- Options can be used for speculation, protection or hedging purposes.
- Options enable synthetic stock positions at a fraction of the costs.
- Options may have smaller price swings but larger percentage swings than stocks.
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If you've ever opened a brokerage account, even through a mobile app, you've likely heard of options trading. Options trading continues to gain popularity since it enables synthetic directional positions where percentage gains and losses can fluctuate in the double and triple digits.
Options let you bet on the direction and magnitude of stock price moves at a fraction of the cost of owning the stock. Stock options trading requires less capital than day trading but can reap the rewards and losses of trading. In this article, we'll do a deep dive to help you learn how to trade options, complete with basic and advanced strategies, so you can hit the ground running.
Introduction to options trading
What is options trading? Options trading (or option trading) is very similar to trading stocks. Investors buy or sell options to capture profits from price fluctuations. In many cases, you can execute options trading on the same platform you trade stocks on. Margin rules apply the same as the pattern day trader (PDT) designation. However, while you can hold a stock forever, you can only hold an options contract temporarily before it expires.
You should also take note that not all stocks are available for options investing. For example, penny stocks don't have options, but blue chip stocks, large-caps and dividend stocks usually do.
Options are a type of derivative contract, meaning the contract derives its value from the underlying asset's value. It's important to keep this distinction in mind as you learn how to trade options.
An option contract gives you the right but not the obligation to buy or sell a stock at a predetermined price before the predetermined expiration date. You don't own the stock but can buy or sell it at a specific price before a specified date.
When you purchase an options contract, you buy a synthetic long or short position. Most options don't get exercised, meaning they follow through to acquiring the stock positions at the chosen strike prices. Most options expire worthless. This aspect draws in speculators and traders who trade them like stocks to capture profits and flip them.
Options serve many vital roles in the financial markets. They can be a tool to increase the flexibility of your portfolio. There are three key roles they perform for your portfolio. First, you can use options for speculating on the direction and magnitude of a price move in the underlying stock. Second, you can use options to generate income through various strategies like covered calls or iron condors. Third, you can use options to hedge existing positions in your portfolio. In this way, options can perform like an insurance policy in case your stocks collapse because options enable hedging to offset losses in a portfolio. For example, put options can be a hedge against concerns about a position falling.
Types of options
There are two types of stock options: call and put options. These are the building blocks of options strategies and the essence of options trading for beginners.
Call and put options can be combined for any directional movement or even no movement on the underlying stock. Each option contract represents 100 shares of the underlying stock. One call contract of XYZ is the equivalent of 100 shares of XYZ. Let's examine the differences between a call option vs. put option.
A call option is a financial contract that gives the contract holder or buyer the right, but not the requirement, to buy a stock at a specified price on or before a specified date. The specified price is the strike price, and the specified date is the expiration date.
Long call options are upside-directional contracts. Purchasing a call option has expectations that the underlying stock price will rise. The value of the option tends to increase when the underlying stock rises. Traders buy call options in anticipation of the underlying stock price rising. It's a bullish directional derivative.
Example: The ABC Company has a stock price of $30 per share. Amy believes that the stock will rise in the next quarter. She buys a call option from a seller for $31 per share. The seller charges a $3 premium. Since option contracts are generally for 100 shares, Amy is paying $300 (3 x 100) for the option. This premium is the only money Amy is putting at risk.
If Amy is correct and the stock rises past $31 per share, she can "call" in her option, and the seller would have to sell her shares for the strike price of $31 per share. If the stock has increased to $38, Amy would stand to make a $400 profit. Her shares would be worth $3,800, a $700 profit. However, she must factor in her $300 premium (700 – 300 = 400). If Amy is incorrect, and the stock of ABC Company declines, she would allow the option to expire worthless, leaving her with only a $300 loss from the premium.
A put options contract is the opposite of a call option. It gives the holder the right to sell the underlying stock at a specified price on or before a specified date. Traders buy put options when they expect the price of a stock to fall. It's a bearish directional derivative.
Example: The stock of the XYZ Company is currently selling at $40 per share. Based on a weak earnings report, John believes the stock will fall in the next quarter. He buys a put option from a seller for $38 a share. The seller charges a $2 premium. Since option contracts are generally for 100 shares, John will be paying $200 (2 x 100) for the option. The premium is the only money John is putting at risk.
If John is correct, and the XYZ company stock drops below $38 per share, he can "put" the option to the seller and receive 100 shares of the company stock for $3,800. If the stock trades at $33 per share, John will have made a $300 profit ($500 - $200 premium). If John is incorrect and the stock increases in price, he can allow the contract to expire worthless. In this case, he is only out of the $200 premium he paid for the contract.
