Everyone understands how investing in stocks works. You own a small share in a company’s business. If the price goes up, you get a profit. If it goes down, you make a loss or wait until it grows. Trading options is a little less straightforward and can be a source of confusion for beginners. How do options work and how are they different from stocks? How to trade options, who does it and why? What is options trading in stocks? We’ll answer these and other questions in this guide.
Whether you trade options or decide to stick to stocks or any other assets, download Gainy to find investments that fit your interests and goalsTry GainyTry Gainy
Options are a type of asset that allows an investor to make a big profit with a relatively small investment budget. They can also protect an existing investment against losses.
This article is an overview of options trading for beginners. We’ll explain what options are and the benefits they provide. As part of our trading options 101, we’ll cover some basic options trading strategy for beginners and how to start trading options.
Hopefully by the end we’ll have all the basics of options trading explained.
Stock Option Contracts
A stock option contract is a right to buy or sell a specific amount of a stock at a specific price and for a specific period of time.
The holder of an options contract can benefit from the price movement of the underlying asset without having to own the asset itself.
There is a fee for such a contract, called a premium.
The right to buy or sell at a later date allows an investor to make a profit, as long as the price moves in the direction they want. If it does, they can then exercise the contract, i.e. buy or sell the shares at the agreed price, called the option strike price.
If the price moves in the opposite direction, they can let the contract expire. In this case all they lose is the premium paid for the option.
Option contracts are leveraged, meaning an investor is trading with more capital than they are actually using in a transaction. A standard option contract gives an investor the right to buy or sell 100 shares.
Options themselves can also be traded on the exchange market. That’s because this agreement to buy or sell at a fixed price can generate profit and can be of interest to other traders. So instead of buying or selling the shares, the investor has the option to sell the contract to someone else.
It’s useful to think of options as bets on whether the price will go up or down.
A stock option contract is a right to buy or sell a specific amount of a stock at a chosen price before it expires.
Here are some characteristics that every option contract has:
- Expiration: the time at which the contract will expire
- Leverage: how many shares the investor can buy or sell
- Strike price: the fixed price for which the investor can buy or sell
- Premium: the option’s price for the investor
There are two main types of options contracts — “call” and “put.”
Call and Put Options
A call option is the right to buy an asset at an agreed price, or the strike price. This is used when an investor expects the price of a stock to go up.
If it goes up, they can buy at the strike price. This is lower than the current market price, so we can buy the shares and make a profit.
A happy options trader who correctly predicted where a stock would go.
A put option is the right to sell an asset at an agreed price. This is useful when an investor expects the price of a stock to fall.
Then, if the price falls, the investor can profit the other way, i.e. sell the stock at a higher price than the new market price.
Call and put options are similar because selling or buying at prices that are different from the current market prices allows investors to profit, no matter if the market moves up or down.
But it’s important to make a correct prediction about what is going to happen with the price, otherwise the contract becomes worthless.
It’s a little like renting an asset. You have a right to use it for a specific period of time and buy it if the price is right.
If you don’t use it, you lose money.
What is Options Trading?
Options trading refers to buying and selling options on the options market. The answer to “what is options trading?” is slightly more complex than traditional stock trading, but the underlying principle is the same.
The key thing to remember is that options can be traded just like other financial instruments — stocks, mutual funds and ETFs.
Stock Market Options Trading Strategies
Now let’s discuss some basic options strategies. These are essential to know for understanding options trading for beginners. These include buying calls, buying puts, selling covered calls and buying protective puts.
A call option is useful when an investor expects the price of a stock to rise.
Let’s say a company stock is currently trading at $100 per share. If you’re confident the price will grow, you can get a call option to buy the stock at $100 (the strike price) for a premium of $10 per share and with an expiration time of 6 months.
A typical options contract is for 100 shares, so you’ll be paying $1000 — that’s $10 premium per share multiplied by 100.
Let’s say six months later the price goes up to $120. And we have an agreement that lets us buy 100 of these shares at the strike price of $100. Due to leverage, this difference is multiplied by 100.
Now the option position has value of its own, and the investor has several options.
They can exercise the contract, buy 100 shares at $100 and sell them at the current price of $120.
They would be making 20% or $20 per share, which is $2000 in total. But they had to pay the $1000 premium for the contract so they end up with a profit of $1000.
Not bad for a $20 change.
The other option would be to sell the contract itself, because it has positive value of its own. In this case, we say that the option is “in the money”.
If the price goes down, the investor wouldn’t be making any money, furthermore, the difference is also multiplied by 100 shares, but our losses are limited to the premium we’ve paid for the contract.
Any slight change is multiplied by 100. This is why options are similar to bets.
Options give you options. That’s where they get their name.
When an investor expects the price of a stock to go down, a good strategy can be to buy a put. This is a good way to use leverage to profit from falling prices.
A put is the opposite of a call option. It gains value as long as the price is falling. If the stock price goes up, the maximum amount we can lose is the premium. If you’re already familiar with short selling, put options work in a similar way. You borrow a stock to sell at a high and buy later at a lower price. The difference between short selling and put options is that with short selling the losses can be unlimited. With put options, your losses are limited to the premium.
