How to Trade Options and What Even are They

How do options work?

Learning how to trade options is a rather difficult subject for a new trader to understand. In simple words, it is a contract that gives you a date and a price to buy or sell a stock. There are tons of different options all over the trading world, and each provides a different date and price.

The key advantage is that you can sell the stock at a much higher price than what it is worth for usual buyers at a specific time. For instance, if you buy an option to sell X amount of stock on date Y for $20, you can either lose if the same amount of stock will cost more or win if it costs less.

Options lay in a derivative area – in this case, it means they reflect the value of stocks and not companies, like stocks themselves do. For this reason, you can speculate on a whole other level.

How do options work?

You obviously can’t just waltz in and take an opportunity to buy or sell stuff at a predetermined price without any obligations. It would be too profitable, obviously. No, options have two key downsides:

  1. Owning them costs money.
  2. Each option contains a lot of shares, and you’ll have to pay for each of them individually.

It costs a premium to own an option. Usually, an issuer determines the price of each contract beforehand, and you don’t need to pay anything else for them, as a rule. 

Moreover, each option is usually a collection of smaller contracts. For instance, an option can contain 300 individual contracts, each for the same share. If whoever you buy them from charges 10 cents of premium a contract, you’ll have to pay up to $30 for the lot.

Why do options exist?

Despite some of the downsides, it’s still advantageous to own an option if you believe that a stock is about to drop or rise according to your wishes. If you believe a stock will rise in price massively, and you see an option that allows you to buy even a fraction of this rise being sold, you’ll be able to buy shares and immediately sell them for much more. That’s at least one of the strategies of how to trade options.

The problem is that whoever sold you this option bets on a completely opposite outcome. Where you bet on growth, they bet on a drop. Accordingly, their intuition or information may be closer to the truth than yours is. So, unless you have a good source of information, you aren’t advised to trade options.

Types of options

Options don’t differ all that much in terms of what type of stock they represent: technically, underlying security can be anything, although it’s most common to see the oil options alongside other things.

Types of options

In terms of characteristics, there are several sorts of options. When it comes to their purpose, there are:

Both these words – ‘call’ and ‘put’ – represent the buying or selling action, respectively. For options, they mean a specific purpose. If you acquire a call option, you can only use it to buy stock. Both types have their own small differences, like typical rates and so forth.

The most important distinction is that put options are used in short trading. With calls, you can simply buy the stock when the time comes while puts require you to first buy the stock in order to sell it later.

Put options

If you know how shorting works, it’s pretty much the same principle. For instance:

  1. You acquire put options that enable you to sell 100 X stock by the next week for $5 each;
  2. You borrow the same amount of stock from the broker, while the price is at about $10 (higher than your strike price, which is the price you aim for);
  3. You wait until the stock price drops to $3 (below your strike price);
  4. You exercise your right as an options holder to sell your stock for $5 for $500 in total;
  5. You then use $300 of this money to buy back the stock;
  6. You return the borrowed stock to the broker and still have $200 of profits.

That’s pretty much how it works with put options. It’s a much more advanced and riskier activity than trading call options. In fact, it’s even more complicated to short an option than short a stock because you need to factor in more data than usual. 

So, unless you know how to trade short, you’re better off sticking with the call options. At the very least, now you know how to trade options on put.

Risks of trading options

Even options trading for beginners is rather complex, not to mention risky.

Like stock trading, options suffer from time and value sensibility. Over time, the amount of profits you’ll receive from successfully exercising your option can either increase or decrease, depending on the type of option you hold and the current price trend of the stock the option represents.

It’s not the only problem, however. The real problem is that most options can only be exercised on the date they expire. Therefore, you really need to calculate whether the real stock price on that day will be beneficial compared to the strike price on the option you intend upon buying.

Obviously, you don’t have any obligations to exercise the option on that day, which might save you. That said, you still paid a premium for this option, so letting it expire is still a waste.

There are also many options that allow you to turn them in on any day until the expiration date. These are more beneficial, obviously, but acquiring them is often more costly as well.

You’ll have to account for many things, as you see. If you mean to conduct some serious estimations, you’ll need to utilize indicators, risk metrics, and learn exquisite trading strategies.

Final Thoughts

In the end, options trading is harsh. It’s not like trading futures. This activity often doesn’t forgive mistakes. If you understand options, it’s possible to earn sizeable profits in a smart way, like many investors love to do it. Still, there are many risks associated, as you saw.Hopefully, now the question “How does options trading work?” is answered.

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author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192