Options enable US investors to go long or short on an asset with a small percentage of the overall contract value.
In this guide, I explain options trading for beginners, covering the most important factors to consider before risking any capital.
Ready to start trading? Consider reading my guide to the best options trading platforms May 2023
My key takeaways from my guide on options trading for beginners are:
- Options give you the right but not the obligation to purchase an asset on or before the contract expiry date
- When trading options, you can go long (calls) or short (puts), which offers greater flexibility when compared to traditional stocks or index funds
- You will only need to pay a small premium to enter an options trade, which is usually just a fraction of the total contract value
- Losing options trades will only cost you the premium that you paid and no more
- Terms to understand when options trading are strike price and expiration date
The basics of options trading
Options are tradable financial products that enable you to go long or short on an asset, such as Amazon stock or the S&P 500.
This gives you the opportunity to profit from rising and falling prices on the stock market. Options come with an expiry date, which can be anything from one day to 12 months. When the contract expires, you will have the right but not the legal obligation to buy or sell the respective asset.
- For instance, let’s say you have one option contract on Disney stock at a strike price of $80.
- When the contracts expire in three months, Disney stock is trading at a stock price of $110.
- This is $30 above the price you paid for the option contract.
- Therefore, as you hold one option contract on Disney stock, you make a profit of $30 ($110 strike price – $80 option contract price).
The above example shows that you went long on Disney stock, which means you purchased a call option. If you instead wanted to go short, you would need to purchase put options,
An attractive aspect of options trading is that you can purchase calls and puts with just a small percentage of the overall contract value. This is known as the premium, which is often just 5% of the total trade size.
For instance, in the example above, I noted that the Disney call option was purchased at a strike price of $80. In this example, you might have paid just $4 to enter the trade. This means that when trading options, you will be doing so with leverage.
Another key point when learning about options trading is that there are various versions of this financial product and different options strategies..
For example, American options allow you to sell the contracts before the date of expiry. But European options don’t, meaning you will need to hold them until they expire.
Ultimately, it is wise to research some of the most common options trading strategies that are utilized by seasoned traders, especially when it comes to risk management.
Pros And Cons Of Options Trading
I find that the main pros and cons of options trading are as follows:
- You only need to pay a small premium when trading options, with margin requirements as low as 5% of the overall contract value
- You can go long (calls) or short (puts) when trading options, which offers investment opportunities in both rising and falling markets.
- Options come with many strike prices and expiry dates, so your trading parameters can be customized to suit your preferred strategy and risk appetite.
- If your options contracts expire worthless, you will only lose the premium that you paid to enter the trade and are deemed to be out of the money.
- Options trading is a fast-paced investment area, so you will need to have some prior experience in research methods, such as technical analysis.
- Options are not suitable for long-term investment portfolios, rather they are traded on a short-term basis.
- Options offer access to a limited number of stocks and ETFs.
- There is less liquidity when you trade options, so you might experience less favorable spreads – resulting in higher fees.
How options trading works
In this section, I explain everything you will need to know when learning about options trading for the first time.
This includes the fundamentals surrounding calls and puts, expiry dates, strike prices, premiums, and more.
Buying calls (Long calls)
When options trading, you have a choice of purchasing calls or puts.
Call options are to be used when you want to go long – meaning you predict the underlying stock will rise in value on or before the contracts expire.
Buying puts (Long puts)
Although long puts suggest that you are speculating on the options contracts increasing in value, this isn’t the case.
Instead, you will purchase puts if you believe that the underlying stock will decline in value on or before the options expire.
Options expiry date
Options are short-term financial products that always come with an expiry date.
By holding options contracts on the date of expiry, you have the option but not the obligation to purchase the underlying asset.
As noted earlier, you can offload American options before the expiry date. This isn’t the case with European options, which need to be held for the entire contract duration.
Options come with many different expiry dates, but what you have access to will depend on your chosen broker. This can range from one day up to a year.
The longer the contract duration, the more flexibility you have from a risk-management perspective.
The strike price determines how much you need your options contracts to increase or decrease by in order to make a profit.