Put options can also be used to protect an existing investment, also known as hedging. Say you’ve invested $5000 in a stock but you’re worried it might fall. In this case, you can buy a put option. Then, if the price falls, the put option will work in your favor because you can sell your stocks at $5000 any time before the contract expires. But our put option now has value so you’ll be able to sell the option to other options buyers to make up for the loss.
When an open option position has its own value, it’s referred to as being in the money.
This strategy is suitable when a trader expects the stock price to stay the same or rise slightly.
It works like this: you buy 100 shares of a stock and sell a call option for these shares. In this case, you’re the one being paid a premium, which provides some protection in case the price falls. You are also agreeing to sell the shares at the strike price.
Let’s say you buy 1,000 Coca-Cola shares (KO) at $50 per share. Then you create 10 call options at $0.50 per share with a strike price of $52 that will expire in one month. Each contract is for 100 shares, so you can charge $50 for each one and $500 for all 10.
The premium you’ve received reduces the cost basis of the shares, because you got some of the money back through the premium. It’s as if you got the shares for $49.50 each. If the price rises above $52, your counterpart will want to exercise the contract and you’ll have to sell the shares to them at $52.
Of course, if the price keeps going up, you’d be better off holding the stock rather than selling at a price that’s lower than the market price, so this strategy works best if the price doesn’t change significantly. In this case, you get to keep the premium and the shares.
Protective Put Strategy
This strategy is for investors wishing to protect their existing asset from downside movement. It makes sense when they expect the stock to grow over time but want to protect themselves in the short term.
This is done by buying a put option against a stock you own. This works like an insurance policy. If the price goes up, your initial investment is growing. If the price falls, you’ll have a put contract that has value, and you can sell it to another trader.
This type of insurance strategy is also known as hedging an investment.
It’s also a bit like betting against yourself in sports. If you win, you get the prize money. If you lose, you win the bet.
Other Options Strategies
The following strategies are more advanced and you need to know what you’re doing to try and implement any of them. But it’s useful to know all the different strategies that option trading offers.
Married Put Strategy
This strategy is similar to a protective put, and also works as an insurance for stocks you own. Here the investor buys the equivalent of put options at the same time as buying the shares.
The difference is that a married put is more like an overall insurance to offset the risk of the whole investment, while the protective put is more likely to be used to insure against a short-term decline.
Protective Collar Strategy
This strategy is a combination of a covered call and a protective put. Here an investor buys an out-of-the-money put option and writes an out-of-the-money call option at the same time for the same stock.
The protective collar can protect from big losses, but it also limits gains.
Long Straddle Strategy
An investor buys a call option at the same time as a put option for the same stock. This is used when the investor expects the price of a stock to move rapidly in either direction, e.g. in reaction to some news.
Both options need to have the same strike price and expiration date.
This way, if the market reacts to the news, they can profit from the price change no matter which way it moves.
This is another strategy that allows investors to profit from a big price change in any direction. This involves buying a call option that is out of the money (i.e. not in good standing) and a put option simultaneously. They should also have the same expiration date, like in the long straddle strategy, but the strike price for the put should be lower than for the call.
How to Start Trading Options
You’ll need to do a few things before you start trading options. The first is to open an options trading account. Then you’ll need to choose the type of option you’ll be going for and have an idea of what you expect to happen to the price of a stock and decide on your strategy. These are the essential things to do when starting option trading for beginners.
Open an options trading account
The first step to trading options is to choose a broker and open an account with them. You’ll need to verify your identity and go through registration. A good broker will also guide you through the process of trading options.
Decide on your options strategy
We recommend beginners to stick to the more straightforward strategies: buying calls and puts.
You have to be confident about your prediction, at least to an extent. If you commit to a call option, you should be prepared to lose your investment if the price falls. Conversely, if you purchase a put option, any slight upward movement will be multiplied by 100 and you won’t be able to profit from it.
Determine the expiration date and set up your contract
Choosing the right expiration date is key. This is not about long-term growth like in stocks. It's about the difference between the strike price and the market price when the option is due to expire. So whether it’s 3 months or 6 months, put some thought behind it and try to analyze other factors that may come into play.
Once you have a hypothesis that makes sense, or you have an automatic personal investment guide (wink-wink), set up your contract.
Hopefully this article covers all the options trading basics. Here is a recap.
Options are an affordable instrument that allows an investor to make a big profit, due to leverage. This is possible if the investor can correctly predict if the price of a stock will rise or fall.
It’s a right to buy or sell, not the same as owning shares.
The key thing is to be able to use an option within the specific timeframe before it expires. If you don’t use it the contract expires worthless. This is not necessarily a bad thing and can be an intentional risk you’re taking when you use an option as an insurance against a downturn for a stock you already hold.
What are options in stocks?
Options are fixed-time contracts that give an investor a right—but not an obligation—to buy or sell 100 shares of a stock at a fixed price known as the strike price. Options can be tied to any other asset, like ETFs, bonds and indexes.
What are options in trading?
Because options are contracts that allow an investor to buy or sell at a fixed price at a later date, they can have value of their own. In this case they can be traded for profit on the options exchange, just like any other asset.
How to invest in options?
The first step is to choose a broker that offers options trading. Learn your target market and your potential investments as much as you can. Because options are leveraged, it’s possible to make a big profit even if the price only changes slightly.
Get More Value!
You will get from us best tailored content that will help your business grow. Early bird news, bonuses — only for subscribers!