Options Trading Guide
What are Options?
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks, commodities or forex currency pairs. Depending on the type of contract they hold, an options contract offers the buyer the opportunity to buy or sell the underlying asset.
Option contracts come with an expiration date before which the holder needs to exercise their option to buy or sell an underlying asset at an agreed-upon price. The stated price on an option is known as the strike price. Although options may sound similar to futures contracts, traders that buy options contracts are not obligated to settle their positions.
Buyers can choose to exercise their calls and puts or not whereas sellers are obligated according to the buyer decision. Therefore, the sellers (writers) can be exposed to more risk than buyers whose losses can be limited to the premium paid for the contract in the instance they do not exercise the contract. On the other hand, sellers can lose more depending on the asset’s market price.
- In the money: when the underlying market’s price is above the strike (for a call) or below the strike (for a put), the option is said to be ‘in the money’ – meaning that if the holder exercised the option, they’d be able to trade at a better price than the current market price.
- Out of the money: when the underlying market’s price is below the strike (for a call) or above the strike (for a put), the option is said to be ‘out of the money’. If an option is out of the money at expiry, exercising the option will incur a loss.
How do Options Work?
Call options and put options create the base for a variety of different option strategies which are primarily designed for hedging or speculation. As such, traders usually enter into calls when they expect the price of the underlying asset to increase, and puts when they expect the price to decrease.
Call options allow the holder to buy the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a bearish seller.
Put options allow the holder to sell the asset at a stated price within a specific timeframe. Each put option has a bearish buyer and a bullish seller.
What is an Options Contract?
An options contract, or simply option, is defined as “a promise which meets the requirements for the formation of a contract and limits the promisor’s power to revoke an offer”. An option contract is a type of contract that protects an offeree from an offeror’s ability to revoke their offer to engage in a contract.
An options contract consists of at least four main components which are:
- Size: This refers to the number of contracts to be traded. An options contract will typically represent 100 shares of the underlying security, with the buyer paying a premium fee for each contract. As an example, if there is an option that has a premium of 45 cents per contract, buying one option would cost $45 ($0.45 x 100 = $45).
- Expiration date: The date after which a trader can no longer exercise the option. Some contracts give traders the right to exercise their option any time before the expiration date whereas other options contracts can only be exercised at the expiration date.
- Strike price: The price at which the asset will be bought or sold (in case the contract buyer decides to exercise the option). If the strike price is lower than the market price, the trader can buy the underlying asset at a discount and, after including the premium into the equation, they may choose to exercise the contract to make a profit. But if the strike price is higher than the market price, the holder has no reason to exercise the option, and the contract is deemed useless. When the contract is not exercised, the buyer only loses the premium paid when entering the position.
- Premium: The trading price of the options contract. The premium indicates the amount an investor must pay to obtain the power of choice. Thus, buyers acquire contracts from sellers according to the value of the premium, which is constantly changing, as the expiration date gets closer.
How are Options Priced?
The value of the options contract premium can be influenced by a variety of factors. This includes four elements which are the underlying asset’s price, the strike price, the time left until the expiration date, and the volatility of the corresponding market (or index). These main components can represent different effects on the premium of call options and put options.
In general, the asset and strike price can influence the premium of calls and puts in an opposing way. In contrast, the less time there is left until the expiration date, usually the lower the premium prices for both types of options. The primary reason for this is because traders may have a lower probability of those contracts turning in their favour. On the other hand, increased levels of volatility can cause the premium prices to rise. Thus, the option contract premium is a result of those and other factors combined together.
Options Greeks are instruments that are designed to measure some of the various factors that can have an impact on the price of a contract. Specifically, they are statistical values that are used in order to measure the potential risk of a particular contract based on a combination of underlying variables. Here we will take a look at some of the primary Greeks along with a simplified description of what they measure:
- Delta: This measures the amount in which the price of an options contract will change in relation to the underlying asset’s price. As an example, a Delta of 0.4 would suggest that the premium price may move $0.40 for every $1 move in the price of the asset.
- Gamma: This measures the rate of which the Delta changes over time. Thus, if the Delta changed from 0.4 to 0.25, the option’s Gamma would be 0.15.
- Theta: This measures the price change in relation to a one-day decrease in the contract’s time. It can be used as a measure to how much the premium is expected to change as the options contract gets closer to the expiration date.
