Trading options can make you a killing, like the options trader who made over a million in two days.
It does come with its risks though, you can lose everything in a matter of minutes.
Making sure you are doing your due diligence and coming up with a solid training plan are important steps in becoming a successful options trader.
If you are trying to learn more about trading options, keep reading this comprehensive options trading for beginners’ guide to discover the essential things to know before trading stock options.
1. What Are Stock Options?
Stock options, much like stocks, trade on the open markets. The difference being stock options are a derivative, or in other terms, the value comes from the underlying equity (stock.)
Buying an option gives the buyer the right to buy the underlying equity at a specified price on or before a specific date. Individuals will buy or sell options for various reasons, including:
- To protect against risk
- And for income
Stock options trading involves buying or selling a contract specifying what asset you are speculating will either increase or decrease in value. One contract consists of 100 shares of the underlying asset.
The contract will also specify what price (strike price) you believe the asset will reach, and by what date (expiration date) it will reach that price by.
2. Calls and Puts
Stock options are divided into two different types — calls and puts.
When it comes to a call option, the buyer of the contract is purchasing the right to buy the underlying asset. When it comes to a put option, the buyer of the contract is purchasing the right to sell the underlying asset.
Typically, an investor will purchase a call option in expectation the underlying stock will increase in value. In contrast, investors will buy a put option in expectation the underlying stock will decrease in value.
When purchasing a stock option, the trader pays a premium for the right to buy or sell the underlying stock at a specified price. The premium of a stock option is calculated from various factors affecting the price, including:
- Implied volatility (IV)
- The value of the underlying asset
- And time until expiration
Implied volatility (IV) is referring to the probability of movement in the underlying asset. For example, imagine you are considering purchasing a call option on Apple.
The premium is going to be significantly higher when the market is expecting Apple’s stock to move sharply in one direction or the other, like right before an earnings release.
One of the most important things to consider when trading stock options is volatility. Stock option premiums can quickly change prices, and if you are not ready, you can lose a lot of money.
This is one of the hardest things to understand when it comes to options trading for beginners. When volatility is high, the market is expecting more significant price swings than usual.
High volatility doesn’t predict the price of the stock will go up or down. It only predicts how much it is expecting the price to move.
5. The Greeks
Trying to understand how the price of an option will move is a difficult task, no matter how many years of experience you have. Luckily, there are a few metrics you can use to get a better understanding of the risk associated with a particular stock option, known as the greeks.
Is used to assess the price sensitivity of the options price. It is an estimate of how much the options price will change with a $1 move of the underlying stock.
Is used to assess the time-sensitivity of the options price. As the stock option approaches expiration, it experiences time decay, or the price of the premium decreases.
Is also used to assess price sensitivity. It represents the relationship between Delta and movement in the underlying stock.
Is used to assess the relationship between the value of the option and volatility. It represents the amount of change in the options price when experiencing a 1% increase in implied volatility (IV.)
There are other greeks that traders use, but these are the four most popular and widely used metrics when determining option pricing.
6. Reading Options Symbols
Stock options symbols can look deceiving to new investors. They are composed of different numbers and symbols that represent certain things pertaining to the option.
You can find four things from looking at a stock options symbol, including:
- The underlying stock
- The expiration
- Call or put
- And the strike price
For example, suppose the options symbol is AAPL07312020C310. This means the symbol is AAPL (Apple), the expiration is 07/31/2020, and it is a call option with a strike price of 310.
7. In or out the Money
An important concept to understand for stock options trading is if your option is in the money (ITM) or out of the money (OTM.)
When your contract is ITM, it is referring to the underlying asset price exceeding the determined strike price. For example, with Apple, if you are buying a call option with a strike price of 310 and the market price of Apple is 315, then it is considered in the money.
The opposite is true for OTM contracts. If the strike price does not exceed the market price of the underlying stock, it is considered out of the money.
8. Bid and Ask
A few more important concepts to understand when it comes to trading stock options are the bid and ask.
Bid is referring to the price at which individuals are willing to buy a particular option. Ask is referring to the price at which individuals are willing to sell a particular option.
other valuable tips:
There are various stock option trading strategies, one of those is called a spread.
A spread involves buying and selling options of the same underlying asset. A spread can include a combination of different strike prices and expiration dates to manage risk associated with the option.
To learn more about various strategies, check out the best options trading education.
Want to Learn More About Options Trading for Beginners?
When learning options trading for beginners, there are many terms and concepts to learn before jumping right in. Take your time to learn the lingo and develop a trading strategy, and you will be in a much better position.
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