Options Trading: A Step-by-Step Guide for Beginners
Trading stock options can be complex — even more so than stock trading. When you buy a stock, you just decide how many shares you want, and your broker fills the order at the prevailing market price or a limit price you set.
Options trading requires an understanding of advanced strategies, and the process for opening an options trading account includes a few more steps than opening a typical investment account.
How to trade options in four steps
1. Open an options trading account
Before you can start trading options, you’ll have to prove you know what you’re doing, compared with opening a brokerage account for stock trading,
Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks, and their financial preparedness.
These details will be documented in an options trading agreement used to request approval from your prospective broker.
You’ll need to provide your:
Investment objectives — This usually includes income, growth, capital preservation, or speculation.
Trading experience — The broker will want to know your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year, and the size of your trades.
Personal financial information — Have on hand your liquid net worth (or investments easily sold for cash), annual income, total net worth, and employment information.
The types of options you want to trade.
For instance, calls puts, or spreads. And whether they are covered or naked.
The seller or writer of options has an obligation to deliver the underlying stock if the option is exercised.
If the writer also owns the underlying stock, the option position is covered. If the option position is left unprotected, it’s naked.
Based on your answers, the broker typically assigns you an initial trading level based on the level of risk (typically 1 to 5, with 1 being the lowest risk and 5 being the highest). This is your key to placing certain types of options trades.
Screening should go both ways. The broker you choose to trade options with is your most important investing partner.
Finding the broker that offers the tools, research, guidance and supports you need is especially important for investors who are new to options trading.
2. Pick which options to buy or sell
A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price — called the strike price — within a certain time period.
A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.
Depending on which direction you expect the underlying stock to move determines what type of options contract to take on:
If you think the stock price will move up: buy a call option, sell a put option
If you think the stock price will stay stable: sell a call option or sell a put option
If you think the stock price will go down: buy a put option, sell a call option
3. Predict the option strike price
When buying an option, it remains valuable only if the stock price closes the option’s expiration period “in the money.”
That means either above or below the strike price. (For call options, it’s above the strike; for put options, it’s below the strike.)
You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.
For example, if you think the share price of a company currently trading for $100 is going to rise to $120 by some future date, you’d buy a call option with a strike price less than $120 (ideally a strike price no higher than $120 minus the cost of the option, so that the option remains profitable at $120).
If the stock does indeed rise above the strike price, your option is in the money.
Similarly, if you think the company’s share price is going to dip to $80, you’d buy a put option (giving you the right to sell shares) with a strike price above $80. (ideally, a strike price no lower than $80 plus the cost of the option, so that the option remains profitable at $80).
If the stock drops below the strike price, your option is in the money.
You can’t choose just any strike price. Option quotes, technically called an option chain or matrix, contain a range of available strike prices.
The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.
The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price if the stock price is above the strike.
Time value is whatever is left, and factors in how volatile the stock is, the time to expiration, and interest rates, among other elements.
For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while the time value is $5.
This leads us to the final choice you need to make before buying an options contract.
4. Determine the option time frame
Every options contract has an expiration period that indicates the last day you can exercise the option.
Here, too, you cannot just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.
There are two styles of options, American and European, which differ depending on when the options contract can be exercised.
Holders of an American option can exercise at any point up to the expiry date whereas holders of European options can only exercise on the day of expiry.
Since American options offer more flexibility for the option buyer (and more risk for the option seller), they usually cost more than their European counterparts.
Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders.
For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out. As such, the longer the expiration period, the more expensive the option.
A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price.
An option’s time value decays as expiration approaches, and options buyers don’t want to watch their purchased options decline in value, potentially expiring worthless if the stock finishes below the strike price.
If a trade has gone against them, they can usually still sell any time value remaining on the option — and this is more likely if the option contract is longer.