What Is Option Trading?
Option trading is buying the right to buy or sell an asset at a set price on or before a certain date. It is important to note that buying an option does not mean you are required to trade it in full or even at all. Options trades are conducted on the options market. Options trading works by an investor buying an call or put contract on an option such as a security or index.
Why Start Option Trading?
An option contract can consist of either calls or puts.
A call option is a contract that provides the buyer the right to purchase a designated quantity of an underlying stock at a selected price by a specified date.
- A long call option has the same profit potential as a long stock position.
- However, a long call option is a risk-defined strategy and offers greater control.
Example: The SPDR S&P 500 ETF (SPY) closed at 265.78 on January 25, 2019.
Assume you are bullish the market and want to get long SPY. If you buy 100 shares, it will run about $26,500.
Now, for some traders who start with a small account, buy 100 shares of SPY is out of the question.
However, they could buy the right to be long 100 shares of SPY for a lot less. For example, the 266 call options expiring in 30 days are trading for about $4.65 in option premium.
That said, one option contract leverages 100 shares. In other words, you can control 100 shares of SPY for less than $500!
How Does Options Trading Work?
If you buy the call contract, it gives you the right to purchase 100 shares of SPY, but not the obligation. The contract is good till the expiration date, The price you’d be long at is the strike price, in this example 266.
Advantages Option Trading Gives
Option trading gives you the ability to turn a small sum of money into a large amount.
It’s perfect for small accounts.
The power of options at work! That’s what a good trading day for me looks like. If you want to get started with options, make sure to read my free ebook: 30 Days to Option Trading.
Leverage isn’t the only reason why options are so great, there are several more.
- Risk Control. Buyers of options are limited to the premium they spend. In other words, your worst-case scenario is spelled out for you. On the other hand, if you are long stock, you always have to worry about overnight risk. For example, if negative news hits the stock in the after-hours or when the market is closed, it will gap down the next day, and could drop further then what you initially wanted to risk. With options, you can pinpoint your risk.
- More strategies. With stocks, you can either bet they go up or down. However, with options, you can do so much more. You can make volatility bets, and structure trades that profit if a stock moves or doesn’t move to a specific price and a whole lot more. In other words, you’re not limited to directional trading.
- Shift the odds in your favor. In stock trading, it’s 50/50, either a stock goes up or down. However, you can structure option trades that have a high probability of success. How? Well, it’s just like betting on the favorite in sports, if they have a likelihood of winning but the payout for them to win isn’t great. In option trading, you can bet on the favorite, as long as you can accept a lower payout.
How to Start Trading Options
When you buy an option contract, you’re not locked into the trade. Like a stock trade, you can get in and out whenever you wish. Now, not every stock in the market has options, some do not. That said, most stock options have monthly contracts, and the most active stocks have weekly options. You can trade options up until their last day of expiration. You can find all the different contracts in what’s called the option chain in your brokerage platform.
The option chain will tell you how much each option costs, puts and calls, and at what strike. The strike price consists of at-the-money, out-of-the-money, and in-the-money. You see, options are priced on a probability model. If the SPY is trading at 266.50, which strike price will be more expensive, the 267 call or the 290 call?
Of course, the 267 strike. There is a better chance that SPY reaches 267 then 290, the 290 call is considered out-of-the-money. Options that have a low probability of closing in-the-money are cheap. That said, an option is a wasting asset. In other words, at expiration, it will close in-the-money and exercised or it will close out-of-the-money and expire worthless. When you buy an option contract, time is working against you.
Who Determines Option Prices?
It is important to note that companies themselves do not determine options trading prices.
- Option prices are determined by the market.
- The market prices are specified in terms of a bid price and an ask price.
- Bid price represents the price at which you can sell an option.
- Ask price represents the price at which you can buy an option.
The three primary factors that influence the price of an option when trading:
- Time to expiration
- Price of the underlying
- Level of anticipated uncertainty concerning the change in the price of the underlying instrument. This is known as implied volatility (IV).
- 2 minor factors include dividends and interest rates.
What Does It Mean to be Short or Long an Option?
- There are two parties to every option contract – the buyer and the seller.
- The buyer is said to be long the contract while the seller, also known as the option writer, is said to be short the contract.
- Long positions have rights while short positions have obligations.
Buyers pay for their rights in the form of premium pricing.
What Do I Need to Start Trading in Stock Options?
In order to trade stock options you must request it from your broker.
In other words, they’ll ask you questions about your finances, appetite for risk, and experience with options.
That said, there are different stages of clearance. In other words, the ability to buy a call and put is the easiest approval to get for an options account.
However, depending on your experience and financial situation, you can trade complex strategies like the iron condor, straddle, and bull call spread. Going further, you can sell options naked too, if you have the right kind of approval.
Best Way To Start Trading Options
Education is key. Options don’t always move the way stocks do, and you’ll want to learn about what makes them different.
Also, don’t be in a rush, consider paper trading while you start the education process. Options can move fast, and they can move against you if you don’t understand their nuances.