An Introduction to Options Trading

Options trading offers a complex yet potentially rewarding approach to the stock market, allowing investors to buy or sell assets at predetermined prices within specific time frames. Unlike direct stock purchases, these contracts grant the right without obligating the transaction, providing a strategic tool for managing investment risks and capitalizing on market predictions.

lady trading

This guide will explore the fundamentals of options trading, including the differences between call and put options, the process of getting approved for trading, and strategies for minimizing risks while maximizing returns.

What is an option?

An option is a contract that grants you the option buyer, the right, but not the obligation, to buy or sell a particular asset at a set price on a particular date or within a select window of time.

It’s also classified as a derivative, with the associated value directly linked to the underlying asset. This price point is also known as the strike or exercise price, and the expiration date specifies when the contract terminates.

But how does this benefit investors? Well, it’s a cost-efficient way to manage risk because you’re only investing in the opportunity to purchase shares at another date, and not the stock itself. Options also allow you to sell your existing shares at a set price if the market tanks to limit your losses.

How does options trading work?

However, it’s a bit more complex than simply buying and selling shares. In essence, options traders are taking a gamble on the direction they think the stock price will go in. That way, they won’t have to buy or short the actual stock when they think the market is going to skyrocket or dip.

Furthermore, there’s a relatively extensive process to get approved as an options trader. You’ll also need to open a brokerage account and maintain a set amount of reserves to remain in good standing as an investor.

And should you decide not to exercise the option, you’re free to walk away with no strings attached. You can also rake in a little more cash by selling the option, or options contract, to an investor who’s interested.

Benefits of Trading Options

There are several benefits to trading options, including:

  • Flexibility: Options can be used to hedge against potential losses in other investments, or to generate income through the writing of options.
  • Leverage: Because options allow traders to control a large amount of underlying assets for a relatively small investment, they offer significant leverage.
  • Limited risk: The potential loss on an options trade is limited to the premium paid for the option.
  • Customization: Options can be customized to meet the specific needs and objectives of the trader.
  • Liquidity: Options are traded on organized exchanges, making it easy to buy and sell them.
  • Versatility: Options can be used in a variety of market conditions, including bearish, bullish, and neutral markets.

Types of Options

Still sold on the idea of trading options? There are two types to choose from:

  • Call Options: these are deposit rights to purchase the stock at a later date. If the call option is not exercised before the expiration date, you lose your investment in the option and the right to purchase the underlying stock at the strike price.
  • Put Options: these are premiums paid to hedge against the risk of a market downturn. They are similar to an insurance policy that protects your investment. If the price of the underlying stock plummets, you will still have your right to sell a set number of shares at the exercise price. But if the market stays intact or swings upward and you decide not to sell, your premium is lost.

You should also know that call and put holders are owners of options contracts. They absorb minimal risk as there’s no obligation to buy or sell, regardless of market performance. Instead, they are free to exercise the option when they see fit.

By contrast, call and put writers are sellers of options contracts. Unfortunately, they’re exposed to more risk because they must follow through on their promise to buy or sell if the holder exercises their option.

Options Pricing

Options pricing refers to the process of determining the value of an options contract. There are several factors that can impact the price of an options contract. These include the underlying asset’s price, the option’s strike price, the time remaining until the option’s expiration date, the option’s implied volatility, and the risk-free interest rate.

One of the most widely used methods for calculating the price of an option is the Black-Scholes model. This model takes into account the aforementioned factors to determine the theoretical value of an options contract. Other methods for pricing options include the binomial model and the Monte Carlo simulation.

Keep in mind that the price of an options contract can fluctuate significantly over time, and may be affected by a variety of market conditions. Therefore, options traders should carefully consider the potential risks and rewards of their trades and use appropriate risk management strategies.

Risks and Rewards of Options Trading

Options trading can be a complex and risky endeavor, but it can also provide the opportunity for significant profits. It’s essential for investors to understand the potential risks and rewards involved to make informed decisions and manage risk effectively.

One way to minimize risk when trading options is to use investment strategies like spreading. This involves buying and selling options at different strike prices and expiration dates to offset potential losses.

