Financial leverage can make options trading big winners or big losers. Speculators have the chance to increase profits from price movements while investors are able to safeguard their portfolios thanks to the leverage. The options market is constantly flooded with tempting opportunities as a result of this dynamic. However, prospective options traders require a thorough comprehension of how options pricing works, the risks involved, and the best methods for selecting the appropriate trading platform. We have compiled the fundamentals that every option trader should be familiar with and structured this trading options guide to address the most frequently asked questions.
How to Trade Options
The Fundamentals
- The two types of options as well as their definitions: calls versus puts
- how options are priced (in the money vs. out of the money)
- how option prices fluctuate (measured by the Greeks of options
- how to open an options account and begin trading
- how to avoid losing money.
Defined Call and Put Options
Options enable traders to place a leveraged wager on the price of a security in the future. There is a specified strike price and expiration date for each standard option, which grants control over 100 shares.
The holders of an option contract are not obligated to exercise their rights to purchase or sell shares. They can either sell the option contract to another trader for whatever that trader is willing to pay, or they can let the option expire worthless and lose the money they spent on it. They can profit without ever having to exercise the option or own the stock if the contract’s value rises. However, losses occur when the value decreases.
Puts versus calls
You can buy a security using call options at its strike price at any time before it expires. If the price of the underlying shares exceeds the strike price at expiration, the broker will automatically exercise the option. You can sell the security at the strike price at any time before it expires with put options. If the price of the underlying shares falls below the value of the strike price before the contract expires, the broker will exercise the option at that time.
Call options usually gain value as the price of the underlying security rises, while put options gain value as the price of the security decreases. However, there are a few fundamental factors that influence option pricing that every trader ought to be aware of, and the price of the shares that are underlying is just one of these factors.
American versus European
Buyers of call options can use their right to buy shares to take a long position in the stock. Purchasers of put options take advantage of their right to sell shares and open a short position in the stock. However, depending on the design of the option contract, the time at which a contract can be exercised varies.
European-style options can only be exercised on the date of expiration, whereas American-style options can be exercised at any time prior to the expiration date. However, both styles of options can be bought or sold until they expire. The majority of options on exchange-traded securities are American-style, while the majority of options on indexes are European-style.
Choose Cash versus Physical
The terms of an option contract are settled when it expires, ensuring that both parties receive what they are entitled to. Call options for stocks or other exchange-traded securities are settled by assigning the call option seller the obligation to supply the call option buyer with shares of the underlying security. If the seller already owns those shares, they are transferred to the buyer’s account from the seller’s account. The buyer still receives shares if the seller does not have them in their account, but the seller is given a short position in the security.
The contract for options on indexes is settled in cash. Option sellers are required to pay that cash from their account, while option buyers who find their contracts in the money at expiration will receive a cash equivalent of the intrinsic value of the option. Options that are out of the money will have no value and no cash will be transferred at their expiration.
How to Open an Options Trading Account Once you’re ready to get started in the options trading world, you’ll need to look into the brokers with which you can open an account. You can request approval for options trading after selecting a broker and filling out the account application, which is typically completed online and can be completed quickly.
Step 1: Choose a broker. You should go with a reputable online broker like Interactive Brokers, tastytrade, or E*TRADE because they provide you with essential options trading tools like options calculators, extensive charting tools, screeners, demo accounts, robust trading technology, a wealth of educational materials, and a straightforward fee structure.
Step 2: Create a user account. Options trading in your account may require approval from a broker in a variety of ways. Options trading approval may be tier-based at some brokers (lower tiers include buying and selling options; Spread trading, index trading, and selling uncovered options are among the higher tiers.
To demonstrate your understanding of options trading, some brokers may require you to take an online course or complete a questionnaire. The broker imposes all of these conditions solely for the purpose of controlling their risk. As a result, a broker is less likely to enforce such requirements if your account is larger or your net worth is higher.
Step 3: Donate to your account. After your application is processed and you are granted permission to trade options, you should review and agree to the terms of the options agreement and fund your account with more money than the minimum amount required. You will need to meet the margin requirements of your brokerage firm if you intend to trade options on margin. Meeting ongoing minimum balance requirements and promptly responding to margin calls are examples of this. Your account will be able to trade options when these are done.
Step 4: Examine strategies for options. Option trading is more complicated than stock trading because it needs to take into account important factors like volatility and time decay. Options trading strategies range from straightforward one-leg strategies such as buying calls or puts to more complicated multi-leg strategies such as iron condors. It is essential to comprehend the trade-offs that each strategy entails because all strategies have varying sensitivity to time, price changes, and changes in implied volatility.
bid
With a market order, the bid is the price at which you can sell the quoted option. It is the highest limit order price at which a buyer from any exchange is willing to pay for the contract you want to sell.
ask
With a market order, you can buy the quoted option at the ask price. It is the price at which a seller on any exchange is willing to sell the contract you want to buy at the lowest limit order.
Volume
Volume refers to the total number of option contracts that have been traded on this particular contract as of the present. Contracts with a daily volume of less than one hundred may experience wider price discrepancies between the bid and the ask.
