How to Trade Options - Beginners Guide To Getting Started
Becoming a successful options trader is a lot like being a successful stock trader. It takes a commitment to learning and plenty of practice. Time spent on education, strategy development, and understanding the forces that drive the stock options market goes a long way. The options trader must have conviction on their idea, know the purpose for entering into a trade, and continually learn from past actions.
When it comes to developing a winning strategy, options, as the name suggests, gives investors greater flexibility than traditional equity investing. There are a wide range of options trading strategies that can be used to generate portfolio income, protect an existing position, or speculate on the direction of an asset.
Let’s take a closer look at options, the types of options, and how to place a stock options trade.
What Are Options?
An option is a contract between a purchaser and a seller. With stock trading there needs to be a buyer and a seller that agree on a price for a trade to occur. Similarly, in the world of options there is an option buyer and an option seller. The option buyer agrees to pay a fee, called a premium, to the option seller. The option seller, also called the option writer, transfers a certain right to the option buyer. The option buyer then has the right, but not the obligation to buy or sell an underlying asset.
The underlying asset may be a stock, a stock index, a commodity, or some other financial security. As the holder of the stock option, the buyer has the opportunity to buy or sell a stock at a specific price referred to as the strike price. The concept of strike price is a key distinction in option trading. It is a fixed price at which the option holder can buy or sell the underlying asset. The option buyer has a deadline called the expiration date. A decision to buy or sell the underlying asset must be made prior to a specified date.
What To Consider Before Trading Options
So perhaps trading stock options sounds like something you’d like to explore. Before diving in, however, there are several things to consider to make sure you are well-equipped to swim with the big fish.
An important thing to keep in mind is that the options market has many experienced participants that can prey on the inexperienced. This should not scare you, but rather inspire you to have an awareness of the players, strengthen your skill set, and become a successful options trader.
This requires that you first give an honest evaluation of your investing experience level. Novice investors should start slow by keeping a focus on education and developing a comfort level with the basic options trading strategies. Although options can be a great way to hedge your positions, when not properly understood they can represent a high risk of loss.
It is also critical that you have a good grasp on your risk tolerance. Before engaging in options trading, know both your financial ability and willingness to take on risk. Stock options allow an investor to establish a position in a stock without actually trading the stock itself. They are considered to be a cost efficient way to gain exposure to equity. Options have tremendous leveraging power and can enhance return potential, but with this advantage comes with significant risks. Stock options can also carry a greater risk of especially if trading on margin. Know your personal risk level and know that there are unique, inherent risks in options trading.
The popularity of options trading has led to a rise in trading platform choices. Many of today’s trading platforms are beginner friendly and make it easy to trade options. Even the more advanced options strategies can be executed in seconds on the best options platforms. Examine the platform’s price transparency, ease-of-use, and fee structure to make sure you are getting the most for your money. Find a stock options platform that fits your style and is conducive to maximizing your profits.
A platform such as Webull that has the best interests of the self-directed investor in mind is your best bet. Rather than relying on trading commissions like traditional brokerages, It is truly focused on creating the most technologically-advanced platform with easy to use tools. Novice options traders can also benefit immensely from a platform that offers valuable educational resources and client support. The robust Webull system checks all of these boxes. It empowers stock options traders to make better choices by providing transparent, easy-to-understand real time prices, and has $0 commissions.
How To Choose Options
Stock options are often called binary options. This refers to the fact that their outcome can go in one of two directions -- the buyer either receives a payout or loses out on the investment. There are two types of options, call options and put options. Unlike when you purchase a stock and receive shares in a public company, when you buy a call or put option, you are entering into a contract. The contract is typically for the right to buy or sell 100 shares of a stock.
When you hear ‘call option’, think “right to buy”. When you purchase a call option you enter into a contract which gives you the right to buy a stock at a specified price up until the contract expires. The call buyer thinks that stock will rise about its current price. The call option seller takes the opposite view and is obligated to sell the underlying stock.
Over time, if the market price of the stock moves above the strike price, the call buyer will be inclined to exercise the contract. The difference between the stock price at the time of exercise and the strike price (less the premium paid for the option) can be locked in as profits. The option is said to be “in-the-money” because it has value if exercised.
If the stock price does not go above the strike price, the buyer will simply not exercise the option. The option would expire worthless and the call buyer would lose the value of the premium paid. The option would be considered “out-of-the-money”.