- Vega: This measures the rate of change in a contract price in relation to a 1% change in the implied volatility of the underlying asset. An increase in Vega would normally be a reflection of an increase in the price of both call options and put options.
- Rho: This measures the expected price change in relation to fluctuations in interest rates. Increased interest rates can sometimes cause an increase in call options and a decrease in put options. Therefore, the value of Rho is positive for call options and negative for put options.
- Minor Greeks: Some other Greeks that are not as popular include the lambda, epsilon, vomma, vera, speed, zomma, color and ultima. These Greeks are considered to be second- or third-derivatives of the pricing model and affect things such as the change in delta with a change in volatility and more.
Basic Option Strategies
When trading options, traders can implement a variety of option strategies that are based on four basic positions. As a buyer, a trader can buy a call option (right to buy) or put option (right to sell). As a seller (writer), one can sell call or put options contracts. As we mentioned earlier in this article, writers have an obligation to buy or sell the assets if the options contract holder decides to exercise their calls and puts.
The various types of options trading strategies can be based upon combinations of call and put contracts. The following are examples of options strategies:
- Protective put: A protective put is a risk-management strategy using options contracts that investors employ to guard against a loss in a stock or other asset. For the cost of the premium, protective puts act as an insurance policy by providing downside protection from an asset’s price declines.
- Covered call: A covered call is a financial market transaction in which the seller of call options owns the corresponding amount of the underlying instrument, such as shares of a stock or other security.
- Straddle: The straddle option is a neutral strategy in which you simultaneously buy a call option and a put option on the same underlying stock with the same expiration date and strike price.
- Strangle: A strangle is an options strategy that involves holding both a call and a put on the same underlying asset. A strangle covers investors who think an asset will move dramatically but are unsure of the direction. Basically, a strangle is like a straddle, but with lower costs for establishing a position. However, a strangle requires a higher level of volatility to be profitable.
- Spreads: Options spreads are the basic building blocks of many options trading strategies. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates. A call spread refers to buying a call on a strike, and selling another call on a higher strike of the same expiry. A put spread refers to buying a put on a strike, and selling another put on a lower strike of the same expiry.
- Butterfly spread: A butterfly spread is an options strategy combining bull and bear spreads, with a fixed risk and capped profit. These spreads, involving either four calls or four puts are intended as a market-neutral strategy and pay off the most if the underlying does not move prior to option expiration.
What is Options Trading?
Call options (buy) and put options (sell) create the base for a variety of different option strategies which are primarily designed for hedging or speculation. As such, traders usually enter into calls when they expect the price of the underlying asset to increase, and puts when they expect the price to decrease.
The value of the options contract can be influenced by a variety of factors. This includes four elements which are the underlying asset’s price, the strike price, the time left until the expiration date, and the volatility of the corresponding market (or index).
Traders will often speculate on options in order to try and make a profit from the varying prices of the underlying asset.
Options Trade Example
Let’s assume that Apple shares are currently trading at $302 per share and your analysis tells you that you believe the shares may increase in value. You then decide to buy a call option in order to try and benefit from a possible increase in the price of the shares.
You go ahead and purchase one call option with a strike price of $315 for one month in the future at a cost of 57 cents per contract. Your total cash expenditure is $57 for the position, plus any fees and commissions (0.57 x 100 = $57).
If the Apple stock rises to $316, your option would be worth $1, since you could exercise the option to acquire the stock for the strike price of $315 per share and immediately resell it for $316 per share. The profit on the option position would be 75% since you paid 57 cents and earned $1. That is much greater than the 4.6% increase in the underlying stock price from $302 to $316 at the time of expiry.
This means that the profit in US dollar terms would be a net of 43 cents or $43 since one option contract represents 100 shares ($1 – 0.57 x 100 = $43).
However, option trading is also risky. If the stock fell to $300, your option would expire worthless, and you would be out of pocket by the $57 premium. The positive would be that you would not have bought 100 shares at $302, which would have resulted in an $2 per share, or $200, total loss. This is a way that options can help to limit the downside risk.
Options involve significant risks and are not suitable for everyone. Options trading can be speculative in nature and carry substantial risk of loss. It is imperative that you have a clear understand of how options trading works and the significant risks involved with trading online. Most experts would say to never trade with more than you can afford to lose.
Why Trade Options?
Options are commonly traded for speculation and hedging purposes. They allow for the implementation of flexible trading strategies. Typically, option traders are self-directed investors. As a do-it-yourself (DIY) investor, they are in full control of their trading decisions and transactions.
