Many investors find the concept of options trading intimidating because of its complexity.
This guide is going to demystify options trading by breaking down its fundamental components, making it accessible to beginners.
By the end of this article, you will understand the basics of options trading, how to navigate an option chain, and make informed decisions about trading calls and puts.
What Are Options?
Options are financial instruments that give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific expiration date. It might be a great tool for risk management, or perhaps used to bet on future price movements or using leverage.
Understanding Call and Put Options
Call Options: A call option gives the holder the right to buy an asset at a specified strike price within a certain period. Investors buy call options when they anticipate that the underlying stock will rise in value.
Put Options: A put option gives the holder the right to sell an asset at a specified strike price within a certain period. Investors buy put options when they expect the underlying stock to decrease in value.
Navigating the Option Chain
An option chain is a comprehensive listing of all available options for a particular stock, including their strike prices and expiration dates. Here’s how to read and interpret an option chain:
Expiration Dates: The expiration date indicates when the option contract will expire. It is crucial to choose an expiration that aligns with your trading strategy.
Strike Prices: These are the prices which a holder of the option can buy at in the case of calls and sell at for puts. Strike prices are arranged in ascending order on the chain.
Bid and Ask Prices:
Bid Price: The highest price a buyer is willing to pay for an option.
Ask Price: The lowest price at which a seller is willing to accept for an option.
Trading Options
To trade options, you need to:
Select the Expiration Date: Choose an expiration date that suits your trading strategy. Short-term traders may prefer weekly options, while long-term investors might choose options with longer expirations.
Select a Strike Price: Choose the strike price consistent with your belief of the markets. For a call option this is the point you think that the stock price will be exceeded by. A put option means the point the stock price should be below to reach your conclusion.
Place the Trade:
Bullish Strategy – Buying Call Option: Assume the stock will go up from where it sits now, buy a call option at some point lower than the assumed price of stock.
Buying a Put: If you expect the stock price to fall, buy a put option at a strike price above the anticipated stock price.
Options Pricing
Options are priced on several factors such as:
Intrinsic Value: The difference between the stock price and the strike price.
Time Value: The amount of time remaining until expiration. Longer expiration dates generally have higher time value.
Volatility: Greater volatility enhances the premium of an option as a possibility that the stock will reach the strike price is greater.
Example Scenarios
Scenario 1: Purchase a Call Option
You have a feeling that Apple (AAPL) is going to be up in the next two weeks. You find a call option with a strike of $385, and it is 11 days from expiration. The ask is $2.81, which means one contract (controlling 100 shares) costs $281. As the stock goes up and the option price increases to $4.00, you can sell the option for $400 and pocket $119 in profit.
Scenario 2: Buying Multiple Contracts
If you are more confident in your prediction, you might buy two contracts of the same option. At $2.81 per contract, your total cost would be $562. If the price per contract goes up to $4.00, selling both would bring you $800, making you a profit of $238.
Benefits of Options Trading
Leverage: Options let you control a larger position with a smaller investment.
Flexibility: Options can be used for hedging, speculation, or income generation.
Limited Risk: The maximum loss is limited to the premium paid for the option.
Risks of Options Trading
Time Decay: Options lose value as they approach expiration, particularly if they are out of the money.
Complexity: Understanding the factors that influence option pricing requires time and education.
Chances of Total Loss: In case the stock does not move as per expectation, then the entire premium paid might be lost.
Proper usage of options by an investor would enable him to realize the power hidden in this field. By acquiring knowledge about call, put, and option chains, you are ready to be introduced to using options in the investment strategy. Start with the use of small-sized positions that can gradually move to larger investments as you gather confidence and get more experience from the market. As always, consult a financial advisor to assess whether options trading is suitable to your overall investments.
