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A Guide to Options Trading

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Many people find options trading intimidating when they first get into it, and it is much more complex than trading stock. This is why a majority of investors buy short-term calls when beginning to trade options. When the strike price goes higher than the stock price, known as out-of-the-money calls, they follow the same pattern of buying low and selling high.

What Is an Option?

An option is defined as a choice that an investor has when they’re navigating the stock market. This gives you a right to sell (put) or buy (call) the underlying index, ETF, or equity at a price that’s pre-determined, known as the strike price. You have a certain period of time to do this before it expires. You’ve probably seen how options work in your daily life without even knowing it. You’ve likely bought a right to protect yourself against a risk, such as health, car, or home insurance. These principles are also applicable to options trading.

For example, you might buy a new vehicle based on how it feels, fits your needs, and meets safety ratings. You likely wouldn’t just drive it off the dealership lot without making sure it’s protected since this is a large investment. Whether you buy car insurance or life insurance, every month or year you pay a premium to keep it protected. The policy is likely at a higher value than what you actually pay, but this small fee you pay for protection is worth it.

When the year is over and you’ve gone without any accidents, you’ve essentially won since you drove for a year knowing you had insurance and didn’t lose your original investment, or premium. This is similar to options trading, except you replace the vehicle for a stock holding.

Say you think a stock that’s currently at $30 per share will go up to $35 in a few months, but you don’t want to spend thousands of dollars at the moment. Instead of buying one options contract, which has 100 shares, at $1.50 for each contract, you would only spend $150, compared to $3,000 if you decided to buy 100 shares of stock initially.

Types of Options

The two types of options are known as puts and calls. Each options strategy will use one if not both of these as their building blocks, no matter how complex they are.

  • Call options give the buyer a chance to buy a security at a certain price during a set time, but they aren’t obligatory. They’re often bought when you may be bullish regarding what direction the market is going or about the prospect of a certain stock.
  • Put options let you sell a security at a certain price during a set time. These buyers tend to buy puts to make a profit off a downside move that’s unexpected. Put buying is comparable to shorting stock since the trader gets motivated by expecting the shares will decrease to a certain price. The buyer has less at risk than the short seller since there’s a possible maximum loss when it comes to buying options. Those who want to invest in short stocks need to have more capital to purchase shares if the price increases.

For every option, two parties are involved, which consist of one selling and one buying. There are advantages and disadvantages to each strategy. You’ll need to decide which option is the best one for you at the time, in order to successfully option trade.

Options Trading Education

When options trading started in the 70s, there weren’t many securities that were traded. There are now many more optionable indexes, LEAPs, and stocks available, but this has made it harder to have unique symbols compared to when the original three to five character system was used. In 2010, every option ticker became 21 characters long, which helped create a format that could universally be understood by anyone in the market.

Using AAPL190721C00600000 as an example, it initially seems confusing to read. However, AAPL is the options root, which shows what the underlying security is. The number 19 is the year it expires, so 2019 is when the option expires in this case. The numbers 07 is the month, meaning it expires in July. The number after that, 21, indicates the day it expires. Therefore, this stock expires on July 21, 2012.

After that, the letter C shows whether it’s a put or a call. C means to call, while P means put. The numbers following this, 00600000, represent the strike dollar for the first five numbers and the strike decimal for the last four numbers. In this case, the option has a $600 strike price.

Pricing Options

Once you have a basic understanding of how option trades work, you probably want to know how much money you can make from them. That’s not an easy answer, as it could be nothing or it could be very profitable. Most of the price is based on the price of the stock, how much time is left until the expiration of the option, and what the underlying stock’s volatility is.

As previously mentioned, the price of the security is where you begin once you’ve figured out the underlying asset that you want to trade options for. The stock price has a huge influence on the price of the options. If a company trades stock at $525 and then comes out with a popular product, the share may rise up to $575.

Those who currently have shares will want their right to buy the $525 shares secured. When the stock price increases, the call prices will also go up, but the put prices will go down. The same is true when put prices increase and call prices decrease, as the stocks get lower.

