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An option contract gives the holder the right, but not the obligation, to buy with a “call option” or sell with a “put option” an underlying asset at a given price (called the “strike price”) up to or on a certain date (called the “expiry date”).
If you already trade a particular asset and would like to branch out into other ways of taking a view on the market, then options trading may be for you.
Step 1: Educate Yourself About Options.
Before starting to trade options, you’ll want to learn about the various options strategies you can use and their risk profiles so that you understand how options can help you encapsulate a market view. You can take an options trading course or read books on the subject to do this. You will also want to review the specifics and operational mechanics of any options contracts you plan on trading, since missing an expiration date, not knowing the amount of risk you are taking or transacting the wrong type or style of option can be a costly mistake.
Step 2: Connect to the Internet.
Since you will generally want to trade options online via a trading platform, having a relatively modern computer or mobile device connected to the internet is virtually a necessity.
Step 3: Select a Good Online Options Broker.
Many online brokers will allow you to trade options. Select a well-regulated broker that offers options on the asset classes you most want to trade along with a good options trading platform and tight dealing spreads. Since options are more advanced trading instruments, you may also need to qualify to trade options via a particular broker.
Step 4: Open an Account.
Review your chosen broker’s initial deposit requirements and account types to see what will suit you best. Also, familiarize yourself with the broker’s margin requirements for various types of options strategies so that you can have enough funds deposited in your trading account to cover the options you want to trade.
Step 5: Practice Trading Options.
Rather than jumping right into trading options with real money, it makes sense to first practice trading options in a demo account. This helps you understand the mechanics of options trading and gives you a risk-free chance to learn how to use your broker’s trading platform.
Step 6: Develop a Plan.
It’s time to develop and test one or more options trading strategies that have a decent chance of success given the risk you will be taking. You can then incorporate them into an overall trading plan that lays out how you intend to operate your options trading business and manage your risk capital.
Step 7: Fund Your Account and Go Live.
Once you have prepared yourself for trading options by following these steps, you’re ready to start trading options in a live account once you identify a suitable opportunity in the market. Always make sure you have placed enough funds on deposit with your broker as margin to support your options trading strategies and trade only with money you can afford to lose.
Advantages of Trading Options
Trading options has several notable advantages over just trading the underlying asset. Some of them are discussed below.
The leverage that trading options provides can allow you to control large positions with relatively little money. If you think shares in Apple Inc. (NASDAQ: AAPL) will rise from $118, for example, you might buy a December $120 call option on 100 shares for $7 or just $700 in total. That is a considerably lower cost to take a long position in Apple than the $11,800 you would need to buy 100 shares of the stock itself.
Customized Risk Profiles
Using options lets you modify your risk profile when trading to adapt to a specific market view. For example, you can buy a call option to take a bullish view on the underlying asset while having your risk limited to the premium you initially paid.
Using the long option example in the previous section, if Apple’s stock rises to $140 by its December expiration date, then you will have made $20 less the $7 premium you paid (or $13) times 100 shares for a net profit of $1,300 on the option or $2,200 had you purchased the stock. Alternatively, if the stock ends up at $110, then you will just lose the $700 you initially paid for the option while you would have lost $800 had you instead purchased 100 shares of the stock itself.
You can also buy both a put and a call option with the same strike price (a strategy known as a “straddle”) if you expect the market to move significantly, but you are not clear on the direction and want to keep your downside risk limited.
You can use the so-called “covered write” option strategy to sell (write) options against a position in the underlying asset for additional income. For example, if you are long 100 shares of Apple stock at $118, you can sell a December $120 call option for $700.
If the market has moved above $120 by the option’s December expiration date, you can just deliver your Apple stock into the option contract when the option is exercised. Not only will you have made $2 per share or $200 on the underlying stock, but you will also have captured the $700 in option premium for a total gain of $900.
If the market instead declines, you will have the $700 you received from selling the option to buffer losses on the long stock position, giving you an improved breakeven price of $112 instead of $118.
Disadvantages of Trading Options
Although using options expands the choices traders have to express a market view, they do have a few possible disadvantages you should be aware of.
Unlike an actual asset, options contracts expire at a certain time. This means you need to take a market view that also has a time frame associated with it when trading options. You also need to be aware of when your options are expiring in the money since they will generally either be exercised if you are long the option or assigned against you if you’re short the option. This can result in an underlying position you might wish to trade out of, especially if you don’t have the funds required to hold it.
No Dividends on Long Positions
With stock options, when you hold a call option on a stock, you do not receive any dividends paid out to holders of the underlying stock. To receive the dividend, you need to exercise the stock and be holding it on the stock’s date of record for dividend payments, which is generally several weeks before the dividend is paid on the ex-dividend date.
Compared to simply buying or selling an underlying asset, options and the various options strategies you can use when trading them require education to understand and use them effectively.
If you’re trying to figure out if trading options is right for you, you should first understand what options are. An options explanation can turn into something complicated very quickly, so let’s simplify. As with most investing products, an option is a contract. It is exactly how it sounds. This specific type of contract gives you the right to buy or sell an asset at a specific price by a specific date. It’s essentially a contract that is giving you the option to follow through.
How Do Options Work?
Again, as with most investment products, you’re going to want to determine the probability of the future prices of certain assets. You can assume that the more likely it is that something will happen, the more expensive a related option would be.
The basic steps of trading an option are:
- Identify the asset you want to buy or sell.
- Enter a contract to determine a premium, cost and expiration date.
- If you’re the buyer, you pay the premium cost.
- Monitor the asset and decide whether you want to follow through on the contract to buy or sell.
