What is options trading (Trading options for beginners)

Introduction 

At some point in every options trading journey, they are tempted by the notion that they need to “figure out” the market to be successful. They will add countless indicators on their charts, go on an “expert” following spree on Twitter, or try to figure out a magic formula to success. Oftentimes they’ll learn one tactic that works for a while, and then it ultimately fails, and they find themselves back at square one. 

This was the main inspiration to start Trade with Insight. Through more than 11 years of experience, I knew that trading is so much more than technical analysis or one strategy alone. To successfully master the markets, you need to learn how to master your mind. Discipline and patience are highly underrated in trading, and most don’t realize the difference a proper mindset will make. However, your mind is the single most significant edge you can have in the market. With a simple strategy and sound risk management tactics, you can create long-term consistency and success as a trader. 

The desire to create financial independence has fueled the growth and popularity of day-trading. Today, anyone with a cell phone and a few hundred dollars can participate in the stock market. So why options? Options are a way to leverage less capital and make larger returns than traditional stock. However, this does come with an elevated risk that requires effective risk and account management strategies to survive. Otherwise, the freedom that trading options can create will be short-lived. The eBook will help you save time, shorten the learning curve, and prepare you for challenges. We’ll teach you how options work, common pitfalls to avoid, and ultimately help you kickstart your options trading journey.

What are the Options? 

Overview

The use of options allows traders to leverage capital to generate higher returns than trading stocks. They are a derivative that allows the trader to buy or sell a stock at a set price and date, but not the obligation.

When people refer to options trading, they are typically referring to strategies that involve the buying and selling of two types of options: calls and puts. Simply stated, if you believe a stock will rise in value, you will purchase calls, and if you believe a stock will fall in value, you will purchase puts. Though options trading is slightly more complex than trading stock, the potential for higher returns with lower amounts of capital can make learning how to trade these instruments very worthwhile.

What is an option contract?

Options contracts give a trader the right to purchase stocks at a pre-determined price (strike price) before or on a specified date (expiration date).

The two options are calls, a bet on rising stock prices, and puts, which is a bet on falling stock prices.

100 shares of stock are equivalent to one options contract.

In order to purchase an options contract, you must pay a “premium,” which you will lose if you let the contract expire.

Similar to buying or shorting the common stock, if a stock moves in the direction of the bet you placed, your options premium will rise in value, giving you a choice to sell the option to another trader for profit.

How to read an Options Contract

General Terminology

• Before diving in further, there is basic terminology that is important to learn so you can better understand the content in this eBook. 

Expiration date

• An expiration date enables the trader to choose a specific date that they expect the stock to rise or fall by. Expiration dates play a significant role in determining an option’s value. As an option approaches an expiration date, the value of the option will decrease due to time decay.

Strike price

• The strike price is the price a trader expects the stock to be above or below by the expiration date.

In the money

• A call is “in the money” if the strike price is below the current stock price.
• The strike price of a put is “in the money” if it is above the current stock price.

At the money

• A call/put is at the money if the strike price is equal to the current common stock price.

Out of the money

• A call is “out the money” if the strike price is above the current stock price.
• A put is “out the money” if the strike price is below the current stock price.

Premium

• An option’s price is the price you pay for it
• Example: A trader buys one AAPL 105 call for a premium of $2.50, the trader would spend $250 dollars ($2.50 x 100)
• The total premium is determined by taking the price of a call or put and multiplying it by 100 (contract size)

Advantages of Options

A faster way to grow capital

• $ XYZ’s stock is currently trading at $100
• You believe $XYZ stock is going to rise 5% in a month and want to take advantage of that move.
• To make $500 dollars trading stock, you would need to buy 100 shares of $XYZ and sell each share for $105.
• Or you could buy an option for $500 dollars and make a 100% return without buying $10,000 worth of $XYZ stock (100 shares)

Any account size can trade options.

• The price to purchase options can range from $1 to $10K allowing anyone to participate in options trading.
• The options that you trade can vary depending on your account size due to the price of premiums being relative to the stock price.
• A $3,000 stock like $AMZN can have premiums that can range from $2K-10K depending on the strike/expiration date. Whereas a $100 stock like $AMD has options priced near $50-$100 per contract.

The Risks of Trading Options

• Options can expire worthlessly. If your trade idea doesn’t move in the direction of your favor, your initial investment could be worth 0 dollars.

• While options allow you to grow capital quickly, you can also lose your account value quickly. Therefore you must be patient, disciplined, and follow proper account management rules to assure survival in the world of options.

• Trading out of the money contracts (OTM) – The price of options contracts decreases as they become further from the current stock price. While these contracts may be more enticing to smaller account holders, it’s not recommended to trade them due to the risks associated. There are reasons they are cheap. They are inherently riskier and will lose their premium much faster than contracts closer to the underlying stock value. 

Options Trade Example

Let’s review some possible scenarios and outcomes you may experience in an options trade to understand options further.

AAPL’s stock price is currently priced at $100

A trader believes that AAPL will reach $110 by next month.

You buy a $105 AAPL call for $2.50 ($2.50 X 100 = $250 Dollars)

In order to make a profit at expiration, the stock would need to rise above the strike price and cost of the calls, or $107.50 ($105 + $2.50)

Outcome: $110 Target reached (positive) 

• $ AAPL’s stock price is $110.00 at expiration. The contract would be worth $5.00 from $2.50, and the trader would profit +$250 or 100% on their initial investment. 

Common stock value – Strike Price = Premium collected

• $110 – $105 = $5 = $5×100 = $500

Outcome: Break-even (neutral)

• $AAPL’s stock price is $107.50 at expiration, the trader would break even as the contract would be worth $2.50 
• $107.50 – $105 = $2.50 = $2.5×100 = $250

Outcome: $110 Target not reached (negative)

• $AAPL is worth less than 105 at expiration, the options will expire worthlessly, and the trader would lose the entire/majority premium (-$250)

Key Takeaways

• Any account size can trade stock options.
• Options provide a way to grow capital in a shorter time than traditional stock.
• It is a contract that gives a trader the right, but not the obligation, to buy or sell a stock prior to or on a specified date at an agreed-upon price.
• There are two types of options: calls, which are bets that a stock will rise in value, and puts, which are bets that a stock will fall in value. 
• In order to purchase an options contract, you must pay a “premium,” which you will lose if you let the contract expire.
• Similar to buying or shorting the common stock, if a stock moves in the direction of the bet you placed, your options contract will rise in value. It is possible to sell the contract to another investor for a higher premium or even exercise it if you want to own the shares. 
• Avoid far out of the money option strikes.
• Focus on buying and selling calls/puts before moving on to more advanced strategies.

Conclusion

If you grasp the basics of options, they do not have to be difficult to understand. When used correctly, options can provide opportunities, but they can be harmful when misused.

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