What Is Options Trading and How to Get Started
Serious about supercharging your investment portfolio? If so, you’ve probably wondered what exactly is options trading. The short answer is options are a powerful financial instrument… and one of the fastest ways to put your investing capital to work and generate big short-term gains.
Nonetheless, for the uninitiated, they can be intimidating… if not downright scary. But even if you’ve never traded an option before, by the time you finish reading this, you’ll know exactly how to get started.
Options allow investors to make larger and faster returns than they get from traditional stocks. And all for a fraction of the starting cost. But don’t be lulled into a false sense of security. Options traders know that an option’s value can fall just as quickly as it can rise.
Options are an inherently risky investment. With that risk comes the possibility of great reward. But it’s always worth considering the possibility of an options contract expiring worthless. So it’s probably not a good idea to put all of your investment capital into options. Remember, a diversified portfolio is a safe portfolio.
The Nuts and Bolts of Options Trading
The price of an options contract is largely based on the price of an underlying security. For our purpose, we’ll stick with options related to stocks. These contracts give the owner the right – but not the obligation – to either buy or sell the underlying stock at a previously determined price within a certain period of time.
Each options contract controls 100 shares of an underlying stock. And the cost of an options contract is equal to the number of underlying shares multiplied by the option’s price. In other words, for one contract, it’s the price times 100, since a contract controls 100 shares. So, if you bought an options contract priced at $3.25, it would cost $325.
The next important piece of info you need to know is there are two types of options: calls and puts. A call option allows an investor to capitalize on a stock’s upward momentum while putting less capital at risk than buying shares outright. Buying call options gives you virtually unlimited upside. And the only money at risk is the price you paid for the contract.
Let’s say an investor is bullish on Apple (Nasdaq: AAPL). The company has strong fundamentals, and a new series of products is about to be released. That might increase the price of Apple shares. So this investor would want to buy Apple call options.
For call options, there are three pieces of information to look for. The first is the strike price. If the underlying shares rise above the strike price, the investor makes money.
The next piece of information to look for is the expiