When it comes to investing, there is an incredibly large market for you to explore, with plenty of ways to make money. The stock market is the first thought that jumps into people’s minds when thinking of investments but that market is fairly small by comparison to some markets that are valued orders of magnitude higher than the stock market. The Derivatives¹ market is one such example of an absolutely monolithic market.
Derivatives are financial contracts that get their value, risk, and basic term structure from an underlying asset. These contracts are between 2 or more parties in which the contract value is based on an agreed upon asset or security.
These assets and securities can include bonds, interest rates, commodities, market indexes, currencies, and stocks. Today we are going to be breaking down options trading, which is only one part of the derivatives market.
What Are Options? A Quick Refresher
Options are only one category of a derivative and give the holder the right, but not the obligation to buy or sell the underlying asset. These contracts usually come in bundles of 100 and at a pre-negotiated price by a certain date.
However, when that date arrives, you have the option to let it expire instead of buying or selling. To simplify, we are going to be covering options trading in the context of stocks to keep everything as simple and easy to digest as possible.
Here’s a quick run-down before we get started. The two main types of options trading contracts that exist are Call Options and Put Options.
Call Options give you the right to buy a company’s stock for a specified price within a specified time period. The price is referred to as the Strike Price and the time period as “expiration”.
Put Options give you the right to sell a company’s stock at an agreed upon strike price before it expires.
Once you have placed your trade there are now several ways you can complete the trade. You are able to exercise the option (buy or sell), sell to another investor, or let the contract expire without any further financial penalties.
What Are the Benefits Of Options Trading?
People can find a lot of advantages to trading options as opposed to stocks. Most of those advantages have to do with making more money and being able to magnify your returns.
Buying options usually means taking control of more shares than if you bought the stock on its own with the same amount of money.
Options are a type of leverage that can magnify returns on your investment simply by using a different trading method.
Options have the added benefit of allowing the investor to see how things play out and take time to make the right decision which can also include letting it expire and walking away from the trades all together.
Are There Any Downsides To Options Trading?
Taking extra time to see how things play out, and making magnified returns sounds too good to be true right?
Well I am sorry to tell you that it is... There are several downsides to options trading and are usually associated with increased risk.
The main drawback to Options trading is that it is possible to lose your entire investment in a very short period of time. This brings me to my next point which is skill level.
Trading Options is significantly more advanced than trading stocks and can have quite the learning curve to it so leaving it alone until building some trading experience is usually the best option.
How To Start Trading Options
Now that you know what you are getting yourself into and feel ready for the challenge let’s get started on the first steps you should take to start options trading. The first hurdle to pass is getting permission to trade options from your brokerage.
You need to prove you are knowledgeable and can handle yourself in the market. A knowledge test will usually be administered to make sure you have a clear understanding as well as several other requirements. You will need to show:
Based on the answers to these questions you will typically be ranked form 1-5 on a risk scale. This number will identify your risk level 1 being the lowest risk and 5 being the highest risk. Your risk level will dictate the types of options trades you will be able to perform based on the broker’s discretion.
Remember that just like any interview, you should be asking questions and looking for your own answers as well. Be sure that you are working with the right broker.
A good broker will be your best investing partner and offer the best tools, advice, research and guidance to help you achieve your financial goals.
Step 2: To Buy Or To Sell?
Now that your account is set up, you are feeling good and ready to get started, it’s time to pick a security or stock that you want to trade. Once you have done your research and due diligence on your choice of stock it is time to place your contract.
This part can be confusing for newcomers as the language can be difficult to get used to. Let’s make this simple for everyone with some If/then statements.
- If you think a stock will rise in price, then you will want to buy a call option or sell a put option.
- If you think a stock will fall in price, then you will want to sell a call option or buy a put option.
- If you think a stock will hover in price for a while then you will want to sell a call option, or sell a put option.
Step 3: Predicting The Future Price
Your option is only valuable if the stock price closes “in the money”. For call options that means the stock price closes above the strike price. For put options it means that the stock closed below the strike price.
This is obviously the most difficult part of the whole trading experience as nobody can really predict the future.
We can however take educated guesses and take us away from guessing and gambling territory.
Regardless of what method you use for divining stock prices, place your contract according to solid and well thought out research, technical, or fundamental analysis.
It’s time for another example:
Let’s say I believe Stock H which is currently sitting at $10 will rise in price to $15. I would buy a Call option with a strike price somewhere just under $15. My option would be considered “in the money” if the stock price rises above that $15 threshold.
Conversely, If I believe Stock H will fall in price to $8. I would buy a Call option with a strike price somewhere just above $8. My option would be considered “in the money” if the stock price falls below that $8 threshold.
The strike price is not some arbitrary number that you can pluck out of thin air. These quotes, are called option chains or matrices and contain a range of of available strike prices to choose from.
Strike prices are offered in increments such as $1, $2.50, $5, $10, etc, and are standardized based on stock price. The price paid for an option is called the premium and has 2 components, Intrinsic Value and Time Value. We will explore these two terms in our next step when choosing time frames.
Step 4: The Time Frame Of Your Contract
Typically the more time remaining until expiry on an option the greater the likelihood that it will end up in the money. The actual equation for how time affects the premium is very complex and has an exponential decaying factor.
Typically an option will lose ⅓ of its value during the first half of its life and ⅔ during the second half. This is an important concept for securities investors as the closer to the expiration date the more of a move the underlying security would have to perform to make that price a reality.
Just as with choosing your strike price, you must also select a date associated with your option to be the last day to exercise your option, the date of expiry. Two choices exist for options contracts, European or American.
American options contracts can be exercised on any date including the expiry date. European contracts can only be exercised on the date of expiry. American contracts offer more flexibility than European contracts and are therefore more popular and cost a bit more than their European counterparts.
These options contract terms can be for days, months, or even years! Daily and Weekly options exist but are considered to be the riskiest and are typically only used by the seasoned experts.
Longer term options give the stock more time to move towards your expected price points and allow your theories time to play out. Longer term options are the better option for regular retail investors as it adds a lot of breathing room to see if you are in fact on to something.
Additionally, longer term options contracts can be sold to other investors if you suddenly find the trade has turned against you early on and no longer falls within your price predictions. The time value we discussed is worth money and the earlier you are in the contract the more that option’s time value will be worth.
Final Notes / Profit
Options Trading can be very enticing due to how lucrative and appealing it seems.
Remember though that great rewards also come with greater risks.
Be sure to gain plenty of real money trading experience before attempting to dabble in options trading.
This is a more advanced form of trading and for those who are less educated, can turn against them quite easily.
If you are convinced that you are ready I would highly suggest taking a closer look at some brokers and see what each broker can offer you. Be sure to look for as many resources as possible.
Knowledge is power, and having an advantage in the markets is key, use the tools provided to help you make informed and profitable decisions. Remember that your broker is going to be your partner when trading and you will want to trust them and turn to them when you are faced with questions.
If you can remember to not trade emotionally and follow all your trading rules then the sky's the limit and enjoy your trading experience!