What attracts thousands of investors and traders to start trading Options is the lure of making windfall profits on a cheap Option! But is Options trading really such a wonder? In this article, you will find Options Trading basics explained in the language easy enough for even a 5-year-old. This is a definitive guide to trading options profitably. I will cover basics of options trading for beginners, options trading terminology, quick tip on choosing correct Options strike price and maturity, and vanilla options trading strategies.
Let’s begin by answering the basic questions first. What are Options and how to start trading options?
This article contains rich content to be classified as a Beginner’s Options trading tutorial or Guide to Options trading for beginners.
Options Trading basics as explained to a beginner
What are Options?
An Option is a contract giving the buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price on or before a certain date.
In simple words, an option buyer pays a premium (like token money) to a seller to buy certain goods after a set period of time at a price agreed on date of purchase.
The Option premium or token money is paid upfront. The rest of the money is paid “if and when” the buyer exercises his right and takes possession of the goods.
All that you just read in the last 2 sentences fall in the list of Options trading terminology, which I have clearly explained along with other points on Options trading basics further ahead. I have also explained how to pick the correct Options strike price and maturity.
Options are derivative instruments which seem lucrative in terms of percentage return that they can offer. Apart from stocks, bonds, forex, ETFs, mutual funds, investors also invest money in Options. If you trade in Options while being careful on the pitfalls and benefits of Options, they offer benefits that stocks and ETFs cannot.
Options are part of the derivatives family because they derive their value from an underlying asset. What does it mean? An instrument whose price moves in some relation with an “underlying asset” is called a derivative.
Prices of Futures, Options, warrants etc. depend on prices of their underlying securities. For example, IBM futures price replicates IBM’s price movement. Every moment, its price moves in tandem with IBM’s stock price.
Options on the other hand are a different animal. To know more about IBM Options’ price movement, relation and dependency on IBM stock, please visit Investopedia Option Pricing article along with this series of Options Trading basics explained.
And look no further than the latter half of this article if you wish to make Options trading as a career. Keep in mind, you should take it as a career, not a side hustle.
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If you want to know more about the important elements of Options trading, you can see this Complete Udemy video on introduction to Options trading
In the paragraphs below, I have further explained basics of Options Trading with several examples.
Options can give you plenty of trading leverage. It simply means far less trading capital required than when trading ETF or stocks.
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OK, but what are the different types of options I keep hearing about?
There are two categories of options: Call options and Put options.
A call option gives the buyer the right to BUY the underlying asset.
A put option gives the buyer the right to SELL the underlying asset.
However, note that the buyer of the option is NOT obligated to buy or sell the underlying asset.
There are many types of options but since this is more of a detailed guide on the basics of Options trading for beginners, I will be talking only about “vanilla options”.
These are simple CALL and PUT options having no special or unusual features. The primary differences between vanilla and exotic options are as follows. Exotic Options:
- are more customizable
- have more complex features
- are generally traded over the counter
- can be combined into complex structures.
Long? Short ? Are you talking about my new dress?
This is not the textbook-stated options trading terminology but a commonly used one. Going long an option means buying an option while going short (or shorting) an option means selling an option.
This is the same as going long and short an underlying asset. An underlying asset, by the way, is any asset such as stock or gold or forex.
Can you further explain options trading basics with some examples?
The essence of this article is what you will see here: Simplified version of Options Trading basics explained along with examples of Option trading fundamentals, Option trading steps, and Options strategies.
Now let’s see “how to start trading options” with an example. Note that I have mentioned the correct options trading terminology in brackets wherever appropriate.
Let’s say you want to buy a bicycle, and you find the perfect one at the right price: $1,000 (specified price or strike price).
However, at the moment, you don’t have a thousand dollars, and won’t get salary for another three months, say due to Covid-19 job situation. You discuss this with the seller, and he agrees to sell the bicycle at $1,000 after 90 days (expiry date or maturity date), but he asks you to pay $50 (option premium) as token money.
This explanation is a hypothetical example for CALL Options.
There are 3 situations now.
- After three months, you didn’t get your salary and therefore you don’t have the money to buy the bicycle at the agreed price of $1,000. In this case you will lose the $50 token money as well as the right to buy the bicycle.
Or it could also be possible that you see a similar bicycle in Decathlon priced at only $500. Since you bought an option and not the bicycle itself, you are under no obligation to keep your word (exercise your option) of buying the bicycle at $1,000. You can opt not to buy it at all and simply let the contract expire. However, you lose $50 token money. - After 90 days, you get your salary and pay the remaining $950 and take delivery of the bicycle.
- After 80 days (10 days before expiry), you discover that there is a shortage of those kinds of cycles, especially in upcoming race participants. Some of them are even ready to pay $2,000 for a new such cycle. In that case, since you had the right to buy the bicycle (exercise your option), you actually buy it IMMEDIATELY for $1,000. Subsequently, you sell it to a race participant, netting you a profit of $950 (actually a bit less – read option pricing to know more)
The option seller in all the cases pockets the $50 option premium irrespective of whether you purchase the bicycle or not.
Put Options: To further explain Put option trading basics, I would say that it is just like an insurance policy. You can purchase put options to buy insurance on your portfolio. For instance, if you fear that a panic / crash is approaching, and you want to protect (hedge) your portfolio, you can purchase a put option.
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Why trade Options?
Before you think about trading Options full time as a career, do read this section to understand why people generally trade Options. Keep in mind, you should take Options trading as a career, not a side hustle.
There are by and large three reasons why traders trade options:
- Generate regular income: certain option trading strategies if properly implemented can help you achieve that.
