An Introduction to Options Trading

Trading stock is as simple as submitting an order for your broker to execute, but options trading is another story. For starters, you’ll have to determine which type of option is the best fit and your experience will be taken into consideration before you’re allowed to engage in a single transaction.

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This may seem a bit overwhelming, but don’t fret. Keep reading to learn more.

What is an Option?

An option is a contract that grants you the option buyer, the opportunity 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 an 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.

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 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 stock price 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 older exercise their option.

Getting Started with Options Trading

When you want to start trading options, you can’t just call up a broker and tell them what you want to do or buy an option of the internet. Instead, you’ll have to do some legwork before moving forward.

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 prior to 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.

Also, 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 more 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.

Also, you’ll need to maintain a minimum balance of $2,000 in your account at all times, per industry requirements. Furthermore, 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 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 price drops below the strike price and out of the money if the 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 hard 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

While options are intended for seasoned investors, they’re not the only way to minimize risk. You can also derive similar benefits from trading stock, and there are very few barriers to entry when getting started.

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.