- Options can be cost effective
- Options allow traders to speculate long and short on price movements
- Options can help diversify a trading portfolio
- They offer a number of strategic alternatives
Options traders can profit by being an option buyer or an option writer. Options allow for potential profit during both volatile times, and when the market is quiet or less volatile. However, it must be stated that there are significant risks involved with trading options online. If you are planning on trading options then it is imperative you have a clear understanding on the risks and learn as much as possible.
Speculation is when you invest in the future direction of a price. It usually involves some form of technical and fundamental analysis in order to try and anticipate market movements. A speculative trader may buy a call option if they believe the price will increase or a put option if they believe price will decrease.
Option trades have the potential to profit from all the bull, bear, and side-way market trends. They offer flexibility in speculative trading with the possibility for several combinations and trading strategies, each with unique risk/reward patterns.
Options contracts are widely used as hedging instruments. A very basic example of a hedging strategy is for traders to buy put options on stocks they already hold. If the overall value is lost in their main holdings due to price declines, exercising the put option can help them mitigate losses. Here, we can consider the use of options similar to having an insurance policy in place to help protect your investments against a downturn.
Say you owned stock in a company, but were worried that its price might fall in the near future. You could buy a put option on your stock with a strike price close to its current level. If your stock’s price is down below the strike at your option’s expiry, your losses are limited by the option’s gains. If your stock’s price increases, then you’ve only lost the cost of buying the option in the first place.
What is an Options Broker?
An options broker is a firm or an individual who executes options on behalf of the clients and usually charges them a commission fee for doing so. A firm or individual who trades options for their own account is called a trader. Most options brokers handle transactions for a number of individual and institutional customers.
Choosing an Options Broker
There are various factors worth considering if you are looking for an options broker to trade online with. In this section, we will cover what we consider to be some of the most important factors that you need to be aware of when choosing a suitable options broker for your own individual needs.
If you are looking for a broker to trade options online with, then regulation should really be one of the first things that you look for. Regulation is very important as it can give traders some protection in the case something was to go wrong. Regulated brokers must follow strict rules and procedures that are put in place to protect investors. Without regulation, there may be no help should the worst happen.
Options are financial instruments that are derivatives based on the value of underlying securities such as stocks, commodities and currency pairs. If you have a particular market in mind, you will need to ensure that the broker you are considering has options in that market available to trade. The more options that the broker has, the more choice you will have if you wish to trade other markets in the future. Brokers can cover a wide range of markets including Forex, Commodities, Cryptocurrency, Stocks, Indices, ETFs, CFDs and Futures.
Brokers will often charge a commission fee for processing your option trades through their platform. There may also be accounting fees and inactivity fees. It is important to be aware of all the broker fees and compare brokers to make sure they are providing good value. If you are looking to save as much as possible on your trading costs, you can take a look at our best discount brokers.
To trade online, you will need an options trading platform which the broker will provide you with. There are various desktop, web and mobile trading platforms available, some more user-friendly than others. Each platform will have a choose of trading tools, features and functionalities. If you are already familiar with a specific trading platform, you may wish to check that the broker provides it. Alternatively, you can opt for a popular and user-friendly options trading platform such as MetaTrader or cTrader. You will find that there are lots of MetaTrader brokers which gives convenient market access for manual and automated trading strategies. If you don’t have the time or skills to trade and want to copy trading signals, you should look for a social trading platform.
In finance, leverage refers to the act of magnifying positions through the use of borrowed capital. You have to qualify for a margin account, but when you do, you’re able to use leverage (margin) when trading options. Leveraged products, such as options, magnify your potential profit but also your potential loss.
For example, if you had an account balance of $1,000 and leverage of 1:3, you would be able to take a position size of $3,000 ($1,000 x 3 = $3,000).
Whilst this does mean that you can control a position size larger than you would have been able to without leverage, it also means the risk is significantly greater. It is imperative that you have a clear understanding of leverage and how it works before trading options with leveraged positions.
The best option brokers should have a generous selection of educational resources such as trading guides, tutorial videos, webinars, eBooks, quizzes and more. These can help you to learn more about trading options online and to help familiarise yourself with the brokers products and services. We are a big advocate of brokers who support informed trading.
