Options Trading: Everything you Need to Know
When you want to diversify your portfolio, options trading gives you a simple alternative to trading stocks or investing in mutual funds. Options come with an average 5% return with an 80% winning ratio.
While they carry their own risks, options can be an excellent way to expand your portfolio. Not to mention, they come with quick returns so you don’t have to play the waiting game with future contracts.
Before you get started, we’ll show you how options trading works and how it can benefit you. Once you learn the ins and outs, you can feel more confident when you start investing.
What are options?
Options trading allows you to buy or sell stocks using a brokerage platform. While trading stocks on the stock market can get complicated, options offer a more straightforward trading venue. However, you still have to pay attention to trends and patterns.
When you trade options, you buy and sell stocks, ETFs, bonds, and other assets. The difference lies in the method. For example, rather than buying one share, you can buy 100 or more at once for a lower price. This feature makes options attractive as a quick way for investors to make money.
Options give you the right to buy or sell an underlying asset, like a stock. The price of the option depends on several factors, including:
- The asset’s market price
- Expiration time
- Specific market factors
Options can be a risky form of trading. You can gain profits fast, but you can also lose money just as fast with incorrect market predictions. Due to the risk, we don’t recommend options trading for beginners.
Types of options
When you trade options, you can choose between two basic options positions: call and put. The options position you choose depends on your plans for the underlying asset. How much time you want to invest in waiting to buy or sell also matters.
Some types of options take longer to sell, like futures contracts. As the options holder, you can purchase options with contracts of varying lengths based on your trade’s underlying asset.
How you buy and sell your assets depends on what you believe the underlying asset price will do. The different asset types indicate whether you predict that the price will rise or fall. If you’re right, you make a profit. If you’re wrong, you lose money.
Call options indicate that someone buys an underlying asset. They give the option holder the right, but not the obligation, to purchase an asset, like a stock, at a set price within a specified amount of time. As with any options, you can only buy before the options contract expires.
With a call, you set the price at which you want to buy an underlying asset. You can then buy that asset in-the-money at any time before the expiration day. Some platforms even have settings where they will buy assets for you automatically. Those settings depend on your preference, brokerage platform, and the country where you trade.
Unlike call options, put options mean you sell an underlying asset because you expect its value to fall. Put options give you the right, but not the obligation, to sell the asset at a specific price before it expires.
When you buy a put option, you believe the asset’s price will fall below a certain price before the expiration time. With options trading, the value of the option goes up as the underlying asset price goes down.
Long and short options
When you buy or sell an underlying asset, you can choose between long and short options contracts. Both long and short calls mean the buyer can buy shares in-the-money until the expiration day. Likewise, a short or long put allows the buyer to sell shares in-the-money before they expire.
The difference between the two is how long you have to buy or sell. Short calls typically last about 30 days. In other words, you have only 30 days to decide to buy or sell your asset.
Long calls give you more time to watch the market and buy or sell your underlying asset. You can find long calls that last up to a year or more, depending on the investment.
How does options trading work?
When a trader invests in options, they believe the market price of a particular asset, often a stock, will rise or fall. They make their trade based on that opinion.
Trading options involves predicting the underlying asset’s market. For example, when trading stocks, you choose whether the stock price will rise or fall.
Once you enter the contract, you buy or sell a call or a put based on that prediction. If you think the price will rise, you buy a call option. If you think it will fall, you sell a put option.
There are always two sides to options trading: the buyer and the writer, or seller. The buyer has the right to purchase an option in a specific price range before the contract’s expiration date. If they exercise the option, they purchase it at a strike price or the buying price.
The seller has not only the right but the obligation to buy or sell a share. If an option expires in-the-money and the buyer exercises the option, the seller must sell to them.
Options function as a predictive, and often quick, buy-and-sell system. Most of the time, they involve buying shares of stock. However, you can also trade options with ETFs, futures, and other assets.
Options don’t work quite like buying stocks on the stock market. You don’t get to own part of the company, and you don’t get voting rights. An options contract gives you none of the extra benefits of buying stocks directly on the market. You only trade for profit.
An options contract typically involves buying or selling 100 shares of a stock at once. However, the price of an options contract is lower than the cost of the stock on the stock market. The contracts have short expiration times, usually within the following limits:
- 30 days
- 60 days
- 90 days
- One year
The expiration date depends on the underlying asset you sell. The more time before expiry, the more value the option has. The short expiration time in options trading makes them a good way for traders to make a quick profit.
What affects the options price?
Several factors contribute to the price of the option. When thinking about which assets are worth the investment, consider the following factors:
- Length of the contract
- Time value
- Intrinsic value
- Current market price of the asset
Volatility tells you how much the asset price fluctuates. Wider price swings raise the odds, making the option price more likely to rise, too.
The longer an asset takes to expire, the more potential it has to increase in price. Compare that to a short one-month contract that can expire before the underlying asset price reaches its peak.
With less volatile assets, shorter contract lengths may not mean much since the price may stay consistent over time. However, if you have a more volatile investment, it can help to watch the market over time and give the price time to rise.
An asset’s intrinsic value depends on how much time it spends in-the-money. When an asset is in-the-money, its price sits above the exercise price. Out-of-the-money tells the buyer when the asset’s price falls below the exercise price. The more time an asset spends in-the-money, the higher its value.
Time value depends less on how long the asset spends on the market and more on its premium and intrinsic value. The difference between the two shows the time value. That’s why the longer the options contract stays open, the more value it gains. If market conditions remain favorable, that value goes up because it stays in-the-money.
Lastly, the worth depends on whether the option is likely to meet the buyer’s or seller’s expectation when it expires. For example, if it spends most of the open contract time out-of-the-money, the value will decrease.
How do I get started with options trading?
Options trading, while simple in theory, takes skill in predicting the market and knowledge of options strategies. If you’re new to options, you need resources to help you make educated predictions. Before you enter your first contract, know what to look for in a brokerage platform and your market.
Choosing your brokerage platform
Not all brokerage platforms work the same. The one you use depends on your trading and investing experience, as well as your options-specific knowledge. Consider these factors before you sign up with a broker:
- Education: If you’re a beginner, choose a broker who offers educational resources and guidance. These resources help you learn how to predict the market and when to exercise an option. You’ll also learn how to apply more advanced strategies in your chosen market.
- Customer service: You want a broker who offers support when you need it. Choose one with service representatives who understand complex trades. Some brokers have 24/7 service, weekend service, and other conveniences for traders.
- Ease of use: Does the broker have a user-friendly platform? You don’t want to bend over backward trying to make your trades. Ideally, you want as close to a one-click system as possible, so you can strike when the price is right. Focus on fast order execution and platform reliability.
- Fees: Every broker comes with a commission fee. Still, you should choose one that you feel charges fair fees for what it offers. Do you have to pay monthly or annual fees? What’s the minimum investment for joining the platform? You want to get your money’s worth, so consider what you have to pay before you profit.
- Tools: Does the quotes feed update often? Does the platform have analytical tools to help predict the market? Do you get screening tools? Some traders like to have extra tools to analyze their trades. If you’re a beginner, you might find it helpful to have a simpler platform with more educational resources than advanced tools.
Once you choose your broker, it’s easy to sign up and create an account. However, make sure you know the regulations in your country. Each one has different rules surrounding options trading. That includes varying regulatory bodies, and some of them are stricter than others.
Know what you want to trade
Before you decide on your asset, determine whether you want to trade American or European options. The key difference between the two lies in when you can exercise your option.
With American options, you can exercise the option anytime up to or on the expiration date. European options only allow you to exercise on the expiry date and not before.
The next step comes with knowing which assets you want to trade. Your choice depends mainly on your portfolio and what you want from your options contracts. You can choose from assets like:
- Mutual funds
Many investors start with stocks for their simplicity. With their shorter contracts, you can make a quicker profit. Other assets, like ETFs and futures, give you more opportunity for complex trades. They also have longer contract terms, which offers the potential for bigger profits — or bigger losses.
What to know when trading options
Before you start trading, you should learn how to read options tables. You’ll need to know elements like:
- Bid price
- Ask price
- Implied bid volatility
- Open interest
- Strike price
While many brokers offer educational resources, you can find in-depth and beginner courses on Udemy. We have courses that show you how to read options tables, make successful trades, and help you find your entry point and make market predictions.
If you trade with American options, you must also learn how to exercise the option to buy or sell and make your exit from the contract. Over time, you can get into more complicated spreads and combinations as you understand the market further.
Why should I invest in trading options?
If you work to understand how options function, you can make a substantial profit. Options carry many advantages for your portfolio and create opportunities when it comes to investment strategy. Traders invest in options for many reasons, like the following.
Many traders use options to hedge, or lower their risk of unfavorable price movements attached to an asset. They have become one of the most reliable forms of hedging.
Options come with less financial commitment than assets like equities and carry no secondary risks. However, you must use them correctly, or they can cost you.
Options are more versatile than other types of investments. They provide many avenues to achieve your investment goals. Keep trying different strategies until you find one that works for you and gives you the best returns.
Even if you start with simple trades, you can branch out into more complex options for higher gains. You can benefit from trading different assets as you explore contract lengths, volatility, and asset prices. Options are the only type of investment available that gives you the strategic alternatives you need to profit across all markets.
With more leveraging power, you can buy a stock at a low price and sell it for more money later. Options give you more returns because you pay less for the call than trading on the market. It’s like getting a discount for buying in bulk at the grocery store.
For example, when you buy stocks as the underlying asset, you’re purchasing a contract, not the stock itself. Instead of buying 100 shares of a $100 stock directly from the market, you buy a $10 call.
In this case, buying 100 shares on the stock market would cost you $10,000. Buying a call gives you a $1,000 outlay instead. You save $9,000 that you can invest in other assets and increase your profit.
High potential returns
Because you spend less on the stock through an options contract, you get higher returns. The stock market has an average of 10% returns. Options can raise your profits much higher.
Your return depends largely on the delta or the percentage of the stock change that affects the option price change. For example, 70 delta means your options price goes up 70% of the stock price increase. If you buy a contract for $10 on a $100 stock and the stock price rises $20, that’s a 20% return on the stock. The options position would gain 70% of that stock’s movement, making the price rise $14. If you spent $10, that’s a 140% return.
Getting these high returns means being able to predict the market. Check out this course to help you understand the market’s direction and improve your predictions.
Are you ready to start learning about trading options?
Udemy offers hundreds of courses to help you learn about options trading in a way that benefits you and your portfolio. We have courses for everyone from beginners to advanced traders. Explore what we have to offer, so you never stop leveling up your investment skills.
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