Options Trading 101 – Tips & Strategies to Get Started
Getting started with investing and in options trading can be a bit intimidating. Learn how to trade options successfully from the experts at RagingBull.
Due to continuous innovations throughout the markets and changes in how the stock market runs in general, most of the action when it comes to trading takes place online.
Investing was once quite a simple concept, where individuals would invest their finances in one or two small companies and stick with those investments as they grew. Today, investing is more complicated than ever before and even includes new forms of currency.
With all of these changes and the fast-paced environment of the online market, getting started with investing and options trading can be a bit intimidating.
Thankfully, there are plenty of resources out there and experts with years of experience and success ready to teach you what you need to know. The key to succeeding in the world of trading is knowledge. If you can gain a thorough understanding of what you’re doing, you will be set up for success. Here’s a start for those wondering how to make money with options trading.
Let’s Get Started…What IS Options Trading?
There are a few ways that options can be approached by investors. Instead of just buying shares in stocks that you anticipate will rise in value, you can buy call options to increase your upside.
Options can also be used for hedging and giving your portfolio a little cushion.
Think about it: you purchase insurance when you buy a new car or other valuable items, why not surround your portfolio with insurance, as well?
Hedging can act as a last resort measure if your portfolio gets to that point.
Limit your downside and grow your potential for profit by approaching options without fear. Trading options doesn’t have to be a complicated process if you don’t want it to be.
Purchasing options with the goal of speculating on the future price movements of stocks allows you to lower your risks compared to buying or shorting a stock outright, while simultaneously opening the door for unlimited earnings.
The First Step:
If you want to learn how to make money in options trading, the first step is to develop a strategy. Don’t just leap in blind, but take some time and really think about your goals and how you plan to achieve them. Many portfolios don’t include any options trading strategies at all, but that’s a mistake. There’s a lot to gain from this aspect of the market.
Call Options Versus Put Options
It’s important to understand the different types of options when trying to make money trading. There are two main types of options, call options and put options. Both are a type of contract. These option contracts involve two parties, the option holder (buyer) and the option issuer (seller). The option holder is given the right to perform a certain transaction with the issuer, but the holder isn’t required to perform that transaction.
Simply stated, call options afford the right to buy, and put options afford the right to sell, the underlying shares at a predetermined price (the strike). So, a call option gives the option holder the right to buy shares at the strike price within a determined period of time. A put option gives the option holder the right to sell shares at the strike price within a set period of time. After that time is up, the contract will expire if the option wasn’t closed or exercised.
So, in the simplest terms, an investor thinks the value of the shares will rise, they buy call options. If they think the value will fall, they buy put options.
How to Buy Call Options
Want to learn how to make money trading call options? Let’s start by understanding a basic call option contract.
Assume the stock of a large company is trading at $200 per share and an investor purchases a call option contract for that stock at a $200 strike price. The cost of the call, or the premium, is $3. Since each option controls 100 shares of the underlying stock, the premium is $300 ($3 x 100). In the open market, buying 100 shares at $200 apiece would cost $20,000.
Once the investor has purchased this call option, there are a few different ways things could play out. For instance, if the share price goes up to $215, the investor has the opportunity to make a profit. They can use their call option contract to buy 100 shares at the $200 strike price, and then turn around and sell those 100 shares at the new price of $215. That’s a $1,500 profit ($15 x 100)– or $1,200, subtracting the $300 cost of the call option contract.
As with most trading, there is some risk involved when it comes to purchasing call options. You’ll want to be sure you purchase call option contracts on stocks that you anticipate will rise in value.
Worst-case scenario, the company’s shares drop below the $200 strike price, and the call contract becomes “out of the money” to expire worthless. This means the buyer is out the full $300 they paid for the call option.
When thinking over your call option strategy, consider that the potential for gain is much greater than the potential for loss.
Basically, if you haven’t thought about adding options to your portfolio for a chance to grow your gains, it’s definitely worth considering. There is certainly money to be made in this practice.
Can You Make More Money Trading Options?
Understanding options trading is the only way you can make more money with this type of market play. Can more money be made with options trading than traditionally trading shares? That depends on your strategy. Here’s a quick comparison of the two strategies.
Say XYZ is currently at $35 per share, but you believe the price is about to go up substantially. This is the time to get in the game. If the stock goes up to $55 per share in the following week, and you purchased 100 shares at the $35 price, you’d make a profit of $2,000 ([$55 – $35] x 100 shares) — a 57 percent return. But, could that return be even higher?
When working the same scenario using call options, you can earn much more than $2,000. Say we jump back in time to when the stock price was at $35, but instead of purchasing 100 shares at the $35 price, you decide to purchase a call option contract with a $35 strike price and an expiration date of two weeks later. Let’s say the call option contract cost $2, or $200 total (since one contract represents 100 shares of XYZ).
