A guide to options basics If you’re trying to figure out if trading options are right for you, you should first understand what options are. As with most investing products, an option is a contract. It is exactly how it sounds. This specific type of contract gives you the right to buy or sell an asset at a specific price by a specific date. It’s essentially a contract that is giving you the option to follow through.
Options Basics About Trading
In essence, an option is a contract which allows you to buy or sell an investment, such as a stock, an exchange-traded fund (ETF), or other assets.
Each contract includes a pre-negotiated price and an expiration date which specifies how long the price is valid.
There are a few key words to understand within an option contract, and here’s what you need to know:
- Premium – The price at which you can buy or sell an options contract
- Strike price – The pre-negotiated price of the security if it’s bought or sold according to the option contract
- Expiration – The date and time the contract ends where you no longer have the ability to buy or sell
The options contract gives you the opportunity to buy or sell shares or to sell it to another investor.
But you aren’t required to do anything, and you could allow the specified period of time to pass, and let the contract expire without having any additional financial obligation.
Usually, an options contract is good for 100 shares, though you can have more than one if you want to trade higher volumes.
Options Basics: How Options Work
As with most investment products, an options trader will want to determine the probability of the future prices of certain assets. One can assume that the more likely it is that something will happen, the more expensive a related option would be.
The basic steps of trading an option are:
- Identify the asset you want to buy or sell (e.g., SPY)
- Enter a contract to determine a premium, cost and expiration date.
- If you’re the buyer, you pay the premium cost.
- Monitor the asset and decide whether you want to follow through on the contract to buy or sell.
Here are some key factors to understand about options:
- Options are typically sold in groups of 100. So, the options trader should be sure to multiply the premium of his contract by 100 to get the total cost of that option.
- The more time a trader has in his contract, the more valuable his option could be. This is because the more time there is, the more chance there is for the price to change.
- If you’re the buyer of an option, you are not obligated to go through with buying. However, you will not get the premium back if you choose not to follow through. The only risk to entering the options contract is losing the amount you spent on the premium. So be sure you’re comfortable with losing the cost of your premium if it comes to that.
- On the other hand, sellers may be required to make good on the options contract to sell. Sellers have greater risk and can lose much more than the cost of the options contract premium.
More Details About Options Contracts and Trading Options
Options trading is precisely what it sounds like: trading options. In much the same way you trade stocks, and bonds by buying and selling, you can trade options contracts, too.
The difference is that buying options doesn’t give you any ownership in the company because you haven’t purchased any shares.
What your contract does give you is a choice to buy the shares later, meaning you have the potential for ownership according to the terms.
When it comes to options trading, there’s more flexibility in your investment since they can include ETFs, commodities, and indexes in addition to the stocks and bonds you’d expect.
Prices fluctuate, and you can try to predict if the price will go up or down in much the same way that you try to predict stock prices.
Then, you buy or sell your options to increase your profits or lower your risk of loss.
Trading options are broken down into two types. Whether it’s a call option or put option depends on if you want to buy or sell.
- Call option – If you have a call option, you have the right to buy shares at the strike price before the expiration date. Having a call option obligates the current owner of those shares to sell them to you according to the option agreement.
- Put option – Having a put option means you have the right to sell shares at the strike price by the expiration date. If you exercise your put option, the shares must be sold and you’ll collect the strike price for each.
- Strike Price
The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. In options trading, the Strike Price for a Call Option indicates the price at which the Stock can be bought (on or before its expiration) and for Put Options trading it refers to the price at which the seller can exercise its right to sell the underlying stocks (on or before its expiration)
Since the Options themselves don’t have an underlying value, the Options premium is the price that you have to pay in order to purchase an Option. The premium is determined by multiple factors including the underlying stock price, volatility in the market and the days until the Option’s expiration. In options trading, choosing the premium is one of the most important components.
- Underlying Asset
In options trading, the underlying asset can be stocks, futures, index, commodity or currency. The price of Options is derived from its underlying asset. For the purpose of this article, we will be considering the underlying asset as the stock. The Option of stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.