Another investment strategy is to use stop-loss orders. They allow you to set a certain price at which your trade will be automatically closed to prevent further losses.

Additionally, you should diversify your portfolio and not rely too heavily on options trading. That way, if one trade doesn’t work out, you won’t be left with all your eggs in one basket.

Investors can maximize their profits and minimize risks by understanding options trading and implementing risk management strategies.

Getting Started with Options Trading

Getting started with options trading requires more than a simple phone call to a broker or an online purchase. It demands a proactive approach and thoughtful preparation to set the stage for your trading activities.

Step 1: Select a Brokerage Firm

Like it or not, you’ll have to work with a brokerage firm to get screened and cleared to trade options. But don’t just settle for the first broker you find. Shop around and carefully analyze your options before making a decision. Remember, they’ll be evaluating your experience, so you should do the same.

Do a little research to determine if they’ll be a good fit. Pay attention to consumer reviews, services they offer, costs or commissions structure, account minimums, and educational resources they offer, just to name a few.

Furthermore, inquire about educational resources, including self-guided online courses and webinars, along with telephone, virtual, and live support designed to help you identify and understand the most strategic routes when trading options.

Finally, feel free to ask questions as they arise to ensure you have all the information you need to make a well-informed decision. The more access you have to support staff, the better.

Remember, it’s your hard-earned money that will be used to buy options, so you want to make sure you derive the greatest benefit in exchange for your investment.

Step 2: Get Screened

Once you’ve selected a brokerage firm, the next step is to get screened. This is a prerequisite to being assigned a trading level. Before screening can begin, the broker will want to get an understanding of your investment goals and which types of options you’re most interested in. They will also inquire about your trading experience and will request additional information about your finances.

Your information will be compiled by the broker and analyzed to determine the optimal trading level. Levels range from 1 to 5 and will dictate the types of transactions you’re able to engage in.

Furthermore, you’ll need to maintain a minimum balance of $2,000 in your account at all times, per industry requirements. Additionally, purchasing a call option may mandate a margin account or line of credit to serve as security. Check with the brokerage firm to confirm minimum reserves and additional details regarding margin accounts.

Step 3: Start Trading Options

Now that you’re in the clear, you have to use your knowledge and judgment to make some critical choices that can boost or dent your wallet. Some important considerations:

How you think the stock will perform – Anticipating an increase in price? A call option is best as it allows you to turn a profit if the price surpasses the strike price within the window of time allotted by the option, and. In this case, you will be in the money. But if the market price drops below the strike price, you’ll be out of the money.

By contrast, if you already own shares and are expecting a dip in the price, you would purchase a put option. You’ll be in the money if the market price drops below the strike price, and out of the money if the market price ends up exceeding the strike price.

The length of the option – Stock options are only valid for a set period of time. Some options last for several days or months, while others span several years.

Optimal strike price – It’s difficult to determine where the stock price will end up, so you’ll have to make an educated guess regarding the strike price before purchasing an option.

Thinking the price of a share currently trading for $50 will increase to $75? Let’s assume you purchase a call option with a strike price below $75. (You want a call option that leaves a little wiggle room to account for the cost of the option). If the share price exceeds the strike price, you will be in the money or turn a profit.

Now assume you owned these shares and expected the share price to drop to $25? By purchasing a put option with a strike price that is above $25 and accounts for the cost of the option, you’ll be in the money if the price does drop below this point.

Bottom Line

Options trading is a sophisticated tool for seasoned investors, offering strategic depth to portfolio management. However, it’s not the sole method to mitigate risk or seek returns. Stock trading presents a more accessible alternative, with its direct approach and fewer entry barriers.

While options can leverage market movements and offer protection, they demand a solid grasp of market intricacies. In contrast, stock trading provides a straightforward path to investment growth. Choosing between them depends on your risk tolerance, investment goals, and willingness to explore market complexities.

Allison Martin
Meet the author

Allison Martin is a syndicated financial writer, author, and Certified Financial Education Instructor (CFEI). She has written about personal finance for almost ten years and holds a master's degree in Accounting from the University of South Florida.