- When purchasing calls, you will need the underlying asset to trade above the strike price to make a profit
- When purchasing puts, you will need to underlying asset to trade below the strike price to make a profit
As I cover in more detail shortly, you also need to cover the expense of the premium when assessing your gains, not just the initial investment.
Online brokers will often give you several strike prices to choose from. The chosen price will directly impact the premium that you need to pay to enter the trade. This is based on the probability of the options trading landing in the money (ITM), rather than out of the money (where you lose money on the trade).
Let’s look at a couple of basic examples to help illustrate how target prices work when trading options:
Example 1 – Call options
- Let’s say that you are looking to purchase a call option on Nike stock with an expiry of one month
- This means you believe its share price will rise
- The strike price on your chosen contracts is $130
- Three weeks after purchasing the call option, Nike stock price is trading at $140
- This means that for each options contract you hold, you can lock in a profit of $10
Example 2 – Put options
- In this example, you are looking to purchase put options on Nike stock
- You take a price of $115, which means you believe that Nike stock will be trading below this figure before the contracts expire
- On the date of expiry, Nike stock is trading at $100 – meaning you make $15 for each contract held
In order to enter an options trade, you will need to pay a premium. This is essentially a non-refundable fee that needs to be paid regardless of whether or not your options trade ends up in the money.
Think of it like an insurance premium, which you pay irrespective of whether you need to make a claim.
The price of the premium that you pay will vary wildly depending on the strike price that you opt for. More on this shortly.
But crucially, if your options trade does not end up in the money, then you will only lose the premium. This is why options are so attractive for traders on a budget, because you know from the get-go exactly how much money you stand to lose should the trade not go to plan.
As I noted above, you will also need to take the premium into account on winning options trades. For instance, if you make $30 per options contract and you paid a premium of $5, then your net gains on this trade amount to $25.
In terms of the size of the premium, this is calculated based on the probability of the price target being met.
- Let’s say that Apple stock is currently trading at $145
- You have two target prices to choose from at your online broker – both with a one-month expiry
- First, there are call options with a price of $160
- Second, there call options with a price of $190
Naturally, there is a higher probability of Apple stock going from $145 to $160 within the following month of trading, when compared to $190.
As a result, this will be built into the premium that you pay to enter the trade. In other words, you will pay a much smaller premium on the $190 strike price, as the probability of this landing in the money is much lower in comparison to $160.
Either way, when trading options, you will be doing so on margin. This means that you will only need to put up a small percentage of the overall contract value to enter the trade.
In the following section, I will give a hypothetical example of both a winning and losing options trade, taking into account the premium.
Example 1 – Winning call options trade
- You purchase Tesla stock call options that are due to expire in three weeks
- The current and strike price of Tesla stock is $200 and $225 respectively
- You pay a $10 premium for each contract that you purchase
- You wait until the contracts expire and Tesla stock closes at $240 on this date
- You make a gross profit of $15 per contract ($240 expiry – $225 strike)
- You then need to subtract the $10 premium, which leaves you with a net profit of $5 for each call option contract you hold
Example 2 – Losing call options trade
- Following the same example as above, let’s say that on the date of expiry – Tesla stock closes at $220
- Your strike price is $225, which means that you are $5 short of the target
- Not only that, but you also need to factor in the premium of $10 that you paid to enter the call option trade
- This means that you were actually $15 short of landing ITM
- However, you only lose the premium – which is $10 for each contract you purchased
As per the above, you need to add the premium onto the strike price to calculate your break even point when purchasing calls. But when purchasing puts, you need to do the opposite.
Why trade options vs. direct assets
Now that I have explained the fundamentals of how to trade options, I can now compare this short-term instrument to traditional stock ownership.
This will enable you to decide whether options or direct assets are the best fit for your financial goals and skill set.
Active or Passive Investing
Options trading requires you to be an active investor, not least because you will be required to watch over the markets regularly.
You will also need to dedicate a significant amount of time to both fundamental and technical analysis, depending on your options strategy.
On the other hand, if you are a passive investor, this means that options likely won’t be suitable. Instead, you will be best suited for long-term investment strategies that will see you invest in quality stocks over the course of many years.
This means that you can spend much less time researching and watching over the markets.