- Expiration Date
In options trading, all stock options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading, the expiration of Options can vary from weeks to months to years depending upon the market and the regulations.
Educational Methods for Options Trading
Knowledge is one of the most important resources a trader needs. Understanding the foundational knowledge of the stock market, why it works, and how you can profit from it is just the launching ground. Even seasoned, professional traders continue learning as it helps to keep your thinking sharp and avoid the creeping in any unintentional bad habits in your trading.
The great news is we are living in the information age where trading education comes in a variety of formats and can be accessed nearly instantly. Here are a few trusted resources to help get you on your way:
There is a vast amount of books on trading, including trading options. However, most books on trading specialize in one specific area, which usually works well for continuing education but can be confusing and overwhelming for a beginning trader.
- Internet Search
For quick help on a specific topic, there is a treasure trove of knowledge at your fingertips via the internet. Search terms can include: “ways to generate income in the market,” “stock option contract,” “different strike prices for options,” “option contract’s strike price,” “out of the money,” “market price for options,” “premium paid for options contracts,” and similar search criteria. Using these more specific searches, one can begin to greatly expand their knowledge in a short time frame.
- Online Trading Education
One of the fastest-growing, most popular ways to learn is through online schools. Your online trading education should walk you from point A to Z, giving you a complete understanding of trading and a model system for trading that you can adapt and personalize. When searching for the online trading education that will serve you best, consider programs that have a combination of on-demand content and live instructors. There is an exceptional value to showing up and asking questions or requesting specific examples of principles being taught.
Initial Trading Capital
You would be surprised by how many people complete their education, set up their broker account, and then realize that they are short the cash to fund their trading account adequately. The good news is you can fund a trading account with as little as $5,000, and even if you need to raise funds, the following are some simple ideas to get going:
- Sell some stuff – Take a look around your home and see what you can sell.
- Pick up a side hustle – Find a side hustle to make a little money and use it to fund your account. Companies like Uber and Doorstep Delivery have changed the way people can make some extra cash and are easy to start doing.
- Rent your stuff – Rent your house or car out for a weekend.
Options Basics: Trading Software
Today, traders can analyze a company’s stock chart with traditional support and resistance drawing tools with the click of a couple of buttons. If you prefer to let the computer do the work, many platforms are using artificial intelligence to assist you in analyzing and understanding the price graph. A very good option for beginner traders is offered by TD Ameritrade, and it is called thinkorswim. However, with a simply search, many other similar options can be found.
Importance of a Mentor to Develop Good Option Trading Strategies
As with any profession, having access to a professional that has substantial experience in the market is critical to learning and developing your knowledge of options.
For starters, due to the potential substantial risk associated with options trading, having someone to guide through the obvious and not so obvious risks will help with early success in trading, and also will help with the confidence to buy and sell options without fear.
Equally important, a mentor can help develop trading strategies that provide consistent profits. These trading strategies come from experience, and are very difficult to find in reading materials and random articles on the internet.
Finally, a good mentor will provide a platform for learning options and option trading strategies that goes beyond basic information, and delves into more sophisticated topics. A mentor can be a good insurance policy against tough times, especially when option prices start to fall, and you do not react emotionally, because you have a strong plan in place for all scenarios.
Summary: Options Basics
Obviously, options and options trading are more sophisticated topics compared with more traditional concepts, such as long-term investments in stocks, and other more traditional investment strategies.
However, if you are interested in developing a new trading skill, learning the basics about options and buying and selling options is critical. This article is intended for just that: a very basic introduction to some concepts related to option and options trading.
To go to the next level, a key takeaway from this article should be to further educate yourself on the area of options, and develop a more detailed understanding of this area of investing.
Also, without question, having a good mentor walk you through the many aspects of options trading will greatly enhance your ability to become an independent and successful options trader.
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
Feel free to check out other FREE educational resources to help guide you as you begin your new journey to financial freedom.
Also, download a (FREE E-BOOK) by Maurice Kenny, “DAY TRADE LIKE A MILLIONAIRE.”