound simple, but the number of underlying factors and mechanics make them quite complex for beginners. Don’t worry; we will clarify everything in detail further in the article.
Different Options Types Explained
You now have a basic understanding of options and how the options trading process works.
Let’s go deeper and analyze the two different types of options you can buy and sell.
Call options
Call options give buyers (holders) the right to purchase an asset or stock at a predetermined price within a preset timeframe (calling the asset or stock to them).
The key thing to remember is that call options are related to purchasing underlying assets or stocks, not selling them. Call options increase in value if the assets’ or stocks’ value increases, and vice versa.
Practical explanation of call options
Let’s look at a practical everyday life example, so you can understand easier how call options work.
Let’s say you’ve won a voucher from a certain shop selling all types of house commodities. That voucher allows you to purchase items from the shop worth $100 within one month.
Now imagine that there is an item that you need to purchase from that store, but it is priced at $150. You use the voucher (call option) to purchase the item for only $50. In other words, you use the discount value of the voucher at the right time and under the right circumstances.
You certainly wouldn’t use it if the item were priced at $80 (at a discount) because then you would lose $20 of the remaining value the voucher provides.
Compare this example to owning a call option (voucher), allowing you to purchase stocks at a company. For example, a 100-call option would give you the right to purchase 100 shares at a company for $100 per stock in a set timeframe.
If the shares are on sale for less than $100, you would certainly not exercise the call option. But if the price of the stocks goes to $150, you will exercise your right to purchase 100 shares for $100 and then resell them for a price of $150, thus gaining a profit.
Put options
Put options are the reverse of call options. They give sellers (writers) the right to sell an asset or a stock at a predetermined price within a preset timeframe (putting the asset or stock away from them).
Put options act as a kind of protection, allowing you to feel safe and protect your position if the price of the stocks goes far below your estimated projections.
Practical explanation of put options
If we continue from our previous example, let’s say that you now own 100 stocks at a certain company, and those stocks are now on the market for $100 per stock.
If you analyze the market and think that the price of those stocks might fall below 10%, you can purchase a put option for $90 per stock. This strategy will secure your position.
Even if the price of the stocks drops to $70, for example, you will still be able to sell them for $90 and limit your losses. That is the security that put options provide.
Explaining the Different Trading Options Terms
The process of trading with options is what scares most beginners.
You may understand the individual concepts and know what each of them means, but when it comes to practically applying what you know, things can get quite complex.
To help you get started easily, in this section, we will cover and explain some of the most common options trading terminology and how the values and prices of options are determined.
How to understand an options chain
An options chain is the most important information you need to know to understand how options trading works. It is often represented in a table containing detailed information about an asset or stock.
You read an options chain to grasp what that asset is, its value, and how many options are traded at a given time related to it. A common options chain has the following values:
Calls and puts
We’ve already discussed these values in previous sections of the article, so there is no need to cover them again here.
Just remember that call options give you the right to buy assets or stocks at a predetermined price, and put options give you the right to sell them at a predetermined price.
Strike price
The strike price represents your “reference” price or the price at which you can exercise a call or put option.
In other words, it is the price you agree to purchase the options at, and it can go up or down in value depending on the market situation and the stability of the company that offered the stocks.
Bids and asks
Bids and asks represent the prices of the options. In other words, bids represent the prices of options you buy (call options), and asks represent the prices of options you sell (put options).
Bids and asks can vary significantly depending on the market and the fluctuation of prices.
The difference or spread between bids and asks is the difference in price that a buyer is prepared to pay (to bid) or sell (to ask).
Volume and open interest
Volume and open interest are often displayed together.
Volume gives you information about the number of options that have been traded in a given day.
Open interest tells you how many contracts or options are available for trade at a given moment.
Greeks quantifiers
Option Greeks are quantifiers that quantify the rate of an option's price in a positive or negative value. You can also think of Greeks as multipliers, as they add or subtract value from an option’s price.
Delta and theta are the most common Greeks in an options chain.
Delta can quantify the option anywhere from -1.0 to 1.0, depending on the dollar price change. Delta is also used to measure the balance between the strike price and the asset’s or stock’s price. When these two are equal, the delta value is 0.5.
Theta is used to quantify and measure the price change of an option the closer it gets to its expiration date. Its value is always negative because the value of an option decreases as the expiration date approaches.
Implied volatility
This value is rarely displayed in an options chain, but it measures how volatile an asset or stock price can be during its lifespan.
The implied volatility metric is at its highest when an option is created, and its value gradually decreases as that option reaches its expiration date. It is a metric used by many advanced traders to predict the long-term prices of assets and stocks.
How to read and understand a stock option quote
Stock options are some of the most common options that people trade. They are often based on equities and are a great way to start trading.
To be able to buy or sell stock options, you need to know how to read stock options quotes. They are a sum of five terms representing several values related to a stock option:
- The name of the stock - a short symbol that explains the name of the stock that the option is tied to
- The expiration date - symbolizes the date the given option will expire
- The strike price - refers to the current price at which you can exercise a stock
- The option type - refers to the type of option (call or put)
- The option cost - refers to the premium or the price you must pay to purchase the options contract
How are options prices determined
The option’s pricing or premium mainly consists of two important values:
- Intrinsic value
- Time value
Intrinsic value explained
The intrinsic value represents the difference between the current price of an asset or stock and the strike (exercise) price.