Time disintegrates the value of every option since they are considered a wasting asset and expire. The more time there is before the option expires, the more value it potentially has. Once it nears the expiration date, time decay increases since there isn’t as much time left to move the option into a territory that’s profitable and in the trader’s favor. This should be considered when making the decision to options trade since you may want to purchase options that have a longer time period until they expire. This way, the underlying stocks have a chance to make in a positive way.

Volatility is another important factor when figuring out an option’s price. Those that have been steady for years will be priced more predictably and lower than those who go up and down unpredictably. However, history isn’t the only factor that determines the price. Implied volatility affects the price, as well, because it is based on what volatility the market thinks the stock will see in the future. A stock that’s on the move will increase in price as more people want to buy it.

When the stock increases, the options market maker, or the trader who works on the floor, will change the implied volatility so it goes up, meaning the option’s premium will see an increase, even if the stock price is the same. The options will be valued higher to investors that want to make sure a specific price is locked before they buy the stock. Each option always has an ask and a bid price. You sell at or close to the bid and buy at or close to the ask price.

If you see an option of prices that are $8.60 X $8.90, you’ll buy at the costlier price of $8.90, which is the ask price, and sell at the cheaper number of $8.60, which is the bid price. The spread is the difference between the ask and bid prices. The thinner the spread, the better it is for liquidity, where it can easily move in and out of positions.

Options Trading Training

Buying short-term calls that are out-of-the-money isn’t a good way to begin trading options, however. If you have a stock that starts trading at $50, you might want to buy calls with a strike price of $55 that expire in 30 days at the cost of 15 cents or $15 per contract. This is tempting since you can buy many of them at this price. Keep in mind that there are usually 100 shares in one option contract.

However, there can be a high risk with options trading. If the stock you’re trading is currently at $50 and it has a strike price of $55 with a cost of 15 cents, you’ll need it to increase in price to $5.15 if you want to break even before the options expire. That requires a substantial rise in a brief time, which is hard to predict.

Another example is if you bought 100 shares at $50 each, which would total $5000. You could instead buy calls at $55 and have 333 contracts, which means you’d have a total of 33,300 shares. If the stocks went up to $56 within the next month and the $55 call trades were $1.05 before they expired, you’d end up making $29,921.10 for the month. This comes from the sale price of $34,965 minus the $4,995 originally paid, minus a $48.90 commission. This appears to be an attractive offer.

One issue with these short-term out-of-the-money calls is you have to accurately predict which way the stock will move, as well as be correct about the timing, which is hard to do. Also, the stock needs to not only go beyond the strike price within a set amount of time, but it also needs to go past what the strike price is, in addition to the cost of the option.

If you have a $55 call on your stock, each stock will need to get to at least $55.15 within a month, so you can break even. This doesn’t include taxes or commission. What this means is that you’re hoping the stock will move a minimum of 10 percent within a month’s time, which is not likely for most stocks. In reality, your stock most likely won’t reach the strike price, and your options will expire and be worthless. This means you need to get lucky or outsmart the market.

Another scenario is imagining if the stock went up to $53 during the option’s 30-day lifetime. Even if you were correct about which direction the stock moved, you’d still be wrong about how far it went within that time frame, meaning your whole investment would be lost. Instead, if you bought 100 shares at a price of $50 each, you would have made a profit of $400. If the forecast was incorrect and the stock decreased in price, it still would be worth a large portion of the original investment.

The lesson from this is not to get persuaded by any leverage you may get from buying tons of calls that are short-term and out-of-the-money. You also shouldn’t completely avoid calls, as you can buy long-term options instead, or write covered calls. These will increase your stock portfolio. If you’re not experienced, it’s best to have a balance between using options and trading stock when appropriate.

Knowing the Risks

When you understand the risks, you’ll become a smarter trader who sees more profit. Some investors are excited when it comes to options trading because they like the leverage they get if the investment goes in their favor. Stock investors tend to make up to 20 percent returns on their stock, while options investors who are aggressive can make up to 1,000 percent returns during the same period of time.

These huge profits are possible due to the leverage that options trading offers. A smart trader knows that they can control the same number of shares as a regular stock investor but at only a fraction of the original cost. Traders who aren’t savvy might not see the leverage they already have and instead make the decision to spend the same amount of money that they originally would, to create a long stock position and put it all into a large options position.