Most option trading platforms will have an array of built-in trading tools to assist with their daily trading activities and thorough market analysis. However, if you require any additional tools, it may be worth checking that they are provided by the broker. Tools can include economic calendars and earning reports to keep up to date with the latest stock market news, which can be used as part of a fundamental analysis. Other trading tools may include trade calculators, trading signals, market alerts and more.
Each options broker will have its own minimum deposit policy so check that you can meet this requirement. You may also need to provide some personal information in order to pass the brokers KYC and AML procedures. The sign-up process can be quicker at some brokers, especially if all of it is conducted online. During the sign-up process it is very important to make sure that you read all of the brokers terms and conditions, only proceeding if you understand and agree with them.
Option brokers can have a variety of different account funding options in order for traders to make deposits and withdrawals to and from their trading account. You should make sure that the broker has a convenient funding options for you along with the time taken and fees involved. Common broker payment methods can include wire transfer, credit/debit card whereas some brokers will offer online payment methods such as Neteller, PayPal and Skrill.
There are options brokers located throughout the globe. Some will offer email and telephone support whereas others will also offer live chat support. You want to be able to contact the broker at a time and via a method that suits you. Therefore, it can be important to check where the brokers’ offices are located, what times they are available and how they can be reached. You could test their response time and quality prior to opening an account.
How to Trade Options Online?
If you have taken the time to read through the above, you should hopefully have an understanding of how to trade options. Here is a summary of the key steps:
1. Decide if options trading is for you
Trading options online carries an element of risk and can take more time than other forms of investing. You will need to research options, manage your options, follow market news and decide how to react to them. It is important to understand the risks and dedication that comes with trading options online.
2. Educate yourself
Before trading options, it is imperative to learn as much as possible about investing and how options work. Any mistake could prove to be costly. There is an abundance of free educational materials provided by many online brokers that can help you to improve your trading skills and knowledge. If you are new to trading and need as much guidance as possible, you might want to explore our best brokers for beginners.
Most brokerages will also provide a free demo trading account so that you can practice trading options online with virtual funds in order to familiarise yourself with the trading platforms and practice various options strategies until you feel confident enough to open a real trading account.
3. Choose a broker
In order to trade options online, you will need a broker account and trading platform to execute your options. When choosing a broker, there are a few important things to consider such as regulation, commission fees, platforms, tools, education, funding options and customer support.
4. Research options
If you have made it this far then you may be ready to start trading options online! The next step is to research the different asset classes to discover which options you have an interest in trading. Perhaps there is a particular industry, product or service that is already of interest to you. Many brokers will allow you to filter options according to various criteria in order to narrow down your search if need be.
Many traders will begin by analysing different companies, studying public information such as finances, earnings and reports from professional analysts. The best brokers should have this information conveniently displayed for you within their trading platforms.
5. Have an options trading plan
Some of the most important factors that can help determine options trading performance can be the trading plan and discipline. It is important to have a solid trading plan personalised to your own needs that includes the money management and trading strategy that you will use. Most experts and professional traders would try to not let negative emotions such as fear, anger and greed affect their trading strategy.
6. Buy and sell options
Once you know what options you want to trade online, you can analyse them to help decide if and when you will place your trades. After placing an options trade, you will need to keep track of how it performs and manage it according to your options trading plan.
Options trading is the act of buying and selling options. These are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a set price, if it moves beyond that price within a set timeframe. By combining long and short options with put and call options, a variety of strategies can be utilized across different market environments.
While you can use options to speculate on the directional price movements of a financial instrument, options are non-linear. So, the probability of profit is also affected by factors such as implied volatility (IV), time to expiration, and location of the strike price in relation to the underlying price.
Now that you have had a brief overview of what options are and what to look for when choosing an options broker, you may be considering opening an online trading account to trade options online. To do so, you will need to choose a broker, follow the account opening process and you will then be able to start trading options online through one of their option trading platforms.
However, it is important to understand the significant risks involved with trading options online, especially when using leveraged positions. Options involve risk and are not suitable for all investors. Most experts would suggest trading on a demo account with virtual funds to begin with.
This can be a useful way to familiarise yourself with how to trade options and use the trading platforms whilst allowing you to practice your trading strategies until you feel confident and produce consistent results. Most trading brokers provide unlimited demo accounts free of charge.
Take your time to research brokers and do your own due diligence, the above information is only for educational purposes and not advice. Please feel free to view our best options brokers if you need some further inspiration.
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