You can trade options like stocks. They can be bought or sold in two ways. When you buy an option to trade, you are opening a long position in the option. When you sell the option you hold, you close the long position. This sequence applies to calls and puts. This is how to learn stock options trading.
You can also sell options without owning the option itself. If you sell an option for a stock you own, you are selling the right for a buyer to purchase your stock at a specific strike price. This is also called a covered call. In this case, you would be opening a short option position. The only way to close the position is to either cover and buy back the option or wait until it expires.
This options trading strategy is a way of deriving income from holding stocks by selling the calls. Here's an example.
If you own 100 shares of XYZ and it trades at $35, you can write the covered call at $37. You wrote a covered call at $37 for a $2 premium on the option that expires next month. This means you sell the rights for someone to buy your stock at $37 on or before the expiration date if the stock price moves above $37. Even if the stock moves to $45, you will have to sell your stock for the $37 strike price. However, if the stock stays below $37 on expiration, then you will keep your stock and the $2 premium.
Keep in mind that you can also exercise options. Exercising an option means if you have a $33 call on XYZ and the stock is trading at $37, you can "exercise" the call option and buy the stock at $33. It's important to note that a stock can be exercised anytime it's trading above the strike price.
How options work
As a way to show how to learn how to trade options, let's review the structure of options contracts. An options contract will include three critical pieces of information: the stock symbol, the strike price and the expiration date.
Options contracts expire on the third Friday of every month. However, many stocks also have weekly options contracts, which expire every Friday at the close of trading. Weekly options are usually available for widely traded stocks. For example, if you have a weekly options contract on Monday, October 2, 2023, it will expire at the end of trading on Friday, October 6, 2023.
For example, a "MRVL $53 Call 10/6" option is a call option on the stock Marvel Technology Inc. (NASDAQ: MRVL) with a $53 strike price expiring on October 6, 2023. If you buy this call option, you expect the MRVL stock price to rise above $53 on or before October 6, 2023.
When you want to buy or sell an option, there are some key components to review. The MRVL $53 Call 10/6 example shows that the option trades for $1.73 while MRVL stock is priced at $54.00. We can see that the bid price is $1.70, and the ask price is $1.75. The option is a weekly option that expires in five days.
If MRVL is trading at $54 and you are buying the $53 call option, it's already $1 in the money. This means the stock trades $1 above the $53 strike price. The option's intrinsic value is the $1 that the stock is trading above the strike price. However, if I want to buy the particular call option, I'll pay the $1.75 ask price. In other words, the $1 of intrinsic value is what the option is worth, but the additional 75 cents is called the premium.
The premium is the extra value of an option contract based on its volatility premium and time premium. The delta is how much an option's premium changes per $1 move in the underlying stock. The delta for the MRVL call option is 0.6815. Delta means that every $1 MRVL stock price increase will increase the option's premium by 68.15 cents. It also applies if MRVL falls by $1. The theta represents time decay. In other words, the amount the option loses value every day as it reaches the expiration date. In this case, MRVL has a theta of -0.0977. This means the option's value will fall by 9.7 cents each day.
Therefore, buying the MRVL $53 call contract will cost $1.75. With MRVL trading at $54, the call contract has a $1 intrinsic value and 75 cents premium. Every day you hold the call option, it will lose 9.7 cents in value from the premium. For every $1 higher MRVL stock price rises, the call option value will increase 68.1 cents. The farther away from the expiration date, the more expensive the time premium. This makes it imperative to benefit from direction options, and you need to get the most movement in the shortest period of time to avoid time decay.
If you own 100 shares of MRVL, you can write the $53 covered call or open a short position by selling the call at the bid price of $1.70. If MRVL stays above $53 in-the-money by Friday's close, your MRVL stock will be acquired from your account at $53 a share, but you get to keep the premium. If the call options close out of the money (OTM), you keep your MRVL stock and also keep the $1.70 premium as the option expires.
Basic options trading strategies
Here are some basic options strategies using call and put options as building blocks.
Long call and long put strategies
These are the basic directional options trades. If you buy a call contract, you expect the stock to rise higher, preferably much higher, above the strike price before the expiration date. For example, you may buy calls based on insider buying or analyst upgrades or downgrades. When you have long calls, you're losing time premium daily based on the theta. Directional trades usually end up expiring worthless either because traders hold them too long as they fall out of the money or they neglect to take the profits while in the money.