Now, following the previous scenario, the stock price rises to $55 per share one week later, possibly on an earnings win or big news. Because the rise in XYZ happened before the call contract’s expiration date, you still reserve the right to purchase those 100 shares at the $35 price, even though the stock price on the open market has changed to $55.
So, now you have a call option contract that cost you $200 and the right to buy the shares at a lower price. You are not, however, obligated to purchase those shares. Because the price of the shares went from $35 to $55, the contract is now “in the money,” and has $2,000 in intrinsic value, because it covers 100 shares at an increase of $20 per share.
If you decide to simply sell to close your call option contract, as opposed to exercising it to buy shares, you would get at least $2,000 — possibly more, depending on how much time is left until expiration. Subtracting the initial $200 you paid to buy the call, that’s an $1,800 profit. That’s a 900 percent return versus the 57 percent return when trading in basic shares. So, can you receive greater returns with options compared to simply buying shares? Yes, yes you can.
Benefits to Trading Call Options
Not only can you make more money with options trading, but you can also put less capital at risk. Simply put, you can never lose more than what you originally paid for the call option contract, no matter how far the value of the stock may drop.
Standard equity and index option contracts in the United States expire on the third Friday of that month. As the stock market continues to adapt to the popularity of these contracts, though, more stocks are offering options contracts with weekly expiration dates for a quicker turn-around. These contracts expire on Friday each week.
Pay Attention to this:
If you purchase a call option contract for $1 with a strike price of $100, and the stock price rises to $1000, your call options would have an intrinsic value of $900 per share, leaving you with a serious profit.
If the underlying shares fall to $0, you’ll only lose the $1 paid for the contract.
So, while the profit potential on a bought call is theoretically unlimited to the upside, downside risk is capped out of the gate.
How to Choose the Best Option for You
Follow these guidelines to help you find the best trading option:
- Determine how bullish or bearish you are on the stock, broad market, or sector: Picking the right strike price, expiration, and options strategy depends on your expectations for the underlying shares on the charts.
- Consider volatility: If the implied volatility of your option isn’t too high, then you may want to try buying calls or puts on the stock, since relatively low IV often indicates premiums are inexpensive, from a historical standpoint.
- Buy options with the longest expiration possible: This gives your trade enough time to rise and provide you with a strong profit.
How Much Can You Make Trading Options?
Investors hoping to make money trading options might need a little encouragement before jumping in. Success stories from other traders can give you the boost of confidence you need to get started with options trading.
One trader was able to make a 1,300 percent return on their money in a matter of minutes in one trading scenario. One day, trading on the shares of animal health firm Zoetis was put on hold due to a report in the Wall Street Journal that said a Canadian pharmaceutical company might be about to buy out Zoetis. Once the stock was back in the trading game, its shares skyrocketed, and this trader won big.
Call volume on Zoetis shares was twice the amount of put volume. As soon as rumors of the buy-out hit, this lucky trader bought 300 of the $50-strike call options for only $0.34 each, or $1,700 total (34 cents x 100 shares per contract x 50 contracts). Once Zoetis shares were back in action, they saw a huge spike in value. The call options went from $0.34 to $4.80. The call buyer made over $20,000 profit.
Paying close attention to takeover reports can lead to big payouts for smart traders. Other reports include people making over $200,000 in options trading. This is a good strategy when played well. Although, you do want to be careful when it comes to buying calls through rumors.
Mistakes to Avoid When Trading Options
The best way to make money with options trading is to move carefully and try to avoid the common pitfalls traders face when starting out. Trading options offer savvy investors an opportunity to keep a good handle on their risks and leverage assets when needed.
Even though options trading can seem like a smart play, you still want to move cautiously. Mistakes can turn into a loss quite easily. When beginning your adventure in options trading, start with a basic strategy and do thorough research. Let yourself learn with experience and then branch out into more complicated strategies, as you feel ready.
While researching and formulating your strategy, you should also learn about the errors that traders frequently make when options trading. Here are some of the most common mistakes. Commit these to memory, so you can help yourself avoid losses and bad decisions:
- Try to avoid buying OTM (out-of-the-money) call options. Some experienced traders will do this to make a profit, but this is a complex and very risky strategy to start with. You have an increased chance of losing your upfront premium when purchasing these call options. Keep things simple as you get your feet wet.
- Many traders make the mistake of committing themselves to one strategy and are unwilling to adapt to changing markets. Try to consider the long spread trading approach.
- Before buying an option, remember that it is going to expire, and be prepared. Even if everything is going well, you’ll need to be ready to make your move when the time comes. If things don’t go your way, try to keep a cool head, and don’t risk even more by just doubling up. Take a moment and reassess the situation.
