Options trading has been around for centuries and can be traced back as far as ancient Greece where options were used in the olive trade. In this beginner’s guide to options trading, we will be taking a look at:
- What options are
- Why they are not as dangerous as you think
- Examples of options trading in practice
- How to get started trading options
Ready? Let’s get started.
What are Options?
An option is a contract that gives you as trader an opportunity to enter a market at a predetermined price after you first had the privilege to evaluate what direction the market is going)
Essential Terms to Know
We’ve included below some of the most common terms you’re likely to encounter in the world of options trading:
- Call: The right (option) to BUY the market
- Put: The right (option) to SELL the market
- Strike Price: The price at which you will buy or sell the market
- Expire Date: The date on which the option expires
- Exercise: Executing the transaction to buy or sell the market at the strike price
- Premium: The amount of money you have to pay to buy the option
- Underlying: The market that you gain the right to buy or sell
- Implied Volatility (IV): A calculated measure of the price (premium)
- Greeks: Reference to the greek characters used to describe changes to the premium
- Delta: Express the change in premium due to price changes in the underlying
- Theta: Express the change in premium due to time passing by
- Gamma: Express the change in premium due to the IV changing
- Long: Buying a market
- Short: Selling a market
- Write (an Option): Selling an option to someone
What Are The Types of Options?
There are two actions you can take in the market – buy or sell – and therefore you are presented with two types of options: Call Options allows you to ‘buy’ the market and Put Options allows you to ‘sell’ the market. They can be used in different ways though, depending on what a trader wants to achieve, for example:
Call options:
- Buying a Call: Gives you the opportunity to buy an instrument at a predetermined price.
- Selling a Call: You are giving someone else the opportunity to buy an instrument at a predetermined price that will legally bind you to sell that instrument to them.
Put options:
- Buying a Put: Gives you the opportunity to sell an instrument at a predetermined price.
- Selling a Put: You are giving someone else the opportunity to sell an instrument at a predetermined price that will legally bind you to buy that instrument from them.
Calls and Puts can also be used in combination with each other to create complex trading strategies.
Are Options Dangerous?
A common misconception prevails that options trading is either too complicated or risky and reserved only for experienced traders. The truth of the matter, however, is that once options are properly understood that this method of trading is not that complicated at all and can provide you with a serious edge in the markets.
Advantages of Options
For the most part, traders and investors can only make money by buying stocks. Futures allow traders to add short selling and leverage to their trading arsenal. Options, on the other hand, add two new tools to the trader’s arsenal:
- Risk limitation: Traders can limit their risk to a known and fixed amount.
- Profit potential: Traders can profit from rising and falling volatility in the marketplace
If a trader buys an option, their risk is limited to whatever they pay for the option. That is because, unlike a futures contract, an option gives the holder the right to buy or sell an asset, but there is no obligation. However, the risk is not limited for the trader that sells, or writes the option.
How Does Options Trading Work?
The option specifies the price at which you will enter the market – it is written in the contract and is called the ‘strike price’, or just the strike in short.
You can get an option at any price in the market within limits – typically these price intervals are called “strike intervals” at which options are available and can range from $2.5 to $5 intervals, but it depends on the market you are trading.
The option is only valid for a certain period – or up to a certain date. Whoever is willing to give you an option does not give you a choice that is valid indefinitely, that would not be sensible – what if 20 years later the price rockets upward?
So, the option will only be valid for a certain amount of time and then expire. Each option has an expiry date – and we specify this when we write the contract.
We know that we can trade the market in one of two ways. We can either buy the market, wait for prices to increase, and then sell back what we have bought at a higher price, or we can sell the market, wait for prices to drop, and then buy the market at a lower price.
How To Trade Options
There are many ways to trade options. These include:
- Buying call options
- Selling put options
- Combing options to form options strategies (buy & sell, calls & puts)
- Combining options with underlying instruments to form trading strategies
However, before you can start trading and developing strategies, it is important to first learn the basics of how to trade options.
This includes determining what instruments you want to trade, finding a broker and how to open an account.
It is essential to build a solid foundation before you start trading in order to reduce your exposure to risk and maximise your profit-earning potential.