The INTC $37 Call, expiring on October 20, 2023, costs 61 cents to buy on the ask, while INTC is trading at $35.56. Its intrinsic value is worthless since it trades $1.44 out of the money. The 61-cent cost for the option is based on volatility and a time premium for 19 days. You have 19 days for INTC to make a move before the option expires worthless. The value of the option can spike if INTC surges $1 today. Based on the delta, if INTC stock rises $1.00 to $36.56 today, the option will increase in value by 33 cents, giving me a 50% profit in one day even as it trades below the strike price and is intrinsically worthless.
Covered call and protective put strategies
If you owned INTC stock at $35 and expected it to move higher, you could also write a covered call at $38 to collect a premium and the potential to get assigned the stock at $38 for a $3 profit in addition to the premium. Selling the call when you own the shares is called writing a covered call. However, if you sell the call without owning the stock, it's called a naked position. A naked position can backfire hard if INTC's price surges through $38 since you can sell the shares at $38 even if you have to buy it at $40. Only investors or traders with options level 4 permissions can take naked calls or puts. Even then, it's a risky trade only seasoned pros should consider doing.
In another scenario, if you expect the price of INTC to drop, you can look at the INTC $34 Put contract expiring in 19 days on October 20, 2023. You would buy the put for two reasons: speculation or protection.
In terms of speculation, you may not want to risk shorting INTC stock and have it squeeze on you indefinitely. In this case, you can limit your loss potential to the 55-cent cost to buy the put contract for speculation, expecting the stock to drop under $34 per share. In this example, one contract will cost me $55 when INTC trades at $35.56 and $1.56 out of the money. If INTC stock collapses $1 today, the put contract will rise by 27.8 cents based on the delta. Every day you hold the put contract, you lose 2.5 cents a day in options value based on the theta. You would need INTC to fall to $33.08 or lose 6.97% to break even on the contract. You need INTC to fall as fast as possible in the quickest amount of time to exit by selling and closing the put position to make a profit.
For protection, if you owned 100 shares of INTC at $35 heading into an earnings report and you want to protect yourself, you can buy the same INTC $34 Put for insurance. If the INTC stock price falls to $33, your stock would fall $2, but your option would be worth $1, which offsets half of the losses. If you want more protection, you could buy the INTC for $35, but it would cost more.
Advanced options trading strategies
Here are some advanced options trading strategies:
Spreads and combinations
Spreads are multi-legged options strategies where you are long one option and short another option with the same or different strike and expiration prices. Spreads can reduce the cost of options positions and minimize the risk while potentially generating income.
There are two types of spreads: vertical and horizontal.
Vertical spreads involve buying (open long) and selling (open short) options contracts with the same expirations but different strike prices.
Horizontal spreads involve buying and selling options with the same strike prices but different expiration dates.
Here are some widely used spread strategies:
- Straddles: In this strategy, you expect a security to have volatility but are unsure what direction the security will move. For this reason, you take out both a call option and a put option at the same strike price and expiration date. The key point is that you should take out the contracts at the same time so the price of the underlying security is the same. You will exercise the option that puts you "in the money" (ITM) and allow the other contract to expire worthless.
- Strangles: This strategy is similar to a straddle strategy, but in the case of a strangle strategy, you are intentionally buying calls and put options that are "out of the money" (OTM). Once again, you use this strategy when you anticipate significant price movement but are unsure of which direction. A benefit to this strategy is that you generally pay a lower premium because you assume a bit more risk of the contract expiring worthless. The added risk is because you allow the strike price to be set further from the underlying stock's current price.
- Bull call spread: This strategy involves buying a call option with a lower strike price ITM and selling a higher strike price OTM call option. You use the spread to profit from a rise in the underlying stock price at a cheaper cost and less risk. Maximum profit is made if the stock rises through the price of the higher strike price. This vertical spread lowers the breakeven price, the net premium paid and limits maximum losses.
- Bull put spread: This strategy involves buying a put option at a higher strike and selling a put option with a lower strike price. You use the spread to profit from the stock price falling. Maximum profit is made if the underlying stock falls through the lower strike price. This vertical spread also lowers the breakeven price, the net premium, while limiting maximum losses.
Implied and historical volatility
Implied volatility (IV) is the expected future volatility of the underlying stock. IV is used to price options premiums and is expressed as a percentage. Options that have high IV are priced higher due to the high volatility. High IV can form due to expected events like earnings reports or surprise events like an earnings warning. For example, if XYZ has an implied volatility of 120%, the volatility premium will be expensive. XYZ may historically move 20% on earnings reports. This historical price movement can set the IV high heading into the earnings report release.
