2021 Options trading basics explained to a 5yr old. Options trading terminology

Options terminology, strategies, examples

Options trading basics explained

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.

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.

tradingview stock screener

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.

FiveStepGuide may earn an Affiliate commission if you purchase through links on this page.

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.

OK, but what are the different types of options I keep hearing about?

There are two categories of options: Call options and Put options. 

call-option-1138476

A call option gives the buyer the right to BUY the underlying asset. 

put option

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.


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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.

buy sell cartoon

There are 3 situations now.

  1. 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.
  2. After 90 days, you get your salary and pay the remaining $950 and take delivery of the bicycle.
  3. 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:

  1. Generate regular income: certain option trading strategies if properly implemented can help you achieve that.
  2. 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.
  3. Hedge risks in their portfolio by trading Put other types of hedging Options strategies.
bull bear

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:

  1. Strike price — contractually agreed price to buy or sell the underlying asset
  2. Spot price of underlying asset
  3. Time to expiry — time to Maturity date or expiry date
  4. Volatility of underlying asset 
  5. 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.

options traders salaries

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 will need to have patience for the trade to move profit. Several days will also come where you will feel all alone sitting in front of your computer for many hours, especially if you are day trading. A trade won’t be profitable or loss-making as soon as you initiate it or even in a few hours. You will need to really wait, be patient, and not succumb to the annoyance of a stagnant price.

But if you follow whatever has been described in the paragraph above, and work on the options trading rules of thumb, you will indeed find options trading as a career suited for you.


Options trading basics - Chapter 1 (Introduction to Options)
Options trading basics explained

The comprehensive guide with simple explanation of Options Trading basics for beginners. Options trading terminology. Pick right strike price & maturity

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Conclusion

I hope you enjoyed reading this article. In subsequent articles in this Options Education series, I will explain more on all the above-mentioned points and write more on some advanced topics.


Thank you for reading this article. I have written several other such Investment knowledge related articles in other sections on this website.

If you liked this post, kindly comment and like using the comment form below.


Frequently Asked Questions (FAQ)

What is the Payout of an Option expiring out of the money?

For a CALL out of the money (OTM) Option, the Spot price is less than the Strike price.
For a PUT out of the money (OTM) Option, the Strike price is less than the Spot price.
On maturity, an out of the money (OTM) Option doesn’t have any juice remaining. There is no reason for a buyer to exercise an out of the money (OTM) Option since its not in profit. However, the seller will pocket the premium paid by the buyer as well as not be obliged to deliver the underlying (in case of physical settlement).
Out of the money (OTM) Option on expiration date –> Buyer bears a loss equal to premium paid. Seller makes a profit equal to Option premium

What are Naked Options?

When a Option seller doesn’t hold the underlying instrument, the Option position is called Naked Options.

What is the difference between American Option and European Option?

American Option: an option contract which can be exercised at any time on or before the maturity date. For instance, lest say you bought AAPL options on 06-Jan-2021 when AAPL stock price was $127. If AAPL stock price rises on 11-jan to $130, the Call option maturing on 15-Jan will be in-the-money (ITM) and therefore profitable. At this point in time all stock options traded in USA are American-style. This means you can profit in 2 ways: sell the option OR exercise the option.
European Option: an option contract which can be exercised only on the maturity date.
Bermudan Options? In a Bermudan option, the buyer can exercise the Option on assigned exercise dates (specified days in the contract) before expiration. It is a kind of mix of an American and a European Option.

Should a buyer sell or exercise an option if it’s in-the-money?

Both selling and exercising an option is practical only when its in-the-money (ITM).
The terms of contract on most stock options brokers disallow you to open a new position on expiry day. All options contracts are generally set sold in the open market about 1 hour before it expires.
If you wish to exercise,
When you exercise an option, you pay Exercise fees. When you sell an Option, you pay Options brokerage. You may decide on whether to sell an option or exercise and option based on whichever has lower charges in your brokerage account.
The other reason is tax. Option exercising can have a different tax obligation than Option selling. You need to be aware of this and should ensure you take the route which has lower tax obligation

What is Options Assignment?

An Assignment is an obligation of a seller while Exercise is a right of a buyer. In other words, when the buyer of the Option exercises his right to buy or sell, one seller is randomly identified by the exchange to be asked to deliver the underlying (physical settlement). This is called Option assignment. The seller is assigned to fulfil his obligations of the options contract. This happens only in case of Amercian style Options.
For instance, on 6-Jan-2021, you sold AAPL $130 Call Option. The price of AAPL rises to $131 on 11-Jan-2021. In such a case, it is possible that some buyer would exercise his Option. On random selection by the exchange, if you are identified, you will be “Assigned” the option to honor the contract and close your position and pay the difference between your Selling price and closing price (cash settlement)

How does stock price movement affect Option price?

A call option price movement mirrors stock price movement if the option is in-the-money (ITM). he price movement in percent or dollar terms will NOT be the same due to Option being a non-linear derivative. However, the direction and speed of change will be exactly same.
More on this with an example. On 6-Jan-2021, AAPL was trading at $127. Assume that you bought an out-of-the-money (OTM) $130 strike price Call Option at $1 hoping AAPL price would move beyond $130 by 15-Jan (option maturity date).
On 15-Jan, if AAPL price were to finish at $132, your option would expire in-the-money with a profit of $1 (spot price of #132 minus strike price of $130 minus the purchase price of $1)
This way you would make profit on Option trading through predicting stock price movement

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