To give an example, instead of spending $3,000 to purchase 100 shares that are $30 each, the trader might put that $3,000 towards options. There is no need to spend that when there are trading options. An advantage of trading options is it limits a person’s risk instead of multiplying it, as in the situation above. A smart rule to stick by is to not invest more than 5 percent of your portfolio into one trade. If your trading portfolio was $25,000, you would want to use only $750 to $1250 for each trade.

Trading options aren’t only about trading risk to get an equal reward. The goal should be to get the edge of a professional trader. You should aim to decrease the risk by carefully selecting which investment opportunities you want. You also want to get bigger returns at the same time. It’s normal and expected to have losses, but each trader’s goal is to have profitable and strong portfolio returns. Investing in anything has a certain level of risk associated with it.

There is a greater risk with options investing, so it’s essential to know the pros and cons of each strategy before you begin trading actively. It’s beneficial to get options trading lessons online if you have no experience with this.

Time isn’t always on your side with options, as they expire. The premium deteriorates faster the closer the option gets to expiring, and this happens very quickly in the days before the expiration date. You need to only invest the amount you’d be comfortable losing, knowing that you could potentially lose everything.

Options Trading Lessons

Image via Flickr by chilot

It’s helpful to educate yourself by learning options trading for free online before beginning this process. By doing so, you’ll learn there are different ways to put time on your side. The first choice is to buy options near or at the money. You can also trade options that have expiration dates that embrace the investment opportunity comfortably. The third alternative is to buy options only at the point where you think volatility is underpriced and sell those options when you think it’s overpriced.

Since options are investments that are highly leveraged, prices can quickly change. Unlike stocks, option prices can change in a matter of minutes or even seconds, compared to hours or days. The small movements found in stocks can change into bigger movements for the underlying options, depending on the expiration date and the stock price’s relationship to the option’s strike price.

When figuring out when to invest in opportunities, you should only look at situations where the potential profit is so large that the pricing per second won’t be the answer to making money. You should go after profit opportunities that are larger, so there’s plenty of reward even if you’re not precise when you sell. You can also structure the options purchase by using the correct expiration months and strike prices, so the risk is decreased.

Depending on what your individual risk tolerance is, you may think about closing the options trades when there’s adequate time before expiration, so the time value doesn’t deteriorate as dramatically. You should also educate yourself on what happens to shorting naked options. This is when you sell options without limiting the position through other stock holdings or options. This can lead to severe or limitless losses.

Having a naked short in options is defined as selling a call or put by itself without appropriately securing it with another option or stock position, or cash. Some investors like to sell calls or puts when they’re combined with stock or other options. This takes out the possible unlimited risk of the naked call or put that’s being sold.

The word short is often used to describe selling options, and its structure is not the same as shorting a stock. It means that you’re selling stock that’s borrowed, and you’ll need to return it to its rightful owner in the future via your broker. You don’t borrow security when you have options but rather take on any obligations associated with selling options in return for the premium payment. Many people find shorting naked options appealing because there’s a potential to have a solid source of gains.

The professional investing world has gotten gains from selling options, as the stocks are less volatile than what the options premium implied. For example, if the 12-strike in May puts in a company was sold near-the-money and received 58 cents, you would keep the premium if the stock stayed above $12 for each share until the expiration date in May. Maximum potential profit is achieved if the company stays put, moves higher, or slightly falls to the 12 strikes. Often, stocks won’t end up moving as much as investors hope or expect.

There’s an essential difference between selling a naked put and selling to open a naked call. If you sell a naked call, the potential risk is unending. You’ll be liable for the difference between how much the stock moves above the price and the strike price. Since there is no limit to how high stock can be traded, your possible loss is also unending. When you sell so you can open a naked put, the difference for the greatest loss is between zero and the strike price.

The risk you face for selling a naked put is the same as having the stock be at the stock price. That means stocks can’t be traded for less than $0, so the possible loss is instead capped. When you sell naked puts, it can be a good way to have a longer exposure to a stock that’s at a good price.

With RagingBull, you can become a successful day trader within seven days. Simply enter your email address on our site to sign up for our free boot camp program and request your e-book, packed with day trading resources. As you learn, spend time with our trainers and learn from your peers in our day trading chat rooms. We strive to provide clients with the tools they need for financial freedom through smart investments.

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