- Speculate: with options trading, a trader can potentially profit from stock market movement in any direction i.e. not just when the market or a specific stock rises, but also when it plummets.
- Hedge risks in their portfolio by trading Put other types of hedging Options strategies.
If you buy an option on a stock instead of buying shares of the stock itself, you commit much less money than you would need to buy the stock outright.
Since an Option is like a promise to sell from a seller’s perspective, a buyer has to pay just a little token money so that the seller is made liable to honor his promise and deliver the underlying asset at agreed contractual terms.
Options trading terminology & characteristics
I will elaborate these key points of Options Trading basics before taking you on a journey to help start trading Options.
Options, a derivative instrument, have the following characteristics:
- Strike price — contractually agreed price to buy or sell the underlying asset
- Spot price of underlying asset
- Time to expiry — time to Maturity date or expiry date
- Volatility of underlying asset
- Risk-free Interest rate – the current federal bank interest
Strike price
Strike Price is $1,000, as described in the Options trading basics example with bicycle as underlying asset. You can think of Strike Price as the contractually agreed price between the buyer and seller which will be used to exchange underlying asset and cash at maturity.
I will further explain that picking up the right Options strike price and maturity is the key to Options trading success
Spot price
The Spot price of the underlying asset is the prevailing price of the bicycle. For example, lets say 40 days after your purchase of the bicycle option, a cyclist approaches the seller and expresses his desire to buy the bicycle by paying him $1250 instead.
He just wants to be the owner of that bicycle after 50 more days and is ready to pay $200 more token money. This way he wants you to move out of the picture and now have the contract between him and the seller.
This $1250 is the Spot price of that underlying asset (bicycle) and $250 new token money is the current price of Option premium.
Time to expiry
Option pricing has a crucial component: TIME. Option premium is directly proportional to time to expiry (or maturity).
Lesser the time to expiry, lesser the remaining option value (also called the time value). For a one-week expiry OTM option, if the stock remains range-bound, the option will massively loose its value with each passing day.
Given the same underlying asset, strike price, volatility and interest rate, an Option expiring in one week will be far less valuable than a three-week option. This unfavorable feature is called time decay.
Volatility
Volatility is a statistical measurement of the degree of fluctuation of an asset. The financial or mathematical definition of volatility is: “standard deviation of asset returns”.
Higher volatility (say ‘vol’ to cast an impression on your boss) means higher Option price. This is because increased uncertainty boosts the expectation of possible larger price swings either side: up and down. Greater and more frequent price swings will increase the likelihood of such an event occurring.
If the volatility of the underlying asset increases, big moves increase the probability of further moves.
Well, volatility is another factor which helps in deciding how to pick the right Options strike price and maturity. Let’s see this in the latter part of this article
Out-of-money (OTM) and In-the-money (ITM)
Another important point in Option trading basics is the understanding of the concept of OTM and ITM. The Strike price with respect to Spot price can be used to define another Option terminology: OTM and ITM. Based on the Options characteristics & terminology used in options trading, I have articulated the differences between in-the-money and out-of-the-money options below.
An ITM option has a favorable difference between the underlying asset’s current price and Option’s strike price.
For ITM call options, this means the underlying asset’s current price is greater than the Strike price. In case of ITM put options, it’s just the reverse i.e. the underlying asset’s current price is less than Option Strike price.
For example, a call option has a strike price of $15 and the underlying asset’s market price is $13.5. This means the option is OTM. If after a week, the strike price rises to $16, the option will become ITM
An OTM option has an unfavorable difference between the underlying asset’s current price and Option’s strike price.
For OTM call options, this means the underlying asset’s market price is less than the Option Strike price. On the contrary, for OTM put options, the underlying asset’s current price is greater than Option Strike price.
Let’s say a put option has a strike price of $15 and the underlying asset’s market price is $13.5. This means the option is ITM. If after a week, the strike price rises to $16, the option will become OTM.
An ATM option (At the money) is an option where the underlying Spot price is almost equal to the strike price.
Can options trading be a career?
The short answer is YES. In fact you should treat any kind of financial trading including Options trading as a career, either part time or full time. See the following screenshot from Glassdoor about Options traders salaries in 2021.
You need to work your way up if you want to make Options trading as a career and be employed by an investment bank or a hedge fund or even a small Asset Management Company. You need to have
- great attitude & aptitude,
- good enough math & calculation skills,
- formal financial education,
- little trading experience (personal or professional), and
- a strong trading personality who doesn’t panic or gets stressed easily.
On the other hand, if you want to make options trading as a career as an individual, you need to fine-tune your personality to become a disciple of these 3 principles:
- military-grade discipline,
- zero-emotions when trading (no fear, greed, panic), and
- patience & loneliness-lover
Once you create a strategy, you need to follow it with military grade discipline. Do not deviate from the rules of your strategy, no matter how the market behaves. Think about the reason you wish to initiate the trade before you press the buy/sell button. Think about the Stop loss price where you will gracefully exit with a loss, and the Target where you will book profits.
Three types of emotions are common in a newbie’s mind while trading: hope, fear and greed. When in profit, will you risk more and increase your position size? If your trade is now in loss, will you exit ASAP without blinking an eye or will you evaluate whether quitting now is the right thing to do?
Hope is a mixture of greed and fear. It is one of the worst emotions for a trader. You hope for your trade to return back in profit whenever you are in loss. if you are in a loss making trade, do you keep holding the trade for the price to reverse and allow you to exit at break-even?
You further need to look at two other points that come in way of finding if options trading can be a career for you.
Creating and testing a strategy or a trading system is sometimes very boring and repetitive. You