Are you an inexperienced private investor? Do you want to explore new territory of investing, possibly expand your retirement portfolio, and you simply don’t know where to start? Welcome, this is “Options For Dummies!”
There are many ways to day trade, including stock trading, options trading, crypto trading, forex, and many other methods. This article is focused only on options trading, and provides basic information about options trading stragtegies; specifically, options strategies for new uniformed investors. This is options for dummies.
Options trading may sound risky or complex for beginner investors, so such investors often stay away. However, some basic strategies for options trading can help novice investors protect their downside and actually become very successful investors. This article, which is an introduction to options trading, can be supplemented with many other materials. For more detailed methods for options trading, and step by step advice, see the link at the end of this article.
What Are Options?
Options trading can be complicated. It takes lots of patience and lots of practice. An option is a contract that gives an investor the option to buy or sell a stock or other security — usually in bundles of 100 — at a pre-negotiated price by a certain date. An option is a type of derivative, because it derives its value from an underlying asset (e.g., a stock, or market price).
An options contract is not an obligation to buy or sell the underlying security. An investor also has the option to let the contract expire, hence the name. However, when buying options, the trader will pay what is known as a “premium” up front, which the trader will lose if he or she lets the contract expire.
How Options Work
Although this is “Trading Options For Dummies,” some detail is going to be needed to explain options trading, options contracts, and buying and selling options. Trading options is inherently complicated, so it can only be dumbed down so much. Attention to detail, and developing a day trading plan are critical. The following provides a basic description of how options work.
Options contracts exist for a variety of securities, but this article focuses primarily on options for stocks. In that context, there are two main types of options contracts:
- Call options. A a call option gives the trader the right to buy a company’s stock for a specific price (known as the “strike price”) within a specific time period, referred to as its “expiration.”
- Put options. A put options gives the trade the right to sell a company’s stock at an agreed upon strike price, before its expiration.
Once a trader buys the contract, a few things can happen between the time it is purchased and the time of expiration. The day trader can:
- Exercise the option, meaning he or she will buy or sell shares of the stock at the strike price.
- Sell the contract to another investor.
- Let the contract expire and walk away with no further financial obligation.
Know These Terms
Here are a few terms that a new day options trader should know:
- In the money. A call option is “in the money” if the strike price is below the stock price, while a put option is in the money if the strike price is above the stock price.
- At the money. If the stock price and strike price are the same for either calls or puts, the option is “at the money.”
- Out of the money. A call option is “out of the money” if the strike price is above the stock price, while a put option is out of the money if the strike price is below the stock price.
- Premiums. This is what a trader will have to pay to buy an options contract. Conversely, this is the money a trader potentially will make if he or she sells an options contract.
- Derivatives. A derivative is a type of financial product whose value depends on — is derived from — the performance of another financial instrument. Options are derivatives.
- Spreads. Spreads are an advanced trading strategy in which an options trader buys and sells multiple contracts at different strike prices.These terms are not related to any particular stock, and they do not take into consideration market timing, market prices and several other factors. These more detailed and sophisticated concepts must be understood and learned with practice and mentorship
Example of a Call Option
The following hopefully helps all new investors learn a trick or two, limit risk, and understand an options trade. Assume a company’s stock is currently $50 per share. The trader could buy a call option to buy the stock at $50 (the strike price) that expires in six months, for a premium of $5. Premiums are assessed per-share, so this call option would cost $500 ($5 premium X 100 shares). Note that when buying options, the day trader must choose from an available list of strike prices, and it doesn’t have to be the same as the current stock price.
If the stock price remains at or drops below $50 during the six-month period and never recovers, you could let the contract expire worthless, and your total loss would be the $500 you spent on the premium. That $500 is also the maximum amount you could lose on the investment.
Now assume the price rises to $60. The trader could then exercise his or her our option to buy the 100 shares at the strike price of $50, then turn around and sell them at $60. In this instance, the trader’s return on investment would be $500. (It would cost $5,000 to buy the shares, but you would sell them for $6,000 for a gain of $1,000. Subtract the cost of the premium, and the trader is left with $500 profit.) If the trade does this, its a very good job at trading options!
Example of a Put Option
Put options serve a similar purpose as shorting a stock — both let the trader profit if the stock price falls. But puts can also be used as a hedge against price drops that might hurt the trader’s portfolio. In today’s markets, have such a trading insurance policy can reduce risk.
