Introduction to Options Trading – an easy to follow guide

Apart from buying or shorting stocks, there are other ways of trading the underlying securities. A good trader is the one that expands his/her tool set. I will be describing options trading in this article. I will try to keep it as simple as possible so especially the new traders can benefit from it and start using it.

Options Basics

As the name suggest, an ‘option’ is a defined contract that grants the trader to buy or sell an underlying asset at a specific price on or before a certain date.

There are two types of options:

  • Call Option: This is the option to consider if you think the price of the security will be going up.
  • Put Option: This is the option to consider if you think the price of the security will be going down.

Please note that the standard stock options and ETF options expire on the third Friday of the month (hence the volume increase in the markets at this specific date). There are also around 80 stocks in the stock market that their options expire every week on Friday. These are referred as ‘weekly options’.

In options trading, the prices are quoted as per share amount. The minimum contract is always for 100 shares. So in example: if the option price is quoted at $5 the actual cost would be $5 x 100 shares = $500 (not including trading commissions).

Option contract example:

XYZ February 10 Call at $2.20

Lets analyse the option contract above:

XYZ: this is the underlying stook (100 shares / option)

February: this is the expiration month (3rd Friday of the month, the contract will expire)

10: strike (exercise) price – so if the contract is exercised, the price for share you will pay is $10.

Call: this is the type of option. It can be either call (when you long) or put option (when you short). In this example we have a call option (so we are going long) and this enables us to buy the shares at the given price (in this particular example at $10).

2.20: this is the ‘premium’ you will pay to be able to buy this stock at the given price of $10. So the premium you will be paying will be $2.20 x 100 shares = $220 for 100 stocks for this example.

Long call strategy

  • This is a bullish strategy with a expectation of higher price of the stock at the expiration date. So if you buy the stock at $10, the expectation is it will be higher at the expiration date of contract (i.e $13)
  • The good news is with this option contract, your maximum loss is limited to the premium paid for the option contract. That is it.
  • Theoretically the maximum gain is unlimited. So the price of the stock can go higher and higher. In real life, of course there will be a limit on how high the stock will go, but can be a very profitable trace for you (if it goes higher).

Let’s look at another example so everyone gets what I mean above:

Let’s say we are bullish on ABC corp and the stock is trading at $34.50 and we think it will go to $40 within the next 45 days before the expiration of an option contract. So in short, the stock is currently trading at $34.50 and our price target for the stock is $40 (within the next 45 days).

when we look at our trading system, theoretically, we shall see some option pricing listed similar to below:

ABC corp @ 34.50

image

Looking at the prices on our system, in this example, the premium for January $30 call is trading at a high premium, $40 call has no value but the best paying option for going long seems like January $35 call. So I can do the following option trade:

BUY 1 January 35 Call @ 1.25

Now let’s have a quick look at our break even point and profit\loss:image

as it can seen on the table below, any price $35 or below, there is no value in this option contract. The maximum loss will occur is only $1.25 (nothing more). But anything above $35 plus the premium we paid (35 + 1.25 = 36.25 is our breakeven point) is a profit.

The good news about option contracts is, you do not need to wait to sell (or cover) your position until after the expiration is reached. You can buy or sell anytime, if the price is going towards the direction you wanted in the first place then you can have a profitable exit within days (and sometimes even hours).

If you take the example above and reverse (if you are bearish instead of bullish and you think the price will go down) then you can go for the PUT option (instead of call option). The trade mechanics and profit/loss calculations will be identical.

Advantages and disadvantages of options trading

Advantages

  • Leverage: if you are a disciplined trader, you can use the advantage of leveraging with options
  • Risk/reward: depending on the strategy, some option strategy will enable traders to have theoretical unlimited upside with defined and limited  loss
  • Strategy plays: some strategies will allow traders to take advantage of volatility and time decay type of plays
  • Low capital requirements: you can do so much more with $1000 in options then with simply trading stocks with the same amount.

Disadvantages

  • Lower liquidity: very low volumes of trading unless they are very popular underlying stocks. For smaller traders this is not much of a problem if they are only trading 10, 20 option contracts. But if you are trading over 100 contracts then it might be difficult to get out of the trade when you want with low liquidity.
  • Higher spreads / commissions: options tend to have higher spreads because of lack of liquidity as mentioned above. Options commissions are also generally higher than simply trading stocks.
  • Options are not available for all stocks: This is one of the biggest disadvantages. Not all penny stocks have options available to them.

I hope this gives you a good idea of what options are, how to do an option trade and the main benefits & disadvantages of options trading. If you like this and found it useful then please like it or comment on Twitter so I know, and according to that I will have a part 2 write up where I will discuss best option trading strategies and how to benefit from them.

Have a nice Sunday.

MT

If you have finished reading this, you can read PART 2 HERE.

 

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