Options Trading Strategies
By adding options to your trading or investing activity, you’re also adding an additional dimension to your potential for risk. Being ‘long’ or ‘short’ are two of these dimensions, however, adding options produces a third.
It requires sophisticated systems and risk management tools and is also capital intensive. While volatility trading may – on the surface – seem best suited for professionals and hedge funds, there are some options trading strategies you can deploy even if you’re not bankrolled by a hedge fund.
What Is the Best Options Trading Platform?
The idea of a ‘best’ options trading platform is a misnomer; the best options trading platform is the one that suits your needs.
In general, the broker will make a trading platform available for you to use, to interact with him and through which you enter your trades.
Most of the time this platform is adequate for what you need. A demo account would be a great starting point as it allows you to learn the trading platform, how to route orders, etc.
How Do I Choose Which Options To Trade?
Pick Your Strategy
You need to have clear goals and a trading plan or strategy that you intend to follow. You need to know what it is you are looking for in a trade, and then you need to search for the entry signals and formulate an approach – a strategy to trade that market.
Maybe you have one strategy that you employ and the underlying market needs to comply with certain requirements to apply the strategy.
Maybe you have a number of strategies for different market conditions. Whatever – you need to have formulated a clear goal, a clear trading plan in your mind. You cannot really search for which options to trade until you have a clear strategy.
So, strategy comes first.
Choose a Market
Then comes the market – you need to find a market that complies with your strategy.
Once you have identified these two, you go through the list of options available for the instrument – there will be both a Call and a Put Option at each strike price – look at the premiums required or that the market is willing to pay and reach a decision on whether you want to enter this market or not. And then commit to the trade.
You do get specialised software to assist you to formulate trading strategies that will teach you the different strategies and, depending on which market, may even select options for you.
It certainly pays to get access to such software – it greatly accelerates your learning curve and in some cases will become an indispensable tool in your trading.
Such software, however, is not a necessity and you might choose to use a program like Excel to assist you with your analysis, or if you’re using a strategy then you may have a predetermined set of rules that you apply.
How Much Money Do You Need for Options Trading?
The amount of money, or account size you will need depends largely on the strategy that you follow and how you want to do it. Anything from $300 to $20,000 or more, depending on how patient you are and how you are planning on managing your risk.
It all boils down to two factors:
- Risk appetite
- Trade/money management
Risk Appetite
How much money are you going to put at risk on a trade? The more risk, the more margin-money (safety deposit) you will need, the larger the account size required.
Selling options carries about the same risk as buying or selling the underlying instrument – with instruments such as commodities the margin requirement for a single position may well be anywhere from around $1,200 to around $7,000 (depending on whether it is a currency or a commodity like crude oil).
In some cases it might be even more and apart from the margin requirement, you will also need enough money to cover for the daily price fluctuations in the market you choose to trade.
If you limit yourself to buying options, you only need to pay the premium for the option, which will be the maximum risk you take – allowing you to trade with between $600 – $3,000.
Then there are certain options trading strategies where you may limit your exposure to only $250 or less – even with Crude Oil! If you are starting off with a small account, then you will have to be patient and disciplined while you slowly build an account and restrict yourself only to these specific low-risk strategies.
Trade Management
We all know the saying – keep your losses small and let your winners run but doing this effectively requires a good strategy with sound trade management rules.
Good traders are experts at managing their risk and they have learned to follow and trust their strategy. Entering a position is only a small part of trading, effectively managing your open position is very important which most inexperienced traders unfortunately ignore or simply do not know how to manage.
Knowing what it is that your strategy aims to achieve will dictate how much risk you are exposing yourself to and how much money you will need to trade.
As traders we need to accept risk but at the same time we need to have enough money in our accounts to account for losses, which is why trade management forms an integral part of trading successfully over the long run.
The Bottom Line
When you decide to trade the markets, you are naturally exposed to price fluctuations in either direction and you may incur substantial losses if you fail to exercise sound risk management principles.
Trading Options allows you to drastically reduce the risk of loss, it gives you the ability to control the size of the potential loss and to limit it to a fixed amount.
Options allow you to interact with an unforgiving market, to manage and control the risk, it frees your time, allowing you to step away from the market.
Employing options strategies allows you to trade in any market condition, notably a level trading market, giving you even more opportunities to trade.
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