Here are some key factors to understand about options:
- Options are typically sold in increments of 100. So you should be sure to multiply the premium of your contract by 100 to get the total cost of your option.
- The more time you have in your contract, the more valuable your option could be. This is because the more time there is, the more chance there is for the price to change.
- If you’re the buyer of an option, you are not obligated to go through with buying. However, you will not get the premium back if you choose not to follow through. The only risk to entering the options contract is losing the amount you spent on the premium. So be sure you’re comfortable with losing the cost of your premium if it comes to that.
- On the other hand, sellers may be required to make good on the options contract to sell. Sellers have greater risk and can lose much more than the cost of the options contract premium.
Types of Options
If you want to trade options, you’ll need to understand the different types of options. Even though the options we talk about below seem like they’re related to geography, understand that geography has nothing to do with it.
American options: These options can be exercised at any time between the date you purchase your option and the expiration date that is set on your option. This option type typically has a higher premium since it is allowing you to exercise your option at any time.
European options: Unlike American options, European options can only be exercised as the expiration date gets closer.
Exotic options: This type of option offers more variation. The payment structure and expiration dates can be different than the American or European options. If you’re looking for a more customizable option, this is what you’ll probably want to look for.
You’ll also need to understand the difference between call and put options:
- A call option gives you the right to buy a stock.
- A put option gives you the right to sell a stock.
Call Option Example
You might be asking “how do call options work?” Let’s say there’s a new business opening up in your town. It seems like it’s going to be a profitable business with a lot of potential. You’re considering offering to buy the business with the hopes of getting in at the start of something big. Of course, this is a risk on your part.
Even though the business shows a lot of potential, there’s no way to know how things will turn out. This is where call options would benefit you. If you could buy a call option on the business, you could offer to purchase the business at $500,000 sometime in the next 5 years.
Now, the current owner of the business would want to know you’re serious. So imagine that they would require a down payment of $50,000. If this were an options contract, that down payment would be referred to as the premium. The premium is the price of the option contract.
Now let’s fast forward 2 years. The business is booming, and it is now worth closer to $1 million. You decide at this point that you want to go ahead and exercise your option to purchase the business for $500,000. You can do this even though it is less than the current value of the business because you locked in the price with your down payment.
|Start of Contract||2 Years Later|
|Value of Business||Undetermined||$950,000|
|Your Price||$50,000 down payment||$500,000|
Put Option Example
You might want to have an option to sell your asset at a set price if you fear that your asset’s worth might plummet. This will allow you to protect yourself from losing a larger amount of money.
So how do put options work? Let’s say that you fear that your stock in Apple is about to become much less valuable. So you decide to take out the option to sell it, just in case. It’s currently trading at $3,000, so you decide to take out the option to sell it at $2,700 at any time in the next 3 years.
You’ll have to pay the premium, let’s say that’s $300 in this case. So if you decide not to sell, you’ll lose this $300 but you’ve probably gained much more by keeping your stock. If you’re right and the stock plummets, you can sell it for the $2,700 you locked in, even if it’s only selling at $2,200 when you sell it.
|Start of Contract||2 Years Later|
|Your Price||$300 down payment||$2,700|
Though an options table might look intimidating, the truth is that they’re relatively easy to read once you know what each abbreviation means. Here are a few of the most common sections you’ll see on an options table:
- Symbol: The ticker symbol for the underlying asset the option represents.
- Last: The most recent posted trade price for each share of stock.
- Change: Shows how much the last trade varied from the previous day’s closing price.
- Bid: The latest price at which you can sell an option.
- Ask: The latest price at which you can buy an option.
- Volume: Tells you how many contracts of an option were traded during the current session.
- Open interest: Indicates the total number of contracts for a particular option that have been opened. This number decreases as open options are closed out.
- Strike price: The strike price is the price at which you can buy or sell the stock if you choose to exercise the contract after purchase.
Most Profitable Option Strategy
There are many different options trading strategies, and the strategy that will be best for you may vary depending on your position and the stocks you’re trading. One of the most popular strategies is the “covered call.”
When you structure a covered call, you sell a call option against shares of stock that you already own. For example, you might sell one call option for every 100 shares of stock that you own. You may even use the premium from your sold calls to accumulate more shares of stock.
This is a very popular strategy because it allows you to receive income from your investment portfolio. If the price of the stock increases beyond the call option’s strike price, your long stock position covers the losses from the short option position. If the price of the stock falls, then your losses are buffered somewhat by the premium you received for selling the call.
Benzinga Options Newsletter
The most important tools that an options trader can have at his or her disposal? Up-to-the-minute price data and professional, hand-picked recommendations. Benzinga’s options newsletter is your one-stop-shop for the day’s top stocks and options you need to be watching. Don’t spend hours guessing which stocks to buy — let the professionals deliver their picks straight to your inbox with Benzinga’s Stocks to Watch.
Knowledge is Power in Options Trading
Options provide traders with a greater choice of ways to express a market view. Since options can add considerable complexity to your trading activities, however, you will want to educate yourself thoroughly about how to best use them so that they boost your bottom line as a trader.
You may want to take an options trading course, read relevant articles, watch related tutorial videos and even hire an options trading mentor. Your online options broker could also provide you with its guides and tips to train yourself with, so check to see what it offers.
Frequently Asked Questions
What are the risks of options trading?
The risks in options trading are you can lose the premium you paid for the option. Those who write uncovered calls face unlimited risks when prices start to rise.
What are the best options brokers for beginners?
Benzinga recommends TD Ameritrade, Webull and Moomoo for best options brokers for beginners.
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