Using the same example above, let’s say a company’s stock is trading for $50, and you buy a put option with a strike price of $50, with a premium of $5 and an expiration of six months. The contract costs $500.
If the stock price falls to $40, a trader could exercise his or her right to sell the stock at the $50 strike price. In this instance, the trader won’t earn any profit, but he or she would protect their shares from losing value. If the price rises, the contract will expire worthless, and then the trader would be out a maximum of $500. In a sense, put options could be considered insurance for a trader’s stocks: If the stock price falls, the trader is insured to sell at the higher strike price, and if it rises, the premium paid was the fixed cost of that insurance.
But put options can be used for speculation, too, and a trader does not have to own the underlying stock to buy a put option. Assume the trader bought the put option and the stock drops to $40, but the trader does not own it. The trader could then buy the stock at $40, and then turn around and sell it at $50. This would return a profit of $500. (The trader would buy 100 shares at $40 for $4,000, then sell them at $50 for $5,000, generating $1,000. Subtract the $500 premium, and you earned $500.)
Like call options contracts, a put options contract can have intrinsic value. If the underlying stock price drops below the strike price, the contract will become more attractive, and the cost of its premium will rise accordingly. In this case, the trader could sell the contract to another investor for a profit.
Puts are also an excellent tool for day traders, as it does not matter what the Wall Street Journal or other news article is saying, a trader can make profits on an up or down market over a short and/or long period of time.
Remember, this is “trading options for dummies,” and there is much more to learn beyond this article.
Risk vs Return In Options Trading
If the trader thinks a stock is going to rise, he or she can either buy and own the stock outright, or buy call options. But there’s a big difference between these two, especially given today’s markets
In the example above, notice that it costs $500 to take control of 100 shares of a stock valued at $50 per share. If the trader were to buy the stock outright with the same $500 investment, the trader would only be able to take control of 10 shares. This is where the return-magnifying power of options comes into play, and why options are considered a form of leverage.
From the example above, it is known that if the stock price rises to $60, it yields a $500 return — the trader has doubled the money invested. But if it rises to $70, the trader’s profit rises to $1,500. If it rises to $80? That’s a 60% increase in the stock’s price that resulted in a return of $2,500. Had the trader bought the stock outright, that same 60% price increase would give him or her a return of a comparatively meager $300.
But where there’s the chance for high reward, there’s high risk. If you’d invested $500 in the stock outright, a subtle dip in the price doesn’t mean much. A 10% decline, for example, means the trader is down $50, and he or she can wait indefinitely for the price to rise again before selling.
Spending $500 on a call options contract, though, means a 10% drop in the stock price could render the contract worthless if the stock price falls below the strike price, and the trader has a limited amount of time for it to rise again. If it doesn’t, that’s a $500 loss, or 100% of the trader’s investment.
When buying put options, the max amount you can lose is similar to call options: If the stock price rises above the strike price, and the trader let’s the contract expire, he or she will lose the whole $500 investment.
However, the magnification of returns seen in call options goes the other way in put options. If the stock price drops to $30, the trader would see $1,500 in profit. At $20, profit would be $2,500. But this also means there’s a limit to profit on put options — the stock can’t go any lower than zero. Conversely, when buying a call option, profit potential is theoretically limitless.
Pros and Cons of Trading Options for Dummies
A private investor uses options for different reasons, but the main advantages are:
- Buying an option means taking control of more shares than if the trader bought the stock outright with the same amount of money.
- Options reduce risk, and are a form of leverage, offering magnified returns.
- When conducting options trading, an options contract gives an investor time to see how things play out.
- An option protects investors from downside risk by locking in the price without the obligation to buy.
- Options contracts can be day traded.
- A trader can focus on the same stock (e.g., SPY), and not get burdened by heaving technical analysis of many different stocks and stock prices.
But there are also risks with options trading, including:
- The trader can lose his or her entire investment in a relatively short period when conducting options trading.
- It can get a lot more complicated than buying stocks — the trader has to know what he or she is doing. Options trades come with significant risk. A trader has to have a real understanding of the market and trades that are being conducted.
- With certain types of options trades, it’s possible to lose more than your initial investment.
Summary: Options For Dummies
Obviously, you cannot learn everything there is to know about trading options by reading one article. However, the above information provides a foundation of information to build on so that you can move to the next level of investing. To obtain a better understanding of the markets and day trading of options, check out the link below, which will further enhance your knowledge and education.
Looking to Learn More?
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.“