Option Trading Basics A Guide To Getting Started

Option trading basics a guide to getting started

When people think of investments, they often think of stocks and bonds. However, when it comes to investing there are plenty of options.

In fact, one of the most popular investment vehicles are “options”, which are a special type of financial derivative.

We have written this short guide to introduce you to financial options trading. We hope that this short options trading guide will represent your jump-start into the realm of options trading.

Advantages to Options Trading

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  • Option contracts offer high-profit potential.
  • Options allow for high levels of leverage, meaning a relatively small amount of money can produce large profits.
  • Options can be written for numerous assets including stocks and commodities.
  • Fees are relatively low and affordable.
  • Flexible strategies allow traders to raise or lower risk and profit potential.

Disadvantages to Options Trading

  • Risks can be quite high, especially for beginners who do not understand the nuances of options trading.
  • Options trading can be complex and to take full advantage of the market you will need to utilize advanced strategies.
  • As with any financial trading, fees can add up to a substantial amount if you’re not careful.

The above risks are more of a result of knowledge gaps.

For example, risks are high with certain options trades. However, experienced traders know how to lower risks.

So What Are Options?

To put it simply, options give you the option to buy or sell another asset.

With an option, you have the right -but not obligation- to buy or sell a certain asset at a specified time for an agreed-upon amount. Don’t worry if this doesn’t make sense just yet, we’re going to go through this concept in detail.

An option is a derivative contract.

“Derivatives” have earned a seedy reputation since the 2007-08 Financial Crisis. However, a derivative simply refers to a financial asset that derives its value from another asset.

Let’s look at how and why options are considered “derivatives.” Consider stocks. They are one of the most common investment assets. You can buy options based on stocks.

Because the value of the option is based on a stock, it is a derivative.

So what specifically are option contracts? An option contract will give you the right, but not obligation, to buy or sell an asset at an agreed-upon price on or before the option expires.

For example, you can set up an options contract to buy GM shares at $40 dollars a share within one month. On or before that expiration date, you can buy the shares at the agreed-upon $40. You can also choose not to buy them.

If you do not buy the stocks, your contracts expire. You would lose the money you paid for them.

There are other financial derivatives that obligate you to buy assets at an agreed-upon price.

Futures contracts, for example, obligate a buyer to buy an asset at a specific date in the future for a specific price.

Let’s say you buy a future for a barrel of oil for $60 dollars in one month. When the contract is due, you must buy that barrel of oil for $60 dollars, even if  the price of oil declined to $50 dollars a barrel.

Before we go any further, it’s important to understand that you can buy options without owning the underlying assets.

Later on, we are going to talk about how you can buy “put” options that allow you to sell stocks for a certain price. You do not actually have to own the stocks in question, but can instead settle the difference.

This often confusing newer options investors.

Illustrating Why People Buy Options

Let’s say that you believe that General Motors is going to unveil a new electric engine technology in a month, and that it’s going to be a smash hit.

You know it’s going to be big, and you believe the stock market is going to react very positively to it.

So you purchase a call option (we will go over “call” and “put” options later) contract to buy General Motor stocks for $40 dollars a share.

Let’s assume that GM stocks are currently selling for $40 dollars. Let’s also assume that the expiration date is in one month.

You will have to pay for the contract, and options are usually sold in lots of 100.

Let’s assume the contract costs $2 per share. This means that the total contract will cost $200 ($2 X 100 shares).

So, to recap, you’ve bought an option contract for GM shares for $200 dollars.

This option contract gives you the option to buy GM shares for $40 dollars a share within one month.

Your prediction is right, GM unveils an amazing new electric engine technology.

Stock prices climb to $50 dollars a share over the course of that month. However, you have the option to buy 100 shares at $40.

You can execute this contract.

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For each share, you will receive $10, or $1,000 in total.

This is because GM stocks are currently selling for $50, but you have the right to buy them for $40. Now, subtract the amount you spent, meaning $200, and you get your profit.

In this case, that’s $800 dollars.

That’s a huge profit for a $200 investment. However, if you had been wrong, and GM stocks sunk, you would have risked losing your entire investment.

Let’s say GM stock prices dropped to $35. At this point, your options contract would be worthless and you would have lost $200.

If stock prices dropped to $39, you could have exercised your options. You would have lost $1 dollars per share, or $100 dollars in total. This is less than a $200 dollar loss but is still quite substantial.

Let’s Dig Into What An Options Contract Looks Like

By now, you hopefully have a solid grasp on the fundamental nature of options.

No worries if things are still a bit confusing. Seeing the actual structure of an option contract often helps clear up lingering questions and misunderstandings.

Most brokers will present traders with what’s called an “options chain.” The options chain will display the options available for a given security.

The options chain will also display the maturity period and premiums, as well as other useful bits of information.

Options chains can be quite intimidating.

Take a deep breath! Once you start working with them, options chains are actually quite easy to understand.

Let’s go over an Options Chain for General Motors from MarketWatch.com.

 

Look at the above image. First, option chains are always listed as either calls (buy) or puts (sell).