History volatility (HV) is the actual volatility of the underlying stock over a period of time. It's calculated based on the standard deviation over time. HV is a percentage used to compare the volatility of different assets.
IV and HV can differ as IV is based on future expectations while HV is based on the stock's actual historical volatility. IV can rise above its HV heading into an earnings report since volatility is expected to be high. IV and HV can change over time. IV and HV can help to optimize options strategies like spreads and covered calls.
Volatility selling strategy: When IV is higher than HV, it presents an opportunity to sell the volatility. High IV will eventually face a reversion to the mean back towards HV levels. When IV is high, it equates to higher options prices. By selling an option, you are shorting the IV, expecting it to revert to the mean and earning time decay in addition to volatility decay.
For example, if XYZ releases an earnings blowout and shoots up the IV to 140% compared to 60% HV, you can sell or short OTM calls for the premium to fall back down as volatility eventually reduces. You would keep the premium if XYZ fails to close above the strike price.
Volatility buying strategy is the inverse of selling volatility. When IV is lower than HV, it presents an opportunity to buy the volatility. You could buy an OTM put option on the stock at a lower strike price, hoping for the stock to fall under the strike price. You could buy OTM call options expecting the stock to rise above the strike price. This is the ideal time to buy options contracts for directional trades since the premiums are relatively low.
Risk management in options trading
Options trading requires prudent risk management. While options cost a fraction of stock prices, they move on a more significant percentage basis. Always plan out your trade ahead of time and stick with the stop losses. A key way to mitigate some risks involves using spreads, as they lower your cost basis, minimize your losses and define your upside and downside potential on a trade.
Stop-loss orders are also crucial for options if you aren't able to monitor the positions. However, due to the wide spreads that options can have, stop-loss orders may backfire depending on how much liquidity and volume you are trading in the option. The bid and ask spreads and volume can express a lot about options liquidity. Stop-loss orders are most effective when the spreads are as small as 1 cent between the bid and ask. Spreads larger than 50 cents can erroneously trigger a stop-loss order as liquidity may be too light.
Tips for successful options trading
Here are some tips for successful options trading.
Do your research on the underlying stock. If you're taking a directional trade, make sure you know of catalysts and events that can trigger a volatile price move. Don't impulse trade options. Be aware of the HV and compare it to the IV to gauge if the directional trade is in your favor or if selling the volatility may be better. You should be able to explain your options trade to another person; you should if you can.
It's easier said than done, but try to control your emotions when trading. Luckily (or unluckily), only two emotions can screw you up: fear and greed. Avoid getting a case of the fear of missing out (FOMO) with options. Remember that options premiums get expensive when IV rises, which is when FOMO can strike the most. Remember past instances of FOMO that went against you as motivation not to repeat the same mistakes.
Since options are so much cheaper than owning the underlying stock, it's easy to get overleveraged on positions. Traders can make the mistake of thinking that they control 5,000 shares of XYZ for just $500 and figure they could control 10,000 more shares with another $1,000 and go too heavy on the trade. Traders tend to forget that even though you control 100 shares for every 1 option contract, the options contracts have a ticking timer that causes the option to lose value every day from time and IV decay that a stock doesn't. Options also have larger percentage swings. It's easy to lose 75% to 100% of the capital you put into options, which would be devastating if it were stocks.
Neglecting exit strategies
Most options expire worthless. Most options never get ITM, but there are far too many times an option surged ITM only to fall back OTM or have IV drop as the trader neglects to sell and cash in on the profits. Remember, it doesn't matter where the option goes. It only matters where you open and close the trade. Options are incredibly sensitive to volatility, especially directional trades. No one ever went broke taking a profit. Traders may be so focused on stop-loss discipline that they neglect taking profits when they materialize.
Paper trade or use a simulator first
Just like trading with stocks, options trading also takes practice. A good strategy when trading options for beginners is to start paper trading or using a simulator before staking real money on your trades. If you have less than $25,000 in capital, it may be helpful to use a simulator to get your practice in and avoid the pattern day trader (PDT) designation.
Check with your broker to see if they offer a trading simulator. If they don't, you can practice with paper trading. Practice devising the trade with entry and exit targets, stop-loss triggers and strategy catalysts. Take your time to learn options trading. It takes time to learn to trade options.
You may even consider taking a reputable options trading course. Options trading courses will cost you some money, but they will more than pay for themselves if you're serious about trading options.
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