Options trading may seem overwhelming at first, but it’s easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes, including stocks, bonds, ETFs, and mutual funds. In this Options Trading 101 article we will cover the basics to get you started in your stock options trading journey.
Options are another asset class that, when used correctly, offer many advantages that trading stocks and ETFs alone cannot. Options are powerful because they can enhance an individual’s portfolio. They do this through added leverage, flexibility, and hedging.
In options trading, leverage allows you to maximize the advantages of stock trading and control a large investment with a relatively small amount of money.. In other words, you can speculate with less capital. One option contract controls 100 shares of the underlying stock. An options trade allows for strong potential returns and the potential for significant losses.
Options also allow you the flexibility to speculate in the market in a variety of ways. There are a wide variety of option contracts available to trade for many underlying securities, such as stocks, indexes, and futures contracts.
In addition, options can be used as an effective hedge against a declining stock market to limit downside losses. If you have an existing position in a stock, you can use option contracts to secure unrealized gains or minimize a loss with less initial capital. As already mentioned, you can purchase an option for significantly less than purchasing the underlying stock outright.
As the saying goes, there is no free lunch with stocks and bonds. Options are no different. Learning the basics of Options trading 101 involves certain risks that you should know before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following.
“Options involve risks and are not suitable for everyone. Options trading can be speculative in nature and carry a substantial risk of loss.”
The tradeoffs for options trading are typically associated with time and leverage. Options have a finite expiration date. They will either expire worthless or be turned into long/short shares of the underlying stock. Similarly, leverage goes both ways; it can hurt you as much as it can help you.
Let’s Get Started
So now that you understand the risks involved, the goal in the sections below is to cover the fundamentals of options trades that address questions such as:
- What are options, puts, and calls?
- What is the option premium and intrinsic value?
- What are In the money, At the money, and Out of the money?
- What is a bid and ask price?
What Is an Option?
Options are contractual agreements between two parties: the buyer and the seller. An option contract is an agreement between two parties to facilitate a possible transaction. This type of contract is for the right to buy or sell an underlying asset, such as stock, at a price set at the time of the contract. This is called the strike price. The transaction can take place up until the contract’s expiration date.
Options belong to the larger group of securities known as derivatives. A derivative’s specified price is dependent on or derived from the price of something else. Options are derivatives of financial securities—their value depends on the price of some other asset. Examples of derivatives include calls, puts, futures, forwards, swaps, and mortgage-backed securities.
An option is a derivative because its price is intrinsically linked to the price of something else. If you buy an options contract, it grants you the right but not the obligation to buy or sell an underlying asset at a set price on or before a specific date.
Types of Options: Calls and Puts
There are two types of options, Calls and Puts. A call option gives the holder the right to buy a stock, and a put option gives the holder the right to sell a stock at the stock’s price. Think of a call option as a down payment on a future purchase.
There Are Four Things You Can Do With Options:
Buy (long) Calls
Allows the option buyer to buy 100 shares at the strike price up to the defined expiration date.
Sell (short) Calls
Obligates the seller to sell 100 shares of the underlying at the strike price up to the defined expiration date.
Buy (long) Puts
Allows the option holder to sell 100 shares at the strike price to the defined expiration date.
Sell (short) Puts
Obligates the seller to buy 100 shares of the underlying at the strike price up to the defined expiration date.
Anatomy of an Option Symbol
The image above shows that a buyer of this call has the right to BUY 100 shares of SPY at $211 per share at any time until December 19, 2015.
The highest price that a buyer is willing to pay for the option. Typically quoted in $0.01 or $0.05 increments.
The lowest price that a seller is willing to sell the option at.
The total number of that particular contract traded on that trading day.
Intrinsic Value: ITM, ATM and OTM
The intrinsic value of an option represents its current value, or how much in the money (ITM) it is. Options trading at the money (ATM) or out of the money (OTM) have no intrinsic value.
ITM – In the Money
Has intrinsic value
Offers higher premiums
Offers call with strikes below where the underlying is currently trading
Offers put with strikes above where the underlying is currently trading
When an option is in the money, it has a positive payoff for the buyer. A $20 call option on a $30 stock would be $10 in the money.
ATM – At the Money
Has a strike price closest to where the underlying is currently trading.
OTM – Out of the Money
Has no intrinsic value
Offers lower premiums
Offers call with strikes above where the underlying is currently trading
Offers put with strikes below where the underlying is currently trading
What Happens If You Don’t Sell Options at the Time of Expiration?
In an ITM situation, if you don’t sell your options before their expiration date, your account will automatically reflect the profits. In an OTM situation, no profits would be reflected in your account.
Other Factors That Affect the Premium
Again, OTM options offer lower premiums, ATM option contracts have the most time value, and ITM options offer higher premiums.
Nearer-term expirations offer the potential for the highest annualized return but offer a lower upfront premium. Longer-dated expirations decay at a slower rate but offer the advantage of a more upfront premium (income certainty.
Higher market volatility (expected price movement) results in higher option’s premiums. When selling options, if that expected volatility becomes realized volatility, it can result in substantial losses.
Options Trading 101: Key Takeaways
- An option is a contract giving the buyer the right—but not the obligation—to buy (in the case of a call) or sell (in the case of a put) the underlying asset at a predetermined price on or before the option expires.
- People use options for income, to speculate, and to hedge risk.
- Options are derivatives because they derive their value from an underlying asset.
- A stock option contract typically represents 100 shares of the underlying stock, but options may be written on the underlying assets, from bonds to currencies to commodities.
Setting Up an Options Account
Like most other asset classes, options can be purchased with brokerage investment accounts. You will also need to choose your broker and trading platform, and apply for and be approved for option privileges in your account.
I suggest you go with TD Ameritrade. This way, you will have access to trading on their thinkorswim trading platform. It has more advanced features for options traders, including Active Trader and a “paper trade” platform for practicing a particular stock option trade.
It is also essential to develop and stick to a trading strategy that works. You must learn the core variables that drive options pricing as you develop a strategy – understanding concepts such as strike price, time of expiration, and implied volatility based on market influences.
Build your Options Trading 101 Skills
Whether you’re new to day trading, or an experienced trader exploring options, the basic strategies and skills you need to profit from options trading should be continually developed.
The Maurice Kenny Trading Program is a great way to start learning the basics of options trading 101 strategies and generate income. For new and veteran traders, my coaching program will help you build your knowledge and options trading skills.
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 our and other FREE educational resources to help guide you as you begin your new journey to financial freedom.
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