MarketWatch conveniently shows calls and puts side-by-side. Starting from the far left, let’s go through each term individually.

Expires

On the far left, at the top, we see the “expires” date. This is the day on which the contract expires.

You must exercise your option by the end of the trading day on which it expires, or you lose your investment.

If the option expires on a Saturday, you must exercise it on the preceding Friday.

For options, this date is perhaps the most important factor.

It tells you when the options contract will become worthless. The farther out the expiration date is, the more expensive the option will be. This is because you will have more time to exercise the option.

Quote

On the far left you see “quote”.

If you were on the actual web page, you’d be able to hover over “quote” to see the symbols for the option. In this case, the first call option would be “GMJ20174220000”.

This allows you to identify and track specific options contracts.

Last

Last tells you the price for the most recently posted trade. For the second option, we see that the last trade was $20.70.

If there is no recent trade, the price will be listed as 0.00

Change

This shows you the difference between the “last” price and the price from the previous closing day.

Vol.

Or, volume. Shows you the volume of options contracts traded thus far that day.

Bid

This shows the price that options buyers are willing to pay right now.

Customer Reviews

For “GMJ20174220000”, this happens to be $23.45. This is expensive. However, this option gives you the right to buy GM shares at $22 (the strike price), which is far cheaper than the market for GM shares at the time ($45.47).

This means you would be able to immediately buy shares for $23.47 dollars less than the current market rate.

Ask

This refers to the price at which potential writers are willing to write option contracts.

In this case, that’s $23.65. Clearinghouses aim to balance the number of sellers and buyers.

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The writer would receive a debit for writing the contract.

Side Note: Bid & Ask In Practice

Usually, there is a bit of back and forth negotiation in order for a sale to go through.

If you want to buy a contract and see that the current “bid” price is $23.45, you might try bumping it up a bit (i.e.

$23.55) in order to secure a transaction.

Open Int.

Or, open interest. This refers to the total number of open contracts for the option on any given day.

Strike

The strike price refers to the price point at which you have the right to either buy (call option) or sell (put option) the underlying asset.

In this case,  the underlying asset is GM stock. If you were to buy “GMJ20174220000”, you would be able to buy GM stocks at $22.

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How Are Options Settled?

Technically, options are settled between whoever bought the contract, and whoever sold or “wrote” the contract (more on that later).

In practice, the clearinghouse handles all of the work. There are two ways to settle a contract:  physical settlement and cash settlement. This settlement must be outlined when the contract is sold and bought.

With cash settlement, you simply settle the difference in cash.

With physical, you have to actually buy or sell the assets in question. In practice, most people with physical settlement contracts will simply sell their contract.

So Why Do People Trade Options Anyways?

Hopefully, options are starting to make sense.

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No worries if you’re still a bit confused. As you read this guide and work more with options, they will continue to make more sense. However, you might be wondering “why do people bother trading options?” Options are a bit complicated, why not just stick to stock trading?

Let’s go back to the General Motors example.

A quick recap: GM is getting ready to launch a hot new electric motor and you believe stock prices are going to jump from $40 per share. You want to invest but you only have $200. You could buy 5 shares of GM.

If stock prices jumped to $50 dollars, that would mean that you would make $50 in profit.

A $50 profit is great, but it’s a heck of a lot less than the $800 profit you would have secured through options trading.

Options offer a lot more leverage. This means you get more bang for your buck. However, there is a downside…

Trading Options Is A Higher Risk Investment

Options are higher risk investments, although certain advanced options trading tactics can be used to lower risk.

Generally speaking, investments with higher profit potential also come with higher risks. Every investor should be aware of this rule of thumb no matter what they are investing in.

Savvy investors will often mix the risk in their portfolio, using a mix of high and low-risk investments.

Ideally, higher risk investments will be limited to “risk capital”, or money that you can afford to lose.

You need to be aware of the risks with options as they are generally higher risk than most stock investments (penny stocks excluded). However, you saw how high the profit potential for options is in the last section.

So what makes options a higher-risk investment?

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Let’s go back to our GM example. Remember, we bought an options contract for a lot of 100 GM stocks for $200 dollars. These contracts have an expiration date. You have to exercise your options contract either on or before that expiration date.

Option trading basics a guide to getting started

If you don’t, the contracts will expire worthless, meaning you lose all of the money you invested.

Let’s say your projections for General Motors stock is wrong.

GM stocks don’t rise, they drop. GM stocks are selling for $37 dollars as you reach the expiration date. In this case, it doesn’t make sense to exercise your right to buy GM stocks for $40 dollars, because you can actually buy them for less on the market.

Instead, your option contracts expire worthless, costing you $200.

Now, let’s say you bought 5 GM shares for $200 dollars instead. Stock prices decline to $37 dollars. This means you lost only $15 dollars. Obviously, a $15 dollar loss is a lot less than a $200 loss.

However, remember that in the preceding scenario, in which GM stocks rose to $50, you would have only made a $50 profit with stocks.

With options, you would have made $800 dollars.

Ultimately, it’s the expiration date that makes options so risky.

The further away the expiration date is, the lower the risks. However, the option contracts themselves will normally be more expensive.

What Is The Difference Between Call and Put Options?

Our GM example used “call” options.

Option trading basics a guide to getting started

However, there is another type of option, a “put” option. It’s important to understand the difference between a call and a put.

A call option gives you the option to buy a stock at a certain price by a specified expiration date.

Generally, you will buy call options contracts when you expect prices to rise.

Option trading basics a guide to getting started

In the GM stock example above, you bought GM call options because you believed GM stock prices would rise.

(We say “generally” because there are advanced trading strategies that will use multiple trading contracts.)

A put option gives you the options to sell a stock at a certain price. You would buy put options if you believed stock prices would decline.

Let’s say you think GM’s soon-to-be-released sales numbers are going to be abysmal.

You think stock prices will decline. So you buy put options giving you the right to sell GM stocks at $40 dollars. You’re proven correct, GM’s stock prices drop to $30 dollars, but you still have the right to sell them at $40.

This means you make $10 per put option.

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Writing Options

This next part can get a bit tricky, especially if you’re still trying to digest all of the above information.

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In addition to buying and selling both call and put options, you can also “write” options. This means that you can write an options contract for someone else to buy. In other words, you are selling option contracts.

This might sound complicated, but in practice your broker will take care of most of the work.

You do not have to own any stock to do this, but you do have to agree to terms.

If you own the assets for which the options contract is being written, the contract is considered “covered.” Your assets will cover your obligation.

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If you do not own the assets for which the option is being written, your contract is considered “naked.” This means you will be exposing yourself to further loses.

Let’s flesh this out with an example.

Going back to GM, let’s say that you believe that GM’s upcoming car is going to be a dud. You expect GM’s stocks to either stay about the same or to decline in price.

So, you decide to write a call option. Now remember, when you buy call options you want the price to go up. When you  write a call option, however, you want prices to either stay the same or to go down.

Do you know why?

Option trading basics a guide to getting started

Remember, when you write a call option, you are basically selling that call option.

You don’t want the person to exercise that option, or you’d have to meet the obligations of the option you wrote. If this happens, you would have to agree to sell your stocks to the person who bought the option (or to buy them stock to repay your GM stock debt).

When you write an option you are given a debit.

This means you are paid for writing the option. The amount you are paid corresponds with the current market price for the option you are writing.

What Is The Difference Between a European Option and an American Option?

You may come across European and American options.

Honestly, most option traders will only ever encounter American options. However, we want to quickly mention European options in case you come across them.

A European option can be exercised only at the expiration date.

So if you bought European options for GM stocks, you would have only been able to buy the GM stocks on the expiration date. So if GM’s stock rose to $46 dollars two weeks before the expiration date, you would not be able to exercise your option.

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If GM’s stock then declined to $36 dollars on the expiration date, you’d be out of your money.

An American option, on the other hand, can also be exercised at any point before the expiration.

So, you could have exercised your American GM options when stock prices rose to $46 dollars, locking up a profit. Most options traders prefer the flexibility of American options and thus trade with them.

Please note, the underlying asset does not affect whether it’s an American or European style option.

You can buy European options for American stocks and assets. You can also buy American options for European stocks and assets.

Binary Options- Exotic and Interesting

Another type of option you may come across is called a “binary” option.

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These options are not particularly popular in the United States and is heavily regulated.

As a result, few American brokers offer them. However, they are becoming more popular in Europe.

Anyways, a binary option refers to an option with a simple “yes or no” proposition.

“Yes”, the value of the underlying asset will be above a certain price by the expiration date.

Option trading basics a guide to getting started

“No” it will not. So let’s say you buy a binary option for GM. Let’s assume that GM is currently trading for $45 per share. You believe GM is going to make a big announcement in a matter of minutes.

So you buy a GM binary option that states that GM will be trading above $46 in one hour.

If you are right, you will be given a fixed payout that will be expressed in terms of a percent.

Let’s say the payout was set at 70%.

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You would get your initial investment back plus 70% (watch out for fees, however). If you are wrong you lose everything you invested.

Conclusion: Options Offer a Great Way to Diversify But Your education has just started

This article only scratches the surface of options trading.

There are many advanced trading strategies and concepts that you can start to use after you master the basics.

For example, “iron condors” and “butterfly spreads” allow you to produce a profit during horizontal markets. This means prices are moving sideways.

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There are only a few ways to produce profits during such markets, but options make it possible.

There are also a variety of tools you can use to crunch data, plot out Probability of Profit (PoP), and other things.

Then there are the “Options Greeks.” You will be able to use the Greeks to build your own trading strategies.

Remember, the risks associated with options trading can be higher than stock trading in some cases.

In other cases, you can use options to lower risk. What’s important is knowing what you’re doing and why you’re doing it.

By approaching option trading with smart and savvy you will increase the likelihood of success!

Finally, education is an on-going project.

By reading this article, you’re off to a great start. However, you should continue to study up.

When it comes to investing, knowledge is profit.

 

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