Buying call options is a limited loss proposition which is one if its the appeals. Stock XYZ that currently trades at $50 could theoretically decline to $0. Purchasing a call option on stock XYZ for $2 limits the potential loss to the $2 premium.
The call option seller’s goal is to collect the premium from the call option buyer and not incur any other financial obligation when the option expires worthless. Therefore, some investors sell call options to generate extra income for their portfolio. An investor who has an existing position in a stock may also sell a call option on that stock to protect themselves from a potential downward move in the stock by earning the premium for selling the call.
Note that the exercise of an options contract usually results in the contract being simply settled. For instance, instead of the underlying stock being bought and then sold by the call buyer, the difference between the value of the stock position (current market price times 100 shares) and the strike value (strike price times 100 shares) is delivered to the call buyer.
When you hear put option, think “right to sell”. It is the mirror image of a call option. Buying a put option gives the option owner the right to sell a stock at a set price within a certain period of time. The put option seller must buy a stock at the option’s strike price if the option is exercised before expiration.
Similar to selling a call option, an investor may choose to buy a put option if they believe a stock’s price will move lower. If the stock does move lower, the put option holder can theoretically sell the stock at the higher strike price and bank profits from the downward move in the stock. This strategy can help the put buyer to protect a position by offsetting the loss from a stock’s decline with the money made from buying the put option.
You may have noticed that call option sellers and put option buyers are in the same camp. Both think that a stock will decline. Conversely, both call option buyers and put option sellers think a stock will rise.
Options Trading Process
In placing an options trade, several decisions must be made. You must decide if a stock will move higher or lower from the purchase date to the expiration date. You must also determine by how much the stock is likely to move up or down, or if it will remain near the current price. Most stock options have several dates and strike price alternatives to choose from.
Before these details are decided upon however, it is paramount that beginners take things slow. Practice makes better options traders which leads to better profits. Now let’s look at the basic steps leading up to the execution of an options trade.
Step 1: Obtain Approval
Industry regulations stipulate that brokerage houses have an approval process for options trading. You will be required to obtain permission to trade stock options. Approval is based on your financial resources and investing experience and can usually be obtained within a day or two.
Step 2: Develop Your Strategy
Devote a significant amount of time to developing your options trading strategy. Decide what you want to accomplish and how you want to do it. Are you looking to hedge existing positions or trying to speculate on the future direction of a stock? Take all the time you need to feel 100% comfortable that the strategy you’ve developed is consistent with your objectives and risk tolerance.
Step 3: Explore The Options
Once you are ready to place real money trades, the due diligence continues. Spend time identifying stock options that match your targeted position on a stock. Browse through the various expiration dates and strike prices to find an option that fits your timeline and gives you the best chance to maximize your risk-adjusted return. Is the option overpriced, underpriced, or fairly priced? Submit your trade with confidence and enjoy the ride!
Step 4: Monitor and Learn
Once the trade has been placed, do not forget it and move on. Active monitoring of your stock options means you are looking closely at where the underlying stock is heading and whether your option is in-the-money or out-of-the money. Pay attention to how volatile the stock is and how this impacts the price of the option itself to gain an understanding of the relationship between volatility and stock options pricing.
Step 5: Continue to Educate Yourself
You can never learn too much with stock options. It is a dynamic market where even the most experienced traders win and lose. Whether your trade has been successful or not, it is important to humbly evaluate your success. Make an effort to understand why a trade was profitable or unprofitable. Learn from your success and failures to continually improve your knowledge and skills. At the same time, continue to explore educational resources about stock options trading to put you in the driver’s seat for success.
Understand The Risks, Enjoy The Experience
The options market has become increasingly popular in recent years especially amongst self-directed investors. The menu of stock options is continually evolving. Both individual companies as well as entire stock indices such as the S&P 500 can be traded through options.
There are several motivations for buying stock options. Stock options purchases designed to hedge a position can serve as an effective portfolio risk management tool. Trading options for hedging purposes is most prudent for novice options investors, but with proper education and experience speculative stock options trading can be used to cash in on your viewpoints.
Stock options can also be a great way to take a stance on a stock, whether bullish or bearish, without actually buying or selling the stock. Such speculative stock option purchases require that you are right on the stock price direction, the magnitude of the move, and the timing. This strategy involves greater risk of loss but can also lead to outsized profits.
An important aspect of trading options successfully is finding a platform that works for you. Ease of use, the availability of educational resources, and affordability are key considerations. The stock options trader must develop a comfort level with the technology to maximize the opportunity for success.