Numerous asset classes are available to build up an investment portfolio, though perhaps none is more misunderstood than options. This investment type involves buying and selling specific assets for a predetermined price and, when done correctly, can be highly profitable. The thing is, options trading strategies are often more complex when compared directly to stocks or other investment types. This reality should not discourage investors from working with options but instead should highlight the need for thorough research before getting started. Read through the following guide on options trading for beginners to learn everything you need to know about options trading.
What Are Options?
Options are contracts that allow an investor to buy or sell a given asset at a predetermined price over a set period. The underlying asset may be a security, commodity, ETF, or even index. They get their name from the fact that investors have the option to buy or sell when the contract runs out, but are not required to. The process begins when investors pay a premium to purchase options contracts at a strike price. Investors then watch to see if the future prices look favorable and either buy or sell the options for a profit. Alternatively, they can let the contract expire at which point they would only lose out on the premium money. There are two types of options depending on whether you are buying or selling:
Call Options: Call options refer to contracts that give investors the right to buy shares, usually 100, over a certain period of time. Investors will buy call options if they believe a stock or security is going to increase in value. By buying these options at a predetermined price (remember, the strike price), they can profit from the increased value when they ultimately sell the shares.
Put Options: Put options are essentially the opposite, they allow investors to sell a certain amount of shares over a set period. This difference means investors are typically hoping for a higher strike price to make a profit — as this signals a higher value for the option. Essentially, when buying put options you want the price of the security or shares to decrease.
One way to think of options as a beginner is to make bets on the stock market. When purchasing options, you guess that prices will either go up or down and act accordingly. This investment type can be used to hedge against stock investments, offering some protection against losses. Options can also be used as a way to generate consistent income, depending on your trading strategy.
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Long Options vs. Short Options
Another distinction you may hear when working with options is long vs short options. This refers to the strategy taken towards buying options contracts. Generally speaking, a long options strategy involves buying and holding the options in the hopes that the price will increase. On the other hand, shorting an option refers to selling the options and profiting from price decreases.
Why Trade Options vs. Direct Assets
Trading options provides investors with the opportunity to diversify rather than exclusively work with direct assets. While both can be solid investors, variety is the key to a strong portfolio. Options trading allows investors to work with stocks, ETFs and indexes; and there are numerous options trading strategies to choose from. These strategies range from relatively simple to highly complex, catering to investors with a variety of experience levels.
How Options Pricing Is Determined
Options pricing is based on two core factors: the intrinsic value and the time value. The intrinsic value is the potential profit that could be earned, and is determined by the difference between the strike price and the current price. The time value is a variable that represents how the asset may be affected until the expiration date is reached. Essentially, the time value is an estimate of the volatility of the asset.
How To Read A Stock Option Quote
Stock options are listed in the form of quotes on the New York Stock Exchange, and they contain several different parts. Before you can consider which stock options to invest in, it is helpful to understand exactly how to read a quote. The following information will be listed in each stock option quote:
Stock Symbol: This is the asset that is attached to the options contract
Strike Price: The price of exercising the options
Type: The type of the options should be specified, for example a call option
Expiration Date: The date the options will expire
Premium: The cost to buy the overall options’ contract should be listed
Depending on the exchange, stock option quotes may also include the current price of the underlying value. Get familiar with the format as you review different options investments.
What Is Options Trading?
Options trading is the practice of buying and selling options in the market. This practice involves a strong understanding of the market you are working in and predicting changes in prices. Investors are typically drawn to options because they often require a smaller initial investment than purchasing stocks outright. Options also give buyers time to watch their investments play out, as contracts are six months long on average.
The best way to understand options trading as a beginner is by looking at an options trading example. Let’s say Lexie has a call option with Tesla for shares at $400 each. If the value of Tesla were to decrease to $300 per share, Lexie could simply let the contract expire without purchasing the shares. However, if Tesla shares increased to $450 each, she could exercise the option and buy the shares at the contract price of $400 each. She could then sell those shares for the new price of $450, and profit from the increase.
