А solid understanding of options trading is required to make profitable trades. This guide will cover the basics of the best options strategies with examples so you can learn to use them as an alternative approach to conventional investing and potentially make a profit.
Let’s immerse right in.
What are trading options for dummies?
To understand what options trading in the share market is and what strategies work best there, you need to find out a few key points:
- Investor portfolios are made up of various assets: stocks, bonds, etc.
- Options are another asset class that can be added to a portfolio.
- An option is a contract that consists of 100 shares of the underlying asset. The underlying asset can be not only shares but also bonds, currencies, or commodities.
- The contract gives the investor the right (but not the obligation) to buy or sell the underlying asset at a predetermined price on or before a certain date.
- Options can be purchased using brokerage investment accounts.
It turns out that options are contracts, the value of which depends on the price of another asset (stocks, bonds, commodities, or another). And to determine how and when it is best to trade options, strategies for beginners will help: long calls, long puts, covered calls, protective puts, and straddles.
Buying Calls (Long Calls)
Buying calls is one of the most popular options trading strategies for beginners. The goal is to increase the value of your investment by buying options.
When you buy call options, you become the holder of options, and you can utilize these at a future date to earn a profit on the trade. A long call option gives you the right to buy shares at a particular price (the strike price) on or before a specific timeframe (the expiration date). This options strategy allows you to profit when the share price moves in your favor.
Let’s learn this option buying strategy with the help of an example.
Let’s assume that Company X is trading at $120 per share, and you want to buy 100 shares that will cost you $12,000 (100 x $120). When you look at the market trends, there is a high certainty that Company X’s share will be trading at more than $150 six months from now. However, you lack the sum to invest $12,000 in stocks right now.
So, instead of purchasing shares upfront, you decide to go for a safer alternative, i.e., to buy call options with a strike price of $150 at an expiration date approximately six months from today by paying a premium of $500, which makes you eligible to purchase 100 shares at a future date.
After four months of buying options, Company X’s share trades at $160 on the stock exchange. Since you made a savvy decision to purchase call options with a strike price of $150, you can now utilize those options to buy 100 shares at $150 even though the current market price is $160 and make a profit by selling them high in line with the current market price.
Risks and Rewards
There is not much risk involved in buying call options, as the maximum bet you can lose is the premium you pay to get call options. However, rewards can be pretty hefty since you only spend up to the strike price.
Buying Puts (Long Puts)
Another of the best options trading strategies is buying a put option. It grants a right to the holder of the option to sell shares at a predetermined rate, unlike a call option where you could purchase shares at a defined rate before the expiration of the options agreement.
Buying a put option can save you from a potential loss. To be more precise, a put option is the exact opposite of the call option. Even though the share price goes down from the strike price, you will still hold the power to sell your shares at the strike price.
Let’s cover this option selling strategy through an example.
Currently, you hold 100 shares of Company X. Due to the economy’s fluctuations, you expect Company X’s share price to dip from $70 to $60 within two months. You don’t want to risk shorting a stock if you’re wrong.
To cover your risk, you buy a $60 put for a premium of $3 per share. If you are correct and the stock drops to $55, you will earn $2 ($60 minus $55 minus the $3 premium).
Risks and Reward
Suppose the odds didn’t happen as anticipated, and the share price never dropped. The most you will lose is the premium paid to get put options.
Covered calls are a type of protective options strategy to generate income from your shares and limit the downside risk associated with those shares. The central concept is that you sell call options on your shares, and if it goes up in price, you’ll make money from the option sale. If the share price goes down, you won’t lose anything because you already own the shares.
This is another best options trading strategy that allows the investor to sell their shares at a fixed price (strike price) on or before the expiration date. If the underlying shares do not exceed this strike price at expiration, the investor keeps the premium received from selling the option and still owns the shares at no cost.
If the shares increase above the strike price, the investor will be forced to sell their shares for a higher price than they purchased them for. It is known as being “forced” to sell your shares, which is why it’s called a “covered call”.
Let’s see how to do options trading with the Covered сalls strategy.
You own 1,000 shares of Company X at $125 per share. You are concerned the Company may soon report disappointing earnings. You decide to sell 10 call options for every 100 shares of Company X you own at a strike price of $150. This creates a covered call position, as your short call options offset the long stock position.
If the price of Company X rises above $150 per share, your short call options will be exercised, and you will have to sell your shares at $150 per share. If the price of Company X shares falls below $150 per share, your short call options will expire worthlessly, and you will keep your shares.
Risks and Rewards
The risk of covered calls is that the stock could rise. If it does, you’ll have to sell at the strike price, which is lower than the current market value. The reward is that you’ll make money on the premium from selling the option.
A protective put is a strategy used by investors who want to protect their position in a stock. The investor buys a put option on the stock, which gives them the right but not the obligation to sell it at a specific price.
Here’s an options trading example to get the centric idea of protective puts.
Let’s say you own some shares of company X. You think they’re going to go up, so you buy more shares of Company X to add to your existing portfolio. But then something terrible happens: Company X drops 20% in value overnight!
You’re panicking; you need to get out of your position as soon as possible before it gets any worse. You can’t afford to sell it at the current market price anymore. So you buy some protective puts on Company X.
That path if the stock goes down even further. You’ll be able to sell it anyway by exercising your right under the put option contract that comes with owning those puts at an agreed-upon price lower than the current market value for Company X’s stock (but still higher than what you paid for those puts).
Risks and Rewards
The risk of protective puts is that you are buying an option, so if the underlying stock’s price moves significantly lower, the value of your invested capital will decrease. Conversely, the reward is that protective puts can be used to limit your losses on a stock position.
A long straddle is a trading strategy that involves buying both a call and put option of the same underlying security, strike price, and expiration date. An investor uses a long straddle strategy when he expects a significant move in the underlying stock’s price due to market volatility but does not know whether it will increase or decrease.
In other words, it’s called a “straddle” because it allows an investor to take advantage of either an increase or decrease in the underlying security price.
If stock XYZ is trading at $50, you can buy an XYZ call option for $10 and an XYZ put option for $10. That will cost you $20 in total.
As time goes on, the price of XYZ will either go up or down. If it goes up, your call option will increase in value and make a profit. If it goes down, your put option will increase in value and make a profit.
Risks and Rewards
There is no limit to how high or low the stock price can go, so there is no guarantee that it will move. In that case, the maximum loss you can incur is the premium paid on both call and put option trading.
Some basic other options strategies
Let’s also look at other basic options trading strategies that novice investors can use with puts and calls to limit their risk.
Bull Call Spread
A bull call spread is a strategy that involves buying one call option and selling another call option of the same underlying asset but with a different strike price. As a beginner, it might be overwhelming, but recall the concepts of what are puts and calls.
The point of this strategy is to profit from an increase in the underlying asset’s price over a certain period. The bull call spread provides limited risk because it only loses money if the underlying asset expires below the lower strike price.
A long strangle is an options trading strategy that involves buying an out-of-the-money put option and an out-of-the-money call option with an exact expiration date. It’s often used when you think that the price of a stock will make a significant move in either direction, but you’re not sure which way it will go.
A vertical spread is a strategy that involves buying and selling options at different strike prices. The goal of a vertical spread is to profit from the movement in the price of the underlying asset.
Advantages and disadvantages of trading options
If you are a beginner, it is essential to understand how options trading works and its pros and cons to make an informed decision about whether it is right for you.
Advantages of trading options
- It gives you an option to make money in a bear market.
- You can use options to get a piece of the action without putting up all your cash.
- There are no limits on how much you can earn; it all depends on how much time and effort you put into learning different options trading strategies.
- Trading options allow you to be a part of the share market even if you don’t have enough capital for stock purchases on margin (it can be costly for small investors who want to invest in stocks with high prices like Apple or Google).
Disadvantages of trading options
They are risky because they require an upfront payment before any money is made on the trade. It means that if the option expires worthless, all of the capital invested into the exchange will be lost – not just some of it like stocks or mutual funds.
What are the levels of options trading?
There are three levels of options trading: basic, advanced, and expert.
At this level, you’re trading options with low leveraged value. This level typically involves call and put option trading; they are simple and are not very complicated to deal with.
At this level, you’re able to trade options with more complexity. You’ll have more choice about what kind of option you want to trade and how much leverage you want.
At this level, you can trade with the highest amount of complexity and leverage available on the market today. You’ll also be able to choose from a variety of different types of options based on what type of investor you are.
How to start trading options?
Options trading is a great way to get started in the stock market, but it can be intimidating for beginners. If you want to trade in options, you should first find a broker who can help you start.
To trade options, you’ll need a brokerage account. Many online brokerages offer options trading; some are better than others, but all will let you open an account with less than $500. For instance, Robinhood or TradeStation is suitable for that.
When do options trade during the day?
You can perform share market option trading during regular stock exchange hours, usually 9:30 a.m. to 4 p.m. EST.
Where do options trade?
There are many exchanges worldwide where you can apply your option trading strategies, but the Chicago Board Options Exchange (CBOE) is the most popular. The CBOE was founded in 1973 and trades options on more than 2,700 stocks.
The other major options exchange is the NASDAQ Stock Market. This exchange was founded in 1971 and trades options on more than 4,000 different stocks.
There are also dozens of smaller options exchanges worldwide where you can learn options trading and start generating profit.
Can you trade options for free?
Options trading requires fees or commissions. Typically there is a transaction fee (e.g., $3) plus a contract fee (e.g., $0.40 per contract). So if you buy 10 options at this pricing structure, your cost is $3 + (10 x $0.40) = $7.
You must understand how the system works and choose the best options trading strategy to use. Options trading does not have to be complicated, but you can lose investment if you are not careful.
As a beginner, it is best to stay away from risky options trading strategies and stick with simple ones like buying puts and calls on stocks that have been performing well recently. The key is to learn the options trading basics first. Once you get more experience, you can start thinking about implementing more advanced stock options trading tricks into your trades.