Things to Know Before You Start Trading Options
Bull call spreads, bear put spreads, derivatives, premiums, strike prices, calls, and puts – these are the complex jargons that you are most likely to encounter when it comes to options trading. But never let these terms scare you.
Trading options provide flexibility for all investors at any level and help them manage risks. To find out if options trading deserves a place in your portfolio, we will show you its basics and why investors use them.
What Are Options?
Options are contracts to purchase or sell stocks. Each contract is often equivalent to 100 shares of stocks, at a negotiated price for a particular date.
In the same way that you can purchase the stock because you believe that the price will increase or short a particular stock because you expect it to drop, options trading will also allow you to bet on a particular direction that you believe the price of the stock is heading to. However, instead of purchasing or shorting assets, if you’re going to buy an option, you’ll end up buying a contract that will allow you to the following things:
- Allow the option contract to expire and then walk away without having to deal with any financial obligation.
- Purchase or sell shares of a particular stock at a negotiated price for a certain period of time.
- Sell your contract to a different investor.
The Options trading might seem like it is only for those who consider themselves “commitment-phobes,” although it can be if you’re planning to capitalize on the short-term movement of stock price and the trade in and trade out of contracts, which we do not want to recommend. However, options are very useful for the investors who buy and hold for the long-term.
What is Options Trading and Why Use Options?
Investors would choose to use options for varying reasons, although the biggest advantages of choosing options trading are:
- An option keeps the investors protected against downside risk by locking the price without obliging the investor to pay.
- Purchasing an option would require smaller initial outlay compared to buying stocks.
- The option buys time for investors to find out how things are going to play out.
If you are eyeing a particular company and you believe that the price of the stock will increase, the call option will give you the right to buy shares at a particular price but on a later date. If what you have predicted is true, you get to purchase the stock for less than the selling price compared to the price of the open market. On the other hand, if your prediction is not right, then your financial loss will only be limited to the cost of the contract.
You’ll also have a limited risk exposure on stock positions if you go for options trading. For instance, you own stock in a particular company, yet you’re worried about its short-term volatility wiping all your investment gains. To hedge against these financial losses, you can purchase a “put” option, which will give you the right to sell a certain number of shares at a pre-determined price. If the price of the share tanks, then the option will limit your losses and the gains that you’re going to earn from selling will be used to offset some of the financial losses.
To fully understand what options are and how to trade them, it’s important to understand some basic terms:
- A broker – This is the firm that will enter into a contract with the investor, which is you, allowing you to trade on options. Take note that the broker also determines the payouts and will not act on behalf of any investor. There are various options to choose from, and it’s important that you take the time to investigate all of them.
- At-the-money – If the asset’s price has not increased or decreased by the time the contract expires, then that’s called at the money, and you’re going to retain all the initial investment you made although this situation rarely happens.
- Call – This is when you predict that the particular item you’re trading is going to increase in cost at the expiration of the contract you have chosen. This is known as the call option, and you’ll earn money depending on the percentage that was given.
- Expiry time – This is when the option you’ve chosen is going to expire. As soon as the option expires, it will become void and can no longer be traded. The time of expiry varies from one broker to another, and they could be as short as 60 seconds to as long as 24 hours.
- In the money – If your prediction has turned out right and the cost of the asset goes towards the direction that you expected, you could win the money back. In this case, you’ll be considered “in the money.”
- Investment money – This is basically the amount of money that you have invested in.
- Out of money – If your prediction turns out to be incorrect, you’ll lose your investment, and you’ll be out of money.
- Put – If you’ve predicted that the price of a particular commodity or asset you’re trading at could fall at a particular time, you’ll earn money based upon the given percentage.
- Stock – Some refer to stocks as the shares of a particular company, and that means the normal stock of a company that’s being traded at the financial markets like NASDAQ or Dow Jones.
- Strike price – This is the cost of the underlying assets that you’re eyeing in at the time of buying the option.
Options Trading is for the DIY Investor
Normally, options traders are self-directed investors which means that they don’t really work directly with any financial advisor to help manage their options trading portfolio. Being a DIY investor, you’re in full control of all your trading transactions and decisions. However, this doesn’t necessarily mean that you’ll be entirely on your own.
There are lots of communities out there that bring traders together to talk about things like option trading strategies and the current marketing outlook.
Beginners Usually Start with Stock Options
Options that are based on equities are more known as stock options, and they are typically a great start for beginners. Stock options are listed in the financial market in the form of a quote. It’s important that you understand the details of a stock option before you decide to make a move, most especially the expiration date and the cost.