The 6 Basic Options Trading Strategies For Beginners
The process of trading options can be more complex than navigating traditional stock trading, but that is often because investors approach options without a real strategy in mind. The key to successfully trading options is learning about the various ways to invest before jumping in. Many investors try to learn as they go — leading to confusion and, in many cases, portfolio losses. The following list should guide you through some of today’s best options trading strategies for beginners:
1. Buying Calls Or “Long Call”
Buying calls is a great options trading strategy for beginners and investors who are confident in the prices of a particular stock, ETF, or index. Buying calls allows investors to take advantage of rising stock prices, as long as they sell before the options expire. This strategy helps to minimize overall risk when trading options. The potential loss is only the premium paid to buy the contract; however, the potential profit is unlimited depending on how much shares rise in price.
2. Buying Puts Or “Long Put”
Buying puts is similar to buying calls, except investors hope the asset will decrease in value rather than increase. Investors typically utilize this strategy as an alternative to short-selling because the risk is significantly smaller. When buying puts, investors are only risking the value of the premium if the asset were to rise past the initial strike price. Depending on the size of the premium, buying puts can be a low-risk way to take advantage of falling prices.
3. Short Put
The short put is a trading strategy for beginners and investors who are selling options. This strategy aims to profit from premiums paid on options contracts. Let’s say Investor A is implementing a short put strategy and sells a put option to Investor B. If the price of those shares stays the same or increases, Investor B will likely let the put contract expire. After the contract expires, Investor A would keep the initial premium, thus profiting from the transaction.
4. Covered Call
The covered call refers to a two-part options trading strategy. First, an investor must own underlying stock in a company. Then, they must sell a call on that stock and receive a premium. In a covered call, the investor is hoping that the stock will remain the same price or slightly decrease — pushing the buyer of the options to let their contract expire. This will then allow the investor to keep the premium money they received. This strategy is common among investors hoping to generate income from stock ownership while share prices remain roughly stagnant.
5. Married Put
The married put gets its name by combining two investment strategies: stocks and options. These investments will be made simultaneously, with investors buying one put option for every 100 shares of stock they purchase. If you remember from above, a put hinges on share prices decreasing. Therefore, in a married put investors are attempting to insure themselves against a loss in share value. When done correctly, this strategy is used to offset portfolio losses while waiting for stock prices to increase.
6. Protective Put
A protective put is another strategy used by investors to protect themselves from potential losses. Investors would buy a long put against an asset they already own, which offers protection if the asset were to decrease in value. The difference between a protective vs. married put is that a protective put is used to minimize losses from an asset you already own, whereas a married put protects assets you are buying simultaneously. This strategy is commonly used when investors are expecting a short-term decrease in share values.
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More Options Trading Strategies Beginners Should Know
When it comes to successful options trading for beginners, the more you know the better. By familiarizing yourself with the available strategies you can set yourself up to make better investment decisions in the long run. Here are a few other options trading strategies to guide your research:
Long Straddle Strategy: This is when investors buy a call option and put option at the same time, each with the same strike price and expiration date. The goal is for the profits of one contract to offset the loss of the premium from the other.
Bull Call Spread: With this strategy investors will simultaneously buy calls at one strike price while selling the same number of calls at a higher strike price. This is used when investors expect the price of the asset to increase moderately.
Bear Put Spread: The bear put spread is another vertical trading strategy, used by investors who expect an asset’s price to lower in value. To implement this strategy investors will purchase put options at a certain strike price while selling the same number of put options at an even lower strike price.
Protective Collar Strategy: The protective collar strategy is when investors buy an out-of-the-money put option while writing an out-of-the-money call option at the same time. (An out-of-the-money option describes when the underlying value of an option is lower than the strike price). This is often used for protection after a stock has experienced significant value increases.
Long Strangle: This strategy sees investors buying both an out-of-the-money put and call option with the same expiration date. The long strangle is used when investors are unsure whether a stock will dramatically increase or decrease in value.
How To Start Options Trading As A Beginner
Now that you are familiar with some of the options trading strategies available, you may still be wondering how to actually get started. The following steps should provide an overview of exactly how you can begin putting your options trading knowledge to use:
Learn Requirements & Open An Account
Decide The Type Of Option
Predict Stock Price Movement
Determine Expiration Date
1. Learn Requirements & Open An Account
As you learn more about the various types of options trading, try to identify a strategy that appeals to you. Take time to write down your investment goals, such as how much income you want to generate, how much capital you have to invest, and how much growth you want to see in your portfolio. Once you have a better picture of your financial goals, start searching for a broker to work with. They will assess your financial readiness and help you open an account.
2. Decide The Type Of Option
Research different stocks to decide which type of option you want to purchase (either a put or call option). Remember, if you expect the stock prices to rise, you will want to purchase a call option. On the other hand, consider purchasing a put option if you expect them to fall. This step is crucial to the success of your overall investment, so be sure to research the assets you are considering carefully.
3. Predict Stock Price Movement
Investors can only profit from options trading if the contracts remain “in the money.” For call options, this means the share value needs to rise above the strike price, while put options need the share value to decrease below the strike price. If you want to be successful when trading options, you will need to learn how to predict future changes in stock prices and act accordingly. This is much easier said than done, but you will be surprised how many predictions you can make with the right research.
4. Determine Expiration Date
The final choice investors must make before purchasing options is determining when they want the contract to expire. If you are confident stocks will increase in value, but are unsure if it will happen before the expiration of your contract you risk losing money. The key to options trading is predicting how the value of stocks will change and within what time frames. The expiration dates of contracts can range from a few days to multiple years, with short-term contracts posing more risks than their long-term counterparts. Keep this in mind as you try to hone in on expiration dates that you feel comfortable with.
Practice With Paper Trading
There are certain online brokers that will allow you to trade fake money through the platform. This practice, called paper trading, is a great way to get experience before putting real money on the line. As you win and lose money, your fake account balance will fluctuate and you can learn from your trades. Overall, the experience is meant to mimic the real practice without the same stakes. While the practice is somewhat limited in terms of features, it can still help you dip your toes in the water as you learn more.
Pros And Cons Of Options Trading
Options trading requires diligence and strategy, but there are numerous benefits associated with this investment type. Options offer flexibility, profit potential, and liquidity. Seasoned investors will be happy to know that options can even be used to safeguard other investments, depending on the strategy used. Overall, options trading can be a great way to diversify an investment portfolio when done right.
Note that there are certain risks associated with options trading, and investors can’t simply dip their toes in the water and expect to be successful. Markets are difficult to predict. Some of the more complex options trading strategies will require a deep level of understanding. To be successful, you will need to learn how markets and investments move. If not, you could expose yourself to significant losses.
Advantages Of Options Trading
There are several benefits of options trading to be aware of as you consider this investment opportunity:
Options have the potential to yield high returns
Options give investors time to watch how the market changes
Options offer the chance not to buy, allowing investors to avoid some risk
Buying options gives investors control of more shares than purchasing stock outright
Risks Of Options Trading
Investors should note that there are some risks associated with options trading, as with any investment type. Here are a few cons to consider:
The investment strategies are more complicated than other, more beginner-friendly investments
Depending on the trade, investors could lose more than their initial investment
Options can result in losses (or gains) in relatively short periods of time
Options are one of many investment vehicles you can use to build a successful financial portfolio, but it will require some work on your part. Options trading strategies are often overwhelming and demand a certain level of planning to be profitable. The best advice I have on options trading for beginners is to do the work ahead of time. Learn about the stock market, research brokers in your area, and ask your network for insight. These steps will help you immensely as you begin trading options. When done right, options can be a highly valuable addition to even the most established investment portfolios.
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