When traders or investors hear of options, they often think these securities are too complex for them to learn. However, just like anything in life, you need to start with the basics. Trading options is not easy, but once you get the hang of things, you could potentially see high returns. The basics of options is not too difficult to understand.
- Options are contracts that give the holder the right to buy or sell an underlying asset, such as a stock or commodity.
- Options are derivatives, meaning that they derive their value from the underlying security.
- Options must be executed by a certain date, called the “strike date.”
- Options give the holder the right to buy or sell, but this is not an obligation.
There are two different types of options, and you could express your opinion on a stock with either one. Moreover, when you become more advanced at trading options, you could combine different options in order to create “complex” strategies. In this article, we tell you everything you need to know about options trading basics.
How to Start Trading Options – The Basics
Options are versatile and could be risky, if you don’t understand the basics and how to use them. Options are considered derivative securities due to the fact they derive their value from an underlying asset. Now, there are various types of options, such as commodity, futures and index. However, we’ll be focused solely on equity options here.
Call Options vs. Put Options
There are two types of options, call options, or calls, and put options, or puts. A call option generally provides the buyer, or holder, with the right to purchase 100 shares of the underlying stock at a specified price, known as the strike, on or before the specified expiration date. Therefore, if you’re bullish on a stock, you might look to purchase a call option.
Here’s a look at the payoff diagram for a long call option.
Notice how the loss limit for a put option is defined. The maximum amount you could lose on a long call option is the premium you paid. However, theoretically, your upside potential is unlimited because you don’t know how high a stock could run to.
On the other hand, there are put options. Put options provide the buyer to sell short 100 shares of the underlying stock at the specified strike price on or before the expiration date. Similar to call options, the maximum loss is the amount you paid for the option. Put options are used to express a bearish opinion on a stock. Your profit potential increases as the underlying stock falls, and the maximum amount you could make is the strike price because a stock can only fall to $0.
Using Options for Stocks
Now, if you want to leverage your capital, you could use options on a stock. For example, let’s say you wanted to purchase 100 shares of Apple (AAPL) at $185 per share, that would cost you $18,500. However, let’s assume you think AAPL could rise to $195 within a month. You could purchase 1 call option contract for much less.
Here’s a look at an options chain, which details the strike price, expiration dates and bid-ask prices for calls and puts.
In this example, the price of a call option with a strike price of $185 expiring 3 weeks is just $535, which is the maximum amount you could lose. However, when you’re trading the stock and don’t have a proper stop loss, you could lose much more than that.
For example, Jeff Bishop uses options to express his opinion on specific securities. Here’s a look at his portfolio one day.
Using options allows you to leverage your capital, and it’s not rare to have gains of over 20% regularly.
Similarly, Kyle Dennis has branched out into the world of options. He’s using his tried-and-true process that he’s used successfully trading stocks in the options market. Here’s a look at how he looks for options to trade.
Now, both Jeff Bishop and Kyle Dennis stick to the basics. They’re not doing anything fancy here. They simply have an opinion on a stock, whether they think it’s going up or down, and execute. In general, they’re looking to double their money with options, and it’s very possible.
The Bottom Line
Depending on which brokerage platform you choose, they may or may not have options available. Don’t look at options as something you can’t learn. Learning how to start trading options requires grit, and if you approach it with tenacity, you too could potentially multiple your capital.
Now that you know the basics and how to start trading options, you’re ready to go to the next level. Check out Raging Bull’s guide to options trading, which is available free as an e-book for a limited time.
Kyle Dennis runs Biotech Breakouts (biotechbreakouts.com). He is an event-based trader, who prefers low-priced and small-cap biotech stocks. He’s also using his knowledge and looking to multiply his capital through options trades.
Jeff Bishop is lead trader at WeeklyMoneyMultiplier.com and widely recognized as the Mensa Trader. He runs short-term trading strategies, using stocks, options and leveraged ETFs.