Access to greater levels of leverage
Options enable casual traders to access much higher levels of leverage when compared to traditional stocks.
This is due to the small premium requirement that is needed to enter an options trade. While being able to trade with high leverage may seem appealing, you should also consider the risks.
After all, if your options trade declines by a certain percentage, your broker might send you a margin call. This means that you will need to add more capital to keep the leveraged position open.
Options are ideal for hedging
One of the best ways to hedge against an open stock position is by purchasing put options. In effect, this means that you will be betting against your current stock investment.
In other words, you are long on the stock but short on the options trade, which cancels any favorable or adverse price changes.
This can be handy if you are concerned about a potential stock price reversal, say because of an impending quarterly earnings call.
Short-selling requires less capital
Options trading is also considered a less cash-intensive way of short-selling a stock that you believe is due to decline in value.
- When opting for the traditional route, you would borrow the stock from a broker and then buy them back at a later date.
- In the US, however, short-selling requires you to put up a huge margin of 150%.
- This means that to short-sell $1,000 worth of stocks, you would need to have $1,500 in your brokerage account.
In comparison, options enable you to short-sell a stock simply by purchasing puts and covering the premium. This means that depending on your preferred target price, you might only need to cover a 5-10% margin.
How options pricing works
The price of an options contract is referred to as the premium.
In order to calculate the premium, two metric needs to be taken into account:
- The intrinsic value of the contract
- The time value of the contract
Starting with the intrinsic value, this refers to the difference between the:
- Strike price of the options contract
- And the current stock price on the stock market
To calculate the time value, this is determined by how much time is left before the options expire. As I briefly noted earlier, the further away the expiration date is, the more chance there is that you will land in the money.
Therefore, the time horizon of an options contract is built into the price. And in turn, this will determine the price of the premium for the options strike price that you wish to target.
- To recap, the price of the options premium will be higher if there is a greater probability of it landing in the money before the date of expiry.
- Conversely, the price of the options premium will be lower if the probability of it landing In the money is smaller.
This is why the term ‘time decay’ is often used in the options trading market. Put simply, the closer the options contract gets to the date of expiry, the greater its decline in value.
This is why beginners may wish to target longer-term contracts when entering this space for the first time. This will give you more time to assess the markets and determine the best exit strategy available.
How to start options trading as a beginner
If you are completely new to options, here’s a brief overview of the required trading process:
Open an options trading account
The first step is to open an account with a suitable options broker.
Many brokers in the US offer commission-free options trading, but you will likely need to pay a fee for each call or put contract that you purchase.
Pick which options to buy or sell
The next step is to find a suitable options market to trade. US brokers typically support large-cap stocks in addition to index funds like the Dow Jones or S&P 500.
Either way, you will need to determine whether you believe the asset will rise (calls) or fall (puts) on or before the options expiry date.
Select a strike price and expiry date
Your options broker will likely give you several options when it comes to selecting a strike price and contract expiry date.
Just remember that the price of the options premium will be determined by both of these factors.
Purchase calls or puts
After you have determined the best target price and expiry date for your options strategy, you can then proceed to purchase the calls or puts.
In this regard, you will only need to cover the premium.
Watch over the markets
As soon as you have completed your options trade, you will then need to keep a watchful eye over the markets.
The value of your options contracts will rise and fall depending on whether the current asset price is edging closer or further away from your strike price.
You can exit the options trade on or before the expiry date.
In summary, the main benefits of options trading are that you can go long or short on an asset without taking ownership upfront, which invites higher levels of leverage.
Traders are also attracted by the premium factor, which is the most that can be lost from an unsuccessful options position (out of the money).
Before you begin trading options, make sure that you are well-versed in what options trading strategies are suitable for your skillset.
Options Trading for Beginners FAQs
Is option trading good for beginners?
Options trading isn’t best for beginners as it is more suited for active traders who understand the complexities of leveraged derivatives. With that said, your loss exposure when trading options is capped to the premium that you pay.
How do I start learning options trading?
You can start learning about options trading by researching key terms surrounding calls and puts, strike price, premiums, and expiration date. After that, consider starting your options journey with a risk-free demo account.