If the current price of the asset or stock is higher than the strike price, then we can say that call options are “in the Money” (ITM), meaning they are profitable for the holder (buyer).
The intrinsic value (call options) = The premium - The strike price
If the current price of the asset or stock is lower than the strike price, then we can say that the put options are “in the Money” (ITM), meaning that they are profitable for the writer (seller).
The intrinsic value (put options) = The strike price - The premium
Time value explained
The time value greatly determines the premium or price of an option. The higher the time value (the longer it takes for an option to expire), the higher the chances that the option will benefit the buyer or the seller.
The time value = The premium - The intrinsic value
4 Strategies You Should Try in Options Trading for Beginners
Now that you know all the terms required to get into options trading, you might wonder how to start trading stock options.
To help you, we will explain four of the most common options trading strategies, and you can apply or adapt any of them to your trading model.
The long calls strategy
You can use the long calls strategy if you believe an asset or stock price will increase in the future. It means buying the assets or stocks at a lower price than what they would be worth (predicting the rise of their value).
With the long calls strategy, the potential profits can be substantial if everything goes as you predict. In other words, small changes in future stock value can mean high changes in option value.
Experienced traders often use long calls to predict the prices of stocks in a highly volatile market. The volatility of a market can manifest in numerous events that can shift the tide in their favor and increase their profits substantially.
Long call example
You decide to purchase stock options at a certain company because you believe those stocks will have a higher price in several months.
The current price of 1 stock is $50 (strike price), and you purchase a call option for 100 shares which are set to expire in five months. Let’s say that the fee for those options (the premium) is only $5 per share.
If your predictions are correct, after three months, the shares are worth $100 per share. You can now exercise your long-call option and buy the shares for $50 each. Then you sell them for $100 each and make a profit of $4,500.
In other words, the shares you bought are worth $5,000 ($50 x 100 shares). The profit you made is $10,000 ($100 x 100 shares), subtracted by the fee (premium) you pay for the option ($5 per share x 100 shares). So $10,000 - $5,000 - $500 = $4,500.
The long puts strategy
Using long puts involves a process that is the opposite of long calls. In other words, if you believe that the stock prices of a certain company are going to drop, you would purchase a long put to have the right to sell them at a higher price later.
Long put example
You decide to purchase stock options at a certain company because you believe that their value will decrease after several months.
You purchase one put option worth 100 shares, which is set to expire in five months. The price (strike price) of one share is $50, and the fee (premium) of the option is $5 per share.
Once your predictions are correct, the value of the shares starts to drop, and now they’re worth $25 each after only three months. You can now exercise the put option, purchasing 100 shares for $25 and then selling them for $50 each. This strategy makes you a profit of $2,000.
In other words, you purchase 100 shares x $25 = $2,500.
You then sell those 100 shares x $50 = $5,000
The profit is $5,000 - $2,500 - $500 (the fee for the option) = $2,000.
The covered calls strategy
This strategy is based on purchasing the stocks and selling call options for those stocks on an individual share basis.
There are two terms associated with covered calls:
- Buy write - which means purchasing stocks and selling calls simultaneously
- Overwrite - which means selling calls on previously owned stocks
Covered call example
An example of a covered call strategy is if you purchase 500 stocks from a certain company and immediately perform a “buy-write” and sell 5 call options against those shares.
The profits you make are the fee (premium) from selling the call options to another potential buyer. In this case, you act as a writer (seller) of options. The same is true if you own stocks for longer and sell them using call options.
The protective puts strategy
Protective puts give you a sense of security against a potential high loss when purchasing stocks. In other words, you purchase stocks from a certain company and immediately purchase put options for those shares to minimize the loss (in case there is any) in a predetermined period.
Protective put example
You decide to purchase 100 shares at a certain company for $100 per share, and then you also decide to protect your investment by minimizing the loss. You do that by purchasing a put option against those shares for $3 per share for three months.
The potential profit you can gain from these shares depends on how much their value increases in the future (which can be unlimited).
However, the loss from those shares is limited to the premium of the put option you purchased, plus some of the commission fees.
In other words, if the price of the shares declines far below $100, you can exercise your put option and sell those shares for $100, only losing the fee (premium) you paid when you purchased the put option ($3 x 100 shares = $300) plus commissions.
How and Where to Begin Your Options Trading Journey?
Now that you know all the basics and understand the strategies we’ve discussed, it is time to start your options trading journey.
The best way to start trading is via an online trading platform. All you need is a computer and internet access, and you’re good to go. Online trading is available on smartphones so that you will monitor your investments 24/7.
The best platform to begin options trading is FoolProof. It is based on all the mechanics and features we’ve discussed. It also is a user-friendly platform with a very affordable pricing plan and will inform you of all your trading activities and changes via trade alerts.
The platform will even provide additional guidance resources, so you can understand all its features in detail and properly manage your trading activities.
Conclusion
Trading with options can be challenging, but now that you know all the strategies and the place to start, you will soon overcome that challenge.
We hope this article has proven useful and that you will also recommend this guide about options trading for beginners to your family and friends so that they can also benefit and gain potentially large profits from trading with options.
If you have any further questions or comments, feel free to leave them in the comment section below, and we will get back to you as soon as possible.