Investing > Options Trading for Beginners

Options Trading for Beginners

Are you looking to enter the world of options trading? This guide has everything you need to know.

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Updated January 15, 2021

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Here to learn how you can make the most of the options trading boom? 📈

Since COVID-19 stay-at-home restrictions were announced, options trading volumes have soared across all platforms, with no signs of slowing. The Nasdaq, CBOE, and ICE are all seeing a volume increase of around 50% in comparison to this time last year.

Given the market’s volatility, many people see now as a great time to enter the market. What could go wrong, right?

The issue is that options trading can be quite complex: without the right strategy in place, and an understanding of the ins-and-outs of options, you could be setting yourself up for unlimited losses. So what exactly should you watch out for? And what are the best tips to give you a leg up?

In this guide we will break down six of the most popular options trading strategies. We’ll highlight the risks to watch out for, along with our three best tips to help you triumph. To finish, we’ll give you the four steps to get your options trading journey started. 

Ready to get nerdy? Let’s dive in! 🤓

What you’ll learn
  • Options Explained Simply
  • The Functionality of Options
  • Benefits of Options Over Stocks
  • Options Strategies (with examples)
  • Risks to Watch Out For
  • Tips for New Options Traders
  • How to Start Trading Options
  • Beginner Options Trading FAQs

Options Explained Simply 👨‍🏫

As we said, options trading can seem quite tricky at first, so let’s start off with what an options contract is. An option is a contract that gives the owner the right (but not the obligation) to buy or sell an underlying asset, like an ETF, or stock at a pre-agreed price over a specified period of time. Traders buy and sell options on the options market, by trading contracts based on the relevant security.

What are Puts and Calls?

There are two kinds of options: Calls and puts. When you buy an option that allows you to purchase shares at a later date, you’ve bought a call option. These are currently being swept up by traders believing that U.S. stocks will run higher. When you buy an option that allows you to sell shares at a later date, you’ve bought a put option. In short, a call option allows you to buy shares, and a put option allows you to sell shares.

An infographic explaining the difference between put and call options.
Understanding the difference between put and call options is the first aspect of understanding options.

Are Options and Stocks the Same?

Don’t get these two confused—options trading and stock trading are not the same. The key difference is that investing in options does not give you ownership in a company. 

With that, although futures use contracts in the same way options do, options offer less risk because you can withdraw (or walk away from) an options contract at any stage (there is  zero obligation). Therefore, an option is priced based on a percentage of the underlying asset or security.

The Functionality of Options ⚙️

Now we’ve highlighted the basics, how does options trading work? When you buy or sell options, you have the right to exercise the option at any stage up to the date of expiry—so buying and selling options doesn’t mean you need to exercise it at the very last moment.

Because options work like this, they are known as derivative securities. This means their price is derived from something else (in this instance, from the value of assets like securities). Due to this, options are typically known to offer lower risk than stocks—when used in the right way.

Essentially, buying options is a bet that a stock will go up or down in price. The price you agree to buy the option at is called the “strike” price, and the fee you pay is known as the “premium”.

When calculating the strike price, you are trying to predict whether the asset will rise or fall in value, so that you can make a profit. The price you pay to place your bet is a premium—and is a percentage of the value of the asset.

Benefits of Options Over Stocks ⚖️

Many experts are making compelling arguments that there’s no better time to be an options trader, as trading options offer several advantages. The Chicago Board of Options Exchange (CBOE) is the biggest such exchange in the world. 

With this, options offer traders the chance to gain access to stocks that they don’t have the money to buy directly. Options can be bought for a fraction of the price, and if the option moves the same percentage as the underlying stock, traders can earn the same amount as investors who own the stock would.

Further, options can be found on a wide variety of single stocks, indexes, and ETFs. With these, you can implement options strategies that focus on buying or selling single options, up to far more complex ones that account for multiple option positions.

Understanding and executing the right strategy is crucial for long-term success: it helps you avoid making emotively driven decisions, and stay focused among all the chaos that comes with 24 hour news and economic data—all of which can seriously set you down the wrong path. To help you get the most out of your trading, we’ve outlined some of the most loved (and effective) options strategies out there.

Options Strategies with Examples 🎯

1. Covered Call 

Image courtesy of Fidelity.

Pros

  • Allows you to earn income from your holdings
  • Helps you benefit from 3 movements of your stocks; rise, marginal fall, sidewise

Cons

  • Unlimited risk with a limited potential for reward

A covered call strategy is when the investor selling the call options already owns the equivalent amount of the stock. Selling the call obligates the trader to sell a stock they already own at strike price A if it gets assigned. The investor’s long position in the asset “covers” the trader because the seller can deliver the shares if the buyer decides to exercise. 