Open Interest
Open Interest Option Contracts are included in open interest if they have been purchased and can still be exercised. The open interest includes both long and short positions because this number includes options that are initiated as either buys or sells.
strike price
The strike price is the price at which the buyer of an option can exercise their right to buy or sell (in the case of call options) or both. There is a strike price and an expiration date for each option contract.
Expiration Date
The option contract cannot be exercised after this date. The option buyer has the option to exercise their right up until this date’s close of trading. On the day after trading closes, options that expire in the money are automatically exercised.
Vega
The implied volatility sensitivity of an option contract is measured by this option Greek, or Vega. All other things being equal, the option contract’s price should increase by the vega value if the implied volatility of the option increases by one percentage point.
Theta
Another option Greek, theta measures the price decline of an option contract over the next 24 hours due to time decay. As the expiration date nears, theta values rise.
Delta
The sensitivity of an option contract to changes in the price of the underlying security is measured by delta, which is an option Greek. The option contract should increase in price by the delta value (all other things being equal) if the price of the underlying stock or other security increases by one dollar.
gamma
Greek option gamma, which is related to delta. It is the ratio of the delta score of an option contract to the increase in the underlying security by one dollar. The option contract should increase in price by the delta value for the first dollar increase and by the delta value plus the gamma value for the second dollar increase if the underlying stock or other security’s price rises by two dollars, all other things being equal. Gamma is a measure of this potential acceleration of option prices as a result.
At-the-money (ATM)
An option contract is said to be “at the money” if its strike price is closest to the underlying security’s current price. When two strike prices are equally priced, the ATM contract is subjective; however, it is common practice to designate the strike that is currently in the money as the option.
ITM (in-the-money)
Options that are in the money (ITM) have intrinsic value because the difference between the strike price of the option and the market price of the underlying asset is favorable, resulting in immediate value if the option is exercised.
OTM (out of the money)
Because the strike price is unfavorable in comparison to the market price, out-of-the-money (OTM) options have no intrinsic value. A decision to exercise an OTM option would be pointless.
When opening an options trading account, things to think about
Customer service: If you’re an option trader, you’ll need a broker that can be reached online or over the phone to respond quickly to questions about unusual notifications like balance changes, margin requirements, margin call notices, and so on. Additionally, a representative of the broker ought to be able to provide clarification on trade-related issues, particularly those pertaining to expiration, assignment, and closing out spread trades.
Commissions and fees: Even though they do not charge commissions for stock trades, some brokers charge commissions for option trades. Because some brokers prefer to deduct some or all commissions from the customer transaction, the costs of commissions and fees can vary greatly. This guide can be a great resource for learning more about the fees charged by the best options trading platforms.
Minimums for accounts: Opening an account for stock and option trading no longer necessitates a minimum deposit of several thousand dollars. Customers can open accounts with most brokers without having to immediately fund them.
Tools for research and trading: The best options trading platforms provide traders with fundamental, technical, and even exclusive research. Compared to mobile-based apps used by some of the newest brokers, such as Robinhood, Webull, and eToro, online web-based brokers typically provide a more advanced trading toolset. When carried out on software-based desktop trading platforms, sophisticated charting tasks result in greater productivity. The same holds true for complex order types like branching orders and conditional orders.
Educational materials: Numerous online brokers now frequently use highly instructive articles, videos, online classes, interactive quizzes, and other forms of content. Option traders who also create educational content for social media platforms feature the most widely used broker platforms. If you find it difficult to find educational content for your trading platform, take that as a red flag.
Account demo: Demo accounts are included in the best options trading platforms so that customers can fully comprehend how options Greeks and shifting market conditions affect options prices. A trader can use these practice accounts to practice making trades using the same trading platform interface. For traders who are just getting started with options trading, this can be very helpful. However, not all brokers offer this tool, so novice traders may want to check out the investopedia simulator if their broker does not offer tools.
FAQs:
Are Futures and Options the Same Thing?
The buyer of options is not obligated to exercise their right to purchase shares, which sets them apart from futures. However, unless they sell the contract before its expiration, futures buyers are obligated to take delivery of the underlying commodity. This indicates that, in contrast to futures, option prices can be highly affected by time decay.
How can options be used to hedge?
The purchase of put options to safeguard against catastrophic price drops is the most common use of options for hedging large portfolios or positions within a portfolio. In the sense that you are paying a premium for the protection, this is comparable to purchasing insurance. Even if the bad thing doesn’t happen, you can still benefit. In either case, unless you can sell the contract for more than you paid for it, you won’t get the premium back. Option contracts can be used to hedge any portfolio position as long as you are willing to pay the contract prices.
Leap Options: What Are They?
Publicly traded options contracts with expiration dates that are longer than one year and typically up to three years from the time they are issued are referred to as “long-term equity anticipation securities” (LEAPS). They function just like the majority of the other options on the list, with the exception of having longer expiration dates.
How much cash is necessary to trade options?
The amount of money a broker needs can be as little as one thousand dollars. The majority of brokers have minimum account sizes of $2,000 or less. However, it is not wise to trade an option account with only a few hundred dollars. When a trader uses only a small portion of their available capital on any given trade, option trading strategies perform best.