- It can be tempting to wait out your options to make the most profit, but it’s wise to act when you have a good opportunity to make a profit and not to let greed be your downfall.
There are four common strategies that come with their own risk/rewards. They include:
- Writing a put: There are two forms of writing a put: naked and covered. “Naked” means the seller doesn’t already own the shares; “covered” means they do. This strategy sometimes involves assigning stock to the put writer, who then buys the stock, this is usually the worst case scenario. The best-case scenario would be the writer retaining the entire option premium amount. A strong risk of put writing is that the writer may pay too much for a stock if it ends up dropping. This makes the risk/reward of put writing less favorable than call or put buying since the maximum reward is the premium they receive. Their maximum loss is typically a lot higher. This also increases the probability of making a higher profit.
- Buying a put: This strategy provides a lower risk than short selling, with the potential for a high reward. This strategy is a less risky alternative to short-selling the underlying asset. You can also purchase puts to hedge the downside risk in your investment portfolio; these are called “protective puts.”
- Writing a call: There are two available forms of writing a call: naked and covered. The maximum reward you may earn in call writing is often equal to the received premium. A naked call is usually used by sophisticated options traders who are more risk-tolerant. Naked calls have a risk profile that’s similar to a short sale in stock, because the seller doesn’t already own the underlying shares. Covered call writing is a popular strategy that many intermediate to advanced options traders regularly use. It’s commonly used to gain extra income from an investment portfolio. Covered call strategies are particularly risky because your underlying stock can easily be called away.
- Buying a call: This strategy is basic and fairly low risk, as your maximum loss is restricted to the premium you used to purchase the call. The maximum reward has the potential to be limitless. Your odds of the trade being significantly profitable are usually fairly low. If the option has low risk, it’s usually assumed the option’s total cost represents a tiny percentage of the trader’s capital. If you risk all your capital in one call option, the trade would be very risky since the money can easily be lost if your option expires.
How to Profit From Trading Options
As an option trader, you can earn a profit if you’re either an option writer (seller) or option buyer. When positioned right, options can help you make money during volatile or non-volatile times in the market. There is almost always an options strategy to align with your outlook.
Different factors can affect an option’s price, and the premium paid for these contracts impacts the breakeven level on the trade. A trader will only successfully make profits from trading call options when they purchase options for a stock that is expected to rise at a decent rate over the following week or month.
Consider how much you expect the stock to rise. This is where good research comes into play. Knowing a certain stock’s history and doing thorough technical analysis is vital to making a profit.
Even though many traders only purchase out-of-the-money options, like we said before, this can be a risky strategy. OTM options do offer lower prices than in-the-money (ITM) ones, so they have the potential for some serious turn-around, but they’re risky. Some people enjoy the thrill, but a profitable trader plays the market carefully and doesn’t take many huge risks.
Consider whether you play the lottery. If you do, maybe trading OTM options is something you’d enjoy. If not, you probably don’t play OTM, because you recognize that the odds are not in your favor. Many are so intrigued by the chance at a huge jackpot win that they ignore the odds. The stock market shouldn’t be played like the lottery. The odds don’t have to be bad. Play it smart and give yourself good odds.
ITM options are more likely to continue to stay in the money before your option contract’s expiration date, but they cost more than OTM options. Plus, you still need the underlying stock to make a move on the charts, to offset the impact of time decay on premiums.
Profit By Sticking to Your Plan
Leaving money on the table is never fun. The safest method is to make your trade as soon as a profit is available. Plenty of seasoned traders are tempted by the chance to make a larger profit, but waiting too long could quickly lead to you kicking yourself because you lost an opportunity.
Before buying an option, make a plan. You should decide on a target profit with your plan. As soon as your option hits that target, make the trade. Stick to your guns. Even if the target is hit early on in the contract duration, make the trade. Sometimes the target won’t be reached. In such cases, it is best to make your trade either when you’ve reached somewhere close to the target or, in the worst case, when you’ve reached your stop-loss level.
Profit By Knowing the Factors
One of the key aspects to profiting from options trading is having a good understanding of the stock market and its current trends. Individual stocks don’t move completely out of touch with the market. Yes, some stocks do better than others, but the overall health of the market has a massive effect on individual stock values.
Knowing every factor that affects a stock before you buy its options is the best way to manage your risk. Don’t jump into any decisions blindly or ill-informed. Be careful when choosing your option contracts.
We want you to succeed. Most new-to-the-scene traders jump into the game without warning or much understanding. The more you know, the more successful you are likely to be. Learn more about trading by joining our Free Bootcamp now! The experts at RagingBull are here to educate and help you reach your full trading potential.