Options trading, is an alternative way for investors to invest in the performance of a security.
Table of Contents
- Options trading contract works unlike a stock
- Option definition (explained)
- Options trading could lead to Several scenarios
- Never forget the risk
- Conclusion
By trading options, an investor attempts to capture the up or down movement of the security. While only investing a fraction of the cost it would take to own the actual security.
for example, consider a stock that’s currently trading at $100. If purchased a share and the price went up By $5 you would have a 5 percent return. You get profit from the same jump in the stock price.
Only pay a small premium that cost significantly less than owning the stock.
The ability, to make more with less is one of the benefits of options trading. The potential for greater profits comes with a greater risk of losses.
Options trading contract works unlike a stock
Let’s take a closer look. how an option contract works.
Unlike a stock, when you buy an option you’re not purchasing the security itself.
Instead, you’re purchasing a contract that gives you the right to buy or sell a security at a certain price before a certain date.
consider this example suppose there’s a car company called Tesla. stock is currently trading at $50 a share an investor believes that the stock price of Tesla will rise.
This investor considers taking advantage of this anticipated price movement by buying 100 shares of the stock but she is concerned about the initial capital requirement.
now let’s assume that there’s another investor who already owns 100 shares of Tesla stock and plans to hold on to it for a while he thinks the stock price will not increase much over the next few months.
Options trading
Option definition (explained)
Both investors can utilize a call option, this type of options contract gives the buyer the right to buy shares of Tesla stocks at a set price called a strike price at a set time called expiration.
In this case, it’s $55 per share in four weeks’ time typically each standard option contract represents 100 shares so this one contract would give the buyer the right to buy 100 shares of Tesla stock at $55 per share.
The buyer purchases the contract by paying the options premium. the price of the option is determined by several factors:
1. The stock price time until expiration.
2. Implied volatility which is how much the stock is expected to move during the life of the contract.
The seller gets credited with the call options and helps to partially offset the original purchase price of the stock.
for this example let’s assume the total premium is $100. our buyer pays the $100 to purchase the contract.
Options trading – could lead to Several scenarios
now let’s examine what could happen to this investment suppose our buyer’s instincts were right and Tesla stock is now selling at $60 a share.
Options trading – Scenario 1
Remember the call option gives the buyer the right to purchase shares of this stock for $55 a share. The buyer could exercise the call and purchase 100 shares for $55 each. And then sell them at market value for $60 each making a profit of $5 per share not including commissions.
Tesla shares have risen by $5. The contract is essentially worth $500.
Options trading – Scenario 2
let’s rewind, suppose the stock moved in the opposite direction and is now selling for $45 a share.
On the last trading day before the expiration date, the contract gives the buyer the right to purchase Tesla stock for $55 per share.
However, no one would want to pay $55 for stock that’s selling at $45 in the open market.
The buyer’s contract will likely expire worthlessly. the buyer is now on track to lose 100% of her initial. $100 investment plus any trading commissions and fees.
For the seller, the option expiring worthless is good news he still owns his shares of stock and
made $100 selling the option although the value of his share declined. he was able to keep the option premium leaving any commissions and fees for selling the option.
Never forget the risk
keep in mind this is a simplified example of the pricing of options are very complex which is why it’s important to educate yourself about options trading and their risks before you invest.
while the biggest change comes from the price of the underlying instrument with the contract represents there are other forces like time decay and implied volatility that influence options prices well.
I showed you one example of options that can be used in a variety of ways.
Call options that we just saw can be profitable to own if the price of a stock goes up. Put options can be profitable if the price of a stock goes down.
calls and puts can also be combined in a variety of ways.
Conclusion
Options trading can be complex and involves a certain level of risk. For beginners interested in getting started with options trading, here are some recommendations:
- Education and Research: Begin by educating yourself about options trading. Understand the basic concepts, terminology, and strategies involved. There are numerous online resources, books, and courses available that can provide a foundation for options trading knowledge.
- Paper Trading: Consider starting with paper trading or virtual trading platforms. These platforms allow you to practice trading options using virtual money without risking real capital. It’s an excellent way to gain experience, test strategies, and understand how options behave in different market conditions.
- Start Small: When you’re ready to trade with real money, start with a small capital allocation. Begin with a comfortable amount that you can afford to lose. Starting small allows you to learn and gain experience while managing risk.
- Basic Options Strategies: Begin with simple options strategies that are easier to understand and implement. Some commonly used strategies for beginners include buying call or put options, covered calls, and cash-secured puts. These strategies can help you grasp the basic mechanics of options trading.
- Risk Management: Prioritize risk management and understand the potential risks involved in options trading. Use stop-loss orders or other risk management tools to limit potential losses. Be aware of your risk tolerance and avoid taking on excessive risks.
- Research Underlying Assets: Thoroughly research the underlying assets on which you plan to trade options. Understand the factors that affect their price movements, earnings reports, news events, and industry trends. Fundamental and technical analysis can help you make informed trading decisions.
- Use Limit Orders: Consider using limit orders instead of market orders when executing options trades.
Limit orders allow you to set the maximum price you’re willing to pay for an option or the minimum price you’re willing to accept when selling it.
This helps ensure you get the desired price and avoid unexpected execution prices. - Seek Guidance: Consider consulting with a financial advisor or an experienced options trader who can provide guidance and help you navigate the complexities of options trading. They can offer insights, provide recommendations, and assist in developing an appropriate trading plan.
Remember that options trading involves risks, and it’s important to understand the potential rewards and pitfalls. Be patient, continue learning, and gradually expand your knowledge and trading skills as you gain experience.
By buying and selling these options, investors have the potential to make money when the market moves in any direction and create strategies with a variety of risk levels you’ve taken the first step in
understanding options trading for beginners.