In some cases, investors will run a covered call once they’ve seen attractive gains on the stock. More often, the trader will sell “out-of-the-money” calls, so if the price of the stock rises they can let go of the stock and still make a profit. This strategy can also be used to make some income on the stock far beyond any dividends. In this case, the aim is that the options expire worthless.

Key Covered Call Facts

Best suited toWhen it should be used
Best suited to:Rookies or higher
When it should be used:When you neutral, or more bullish, and you are ready to sell the stock if it reaches a certain price
Break even at expiration:Current stock price minus the premium received when the call was sold.
Maximum potential for profit:Once the call is sold, the potential profit is capped at the strike price minus the current stock price, and plus the premium received for the call.
Maximum potential for loss:You will earn a premium when you sell the option, but the downside risk mostly comes from the stock you won, which has the potential to drop in value. However, when the option is sold, “opportunity risk” is created. This means that if the price of the stock soars, the calls may be assigned causing you to miss out on the gains.

2. Protective Put

Image courtesy of SlideShare.

Pros

  • Strategy defines risk, giving traders strong upside potential. There is a diverse level of protection which depends on the strike price selected

Cons

  • The hedging will cost you. Though a married put is more conservative than a long stock position, it does have more safety features.

A protective put is another risk management strategy for options to safeguard against a stock or asset dropping in value. To benefit from this strategy you buy a put option for a premium.

Protective puts are commonly used in place of stop orders too. The issue with stop orders is that sometimes they work when they’re not supposed to, and when you’re praying they work, they don’t work in the slightest.

For example, if the price of a stock is fluctuating but not quite tanking, a stop order could be useful to remove you prematurely. In this case, you’ll probably regret it if the stock rises again. 

Another example is that when a news event happens overnight and the stock drops significantly, you might be too late getting out at the stop price. Instead, you might get out at a far lower price. 

With a protective put, you will have full control over when to exercise the option, as well as the price you’ll get is predetermined. However, these benefits do not come free of charge. While a stop order is free, a put will need to be bought. 

So if the stock increases in price you have enough to cover the premium you initially bought the put for, at least. Buying a protective put and a stock at the same time is known as a “married put”. 

Key Protective Put Facts

Best suited toWhen it should be used
Best suited to:Rookies or higher
When it should be used:When you are bullish but unsure
Break even at expiration:As soon as the protective put is in place, the price of the stock plus the premium is the break-even point.
Maximum potential for profit:Maximum potential for profit is unlimited.
Maximum potential for loss:Risk is limited to the current stock value minus the strike price, or the “deductible”.

3. Collar

Image courtesy of The Options Guide.

Pros

  • The trader owns the underlying asset which gives some benefits like voting rights and dividends
  • Risk is limited

Cons

  • Profit is limited

The collar, or otherwise known as a hedge wrapper, can be used to protect against substantial losses. You can create a collar position by buying an out-of-the-money put option while writing an out-of-the-money call option at the same time. 

The put offers some protection in the event of a stock falling in value. When you write the call, you produce more income (which technically should cover the amount you paid for the put) and earn a profit on the stock. This profit will be capped at the strike price of the call.

For example, if you are long 1,000 shares of ABC valued at $60 per share, and the stock is trading at $67 per share. You will be wise to hedge your position temporarily due to the rise in volatility.

Key Collar Facts

Best suited toWhen it should be used
Best suited to:Rookies or higher
When it should be used:When you are bullish but unsure
Break even at expiration:As soon as the protective put is in place, there are two break-even points: 1. If implemented for a net credit, the break-even is the current stock price minus the net credit. 2. If implemented for a net debit, you can break even with the current stock price plus the net debit.
Maximum potential for profit:Profit potential is limited.
Maximum potential for loss:Risk is limited.

4. Long Call and Put Options 

Image courtesy of Quantinsti blog.

Pros

  • High profit potential
  • Don’t need to have a large amount of money upfront to buy the underlying asset

Cons

  • Significant upfront payment needed to buy the call. Note: A long call spread can be used to minimize the cost
  • Potential for negative impact as the expiry date nears

This strategy is so simple that you’ll wish you discovered it sooner. Basically, if you have a high certainty that a stock’s value will increase, you can buy a call option instead of buying the stock itself—which might be too expensive in the first place. In the same sense, you can buy a put option if you want to bet that a stock’s value will lower. 

However, situations where you can make bets like this with confidence will come few and far between. But, if the opportunity arises, long call and put options might just be your ticket to profit—the premiums come low in comparison to your profit potential, and you can close your position at any stage.

That said, do ensure you complete your trade before the expiration date, or you will make a grand total of $0.

Key Long and Put Call Option Facts

Best suited toWhen it should be used
Best suited to: Veterans or higher
When it should be used:When you are bullish
Break even at expiration:When the option reaches strike A plus the price of the call.
Maximum potential for profit:Unlimited profit potential (Note: A stock has yet to reach infinity).
Maximum potential for loss:Risk is limited.

5. Straddle

Image courtesy of Nasdaq.

Pros

  • Long straddles are long volatility strategies
  • Limited downside and unlimited potential for profit

Cons

  • Usually priced accordingly
  • Can be expensive without an understanding of volatility

A straddle strategy consists of buying a call option and put option simultaneously, usually with the same expiration date and the current price of the security.

A straddle option trade will profit when the price of the security changes enough in either direction to compensate for the cost of both the call options’ and put options’ premiums.

Option traders use the straddle options strategy when they are unsure about the direction of an upcoming price change, but are confident in the intensity of the price change.

While this kind of situation can arise for a variety of reasons, straddles are most often used when there is a significant event that is set to occur on or around a specific date.

Press conferences and news releases are common events where traders expect significant price changes but are not confident about the direction of the price change. Straddles can offer relatively low-cost access to substantial profits with little downside risk, which is merely that the price change is not significant enough to cover the cost of both premiums.

Key Straddle Facts

Best suited toWhen it should be used
Best suited to:Leave it to all stars.
When it should be used:When you’re not expecting much movement on the stock—it should stick almost on point to strike A.
Break even at expiration:Strike A minus the net credit and strike A plus the net credit.
Maximum potential for profit:Profit is limited.
Maximum potential for loss:Theoretically unlimited losses if the stock rises. If the stock falls losses can still be substantial, but limited.

6. Strangle

Image courtesy of Wikipedia.

Pros

  • The potential for unlimited returns. 
  • Losses are limited to the value of the options you paid.

Cons

  • Time is of the essence.
  • Downside is limited but still significant.

The strangle is similar enough to a straddle strategy but traders often utilize it for larger price movements. To implement a strangle, you should buy a put and a call option simultaneously, ensuring that they both have different strike prices—the put should be lower and the call should be higher.

A wider spread means that you will have lower premiums, but it also means that a more dramatic price will need to occur in order to make a profit.

When you sell two options, you increase your income substantially from what you would have made from selling one alone. But this also raises the risk involved you are exposed to—which is unlimited. Like the straddle, more advanced traders could use this strategy to benefit from a lowering of implied volatility. 

For example, sometimes implied volatility is unusually high for no valid reason, meaning the call and put could be overvalued. After the sale, you wait patiently for the volatility to fall and close the position to cash in on a profit.

Key Strangle Facts

Best suited toWhen it should be used
Best suited to: Leave it to the all stars.
When it should be used:When you’re not expecting much movement on the stock—it should stick almost on point to strike A.
Break even at expiration:Strike A minus the net credit and strike A plus the net credit.
Maximum potential for profit:Profit is limited.
Maximum potential for loss:Theoretically unlimited losses if the stock rises. If the stock falls losses can still be substantial, but limited.

Danger Alert: Risks with Options ⚠️

Potential for Unlimited Loss 

Theoretically, writing options can have potential for unlimited loss, beyond the premium you initially invest. For example, if the market goes against your position, your losses can escalate. If you don’t own the underlying asset, writing options is riskier because you need to provide the underlying security if you exercise against it.

Option Contracts Might Lose Value

Every option comes with an expiration date, and as such its value decreases over time. The decrease in value accelerates quicker the closer it gets to the expiry date. Additionally, market factors like volatility and changing interest rates can affect how much the option is worth.

Options are Complex

Don’t underestimate the complexity of options trading, especially if you are offsetting positions. If you don’t fully understand this strategy then doing this in and of itself is a risk. Before you begin trading options, ensure that you have a strong understanding of both options, the risk(s) you face, the best options trading strategies available to you, and then talk it out with your broker.

Pro Tips for Beginner Options Traders 💡

As we’ve seen, trading options comes with risk, and complexity. In unusual market conditions, as we’ve seen throughout COVID-19, options can present an even greater challenge if you don’t fully understand them. Luckily, we have outlined some options tips for today’s market.

Use Volatility to Your Advantage ⚡️

COVID-19 has caused some tumultuous volatility on the options market. Over the past several months, stocks have shown some of the biggest gains on record. The Australian market has also recently recovered from losses that occurred over 2020, which were driven by the announcement of the COVID-19 vaccine—all of which is reflected in the prices of options.

Volatility is an often overlooked part of options trading, but in today’s market conditions it needs to be considered. The secret to know is that, even if a stock you own moves in the right direction, the option might not always reflect the stock’s move. Sometimes this is because of implied volatility which, in this case, is the market’s expectations for future volatility.

Set yourself up for success by getting to know both how implied volatility, and historical volatility will impact the value of your options contract.

Look for Dividends 💸

Don’t fall prey to focusing solely on the direction the option moves. Of course, this is important, but it’s not everything: the potential impact that dividends has on the value of options is another nuance that is important to familiarise yourself with—especially with options trading.

Before you initiate an options trade, find out if a dividend is paid and if it is, when it is payable. If the stock pays a dividend, you should examine if the option is in-the-money or near it. If the dividend is more than the time value of the option, then the stock may be assigned (i.e. you could exercise the option to receive the dividend and then sell the stock).

Manage Risk 🚧

Prevention is the best cure, as they say. The best way to succeed in options trading is to actively manage your positions and adapt as necessary. 

And during such uncertainty you might be best keeping your eyes particularly focused on open positions. In an interview, Greg Steven, vice president at Fidelity, said in an interview that traders should not just set options and forget about them, but rather, there are several choices to consider throughout the life of the option. 

He said: “When an options trade is open, there are several choices you may make throughout the life of the contract—including closing out the trade, letting the option expire, and if you still want to be in the position, rolling it out.” That said, if you sell an option, assignment is no longer in your control.

How to Start Trading Options (in 4 Steps)

Now that we’ve covered the strategies, risks, and tips, let’s get into how you can start your options trading journey in four quick steps.

Step 1: Learn (More) About Options 📚

Before you begin trading options, read our options trading guide to familiarize yourself with options trading. If you’re thinking about trading, review the specifics, including the expiry date, risk involved, and the style of the option for the stocks you find most appealing before buying. A lack of understanding of any of these can really cost you.

Step 2: Choose a Suitable Online Options Broker 🤝

A lot of online brokers offer clients access to options, but some quality online options brokers are better than others. Make sure to confirm that the broker is safe and well regulated first and foremost. 

Secondly, make sure sure the broker offers a wide selection of asset classes, especially the ones you want to trade most. Considering that options are for more advanced traders, you might need to qualify to trade options with some brokers.

Step 3: Get Some Practice Trading Options 👨‍💻

Sure, options trading offers the potential for significant gains. But rather than going into it headfirst, get a feel for the trading environment by using a demo account first. This will help you make sense of the mechanics of options trading, give you a feel for the broker’s platform, and allow you to test your strategy—risk-free.

Step 4: Fund Your Account 💰

Once you’ve had a feel of what it’s like to trade options and are happy to get started, just fund your brokerage account with the minimum initial balance required, which varies from broker to broker. Always ensure that you have enough funds with your broker to support your strategies, and again, be aware of how much you stand to lose with each trade.

Pandemic Induced Options Trading: Full Speed Ahead

Since the COVID-19 stay at home requirement was enforced in June, a massive sub-industry in options trading and a rise in equities trading is continuing to grow. And as Tesla just joined the S&P500, learning how to play it with options could help you effortlessly earn some cash.

Young millennial male checking his options trades on a laptop.
Options trading is continuing to see record numbers following the COVID-19 pandemic.

Equity options trading hit record highs in November, carrying on the crazy trend that started at the beginning of the year. Equity option trading is now 50% higher than this time last year across all options platforms. Here’s some stats for equity options (volume).

  • Nasdaq: 49%
  • CBOE: 51%
  • ICE: 58%

Bitcoin (BTC)’s implied volatility has also risen to 81%, influenced by the demand for call and put options. This is the largest increase since May, after starting the month at 58%. 

From this, we can see traders are embracing options at an unprecedented pace. Steve Sosnick of Interactive Brokers said in an interview:

“I attribute some of the popularity to the lockdown… People were stuck at home, many with $1,200 checks or rent/loan moratoria and no sports to watch or bet on. So they went to the stock market, then realized that options have similar payoff structures to sports bets.”

The biggest risk with this, according to Sosnick, is mean aversion. Traders can get caught in a losing streak. With risky calls, it doesn’t take much to lose money within a few days. 

Sosnick goes on to say that he recognizes traders are smart and are trying to get educated. But the best education will be for those that stick around to see a full cycle, which hasn’t come for newer options traders who only entered the market around March.

Beginner Options Trading FAQs

  • How Much Money Do You Need to Start Trading Options

    Really, the amount you need to start trading options will depend on the strategy you choose. Technically, you could start trading with just $100, depending on your broker. However, you will need to make sure your strategy is carefully calculated and thoughtfully implemented.

  • Which Option Strategy is Most Profitable?

    If we were to highlight one strategy as the most profitable, we would argue that it is that of selling puts. This strategy is a bit limited because it works best in a rising market. That said, it offers many advantages, and even IM puts can result in huge returns in the long term due to time decay, no matter how the market turns.

  • Can You Trade Options on Robinhood?

    Yes, you can trade options stocks and ETFs on Robinhood, and all for free. The broker charges no commission and no per contract fee for buying or selling options. Better yet, there are no assignment or exercise fees to worry about either.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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