Different Types of Options
Options are contracts which give the owner the right to purchase and sell assets at a specific price for a certain period of time. Such period of time could be one day or up to a couple of years depending on the kind of option contract that you have.
Luckily, there are only two different types of the standard option price, and these are the put and call.
- The put option contract gives the owner the right to sell 100 shares of a specific security at a specified price in a particular timeframe.
- The call option gives the contract owner the right to buy 100 shares of a particular security at an agreed price and in a particular time period.
It’s worth noting that for both these options, whether it’s the put or call, the owner isn’t obliged to exercise his or her right to sell or purchase.
Options Trade on Different Underlying Securities
Options may be used in some ways, whether to reduce or speculate risk or to trade on the different kinds of securities including ETF (Exchange Traded Funds), Indexes and Equities.
There are quite a few differences between options that are based on indexes and those that are based on ETS and equities. It’s very important that you know the differences before you start trading.
Options Trading is All About Calculated Risk
If probability and statistics are in your wheelhouse, then there’s a good chance that trading options and volatility will be in it as well. Being an individual trader, you should only concern yourself about the two forms of volatility – implied volatility and historical volatility.
Implied volatility is basically based on what the financial market is implying on the volatility of the stock in the future over the lifetime of the option contract. On the other hand, historical volatility means the past and how much the stock price could fluctuate on a daily basis over a period of one year.
Implied volatility is an important concept that options traders must understand since it helps traders to determine the possibility of a stock reaching a certain price at a specific time period. This also shows them how volatile the market will be in the future.
Option Traders Speak Their Own Lingo
When it comes to trading options, you can either sell or call a put. It can be short or long, and neither having something to do with what your height is. Therefore, you can also end up in “at the money” or “in the money.” These are just some of the most common words that you get to hear from options traders.
To put it simply, it pays to get your terminologies straight.
Option Traders Borrow from the Greeks
Options traders have referred to the Greek Alphabet to determine how the prices of the options are going to change in the stock market, which is essential to the overall success of trading options. Some of the most common Greek terms used are Gamma, Theta, and Delta.
Although these Greek references can help to explain the different driving factors in the movement of the option pricing and could collectively indicate how the stock market expects the price of an option to change, the values are merely theoretical in nature. Basically, there’s never a hundred percent guarantee that the forecasts will turn out to be correct.
Option Trading Starts with Your Financial Goals
Just like with a lot of the successful investors, options traders should have a clear understanding of their overall financial goals and their desired position in the marketplace. In general, the way you think and approach money will have a direct effect on how you trade options. The best thing that you can do before funding your account and start trading is to define your financial goals clearly.
Why Buy a Put Instead of Selling Short?
Short selling is tough. Short sellers are expected to deal with margin requirements and some special rules on when they can or cannot place a sale. A margin is basically a line of credit that you can use to trade stock, where you can make a down payment of the minimum amount and then pay your broker a specific interest rate. If the market suddenly moves against you, you’ll be required to add this quickly to a margin call. It’s important that you study the risks of the margin tool that you’re going to use.
If it turns out that you are wrong about your prediction and the price of the stock starts to increase, your risks will also considerably climb. You should deliver these shares of stocks to your brokerage firm. Since there’s no limit on how high the price of the stocks can climb, purchasing them while they are on the rise means there’s technically no limit when it comes to your risk. Furthermore, you will end up paying your interest continuously on the margin balance until such time that the position is closed.
Purchasing a put could potentially offer a hassle-free and low-cost alternative to short selling for the bearish investors.
Options have been around for over 40 years. However, options are only now starting to get the attention that they truly deserve. A lot of investors tend to avoid options thinking that they are just too complicated and difficult to understand. A lot of investors have bad experiences with options at the start, and their brokers don’t train them on the proper way to use options. Improper use of options, just like any powerful tool, could certainly lead to catastrophic problems.
Finally, some people in the financial media and other popular figures in the financial market have incorrectly linked options to terms like dangerous or risky. However, it’s important that an investor knows both sides of the story before they make any decision in trading options.
Here are the four key advantages of options:
- A potential to provide higher percentage returns
- Increased cost efficiency
- Less risky compared to equities
- Some strategic alternatives
With these advantages, it’s easy to understand why those who have been trading options for a while will be at a loss to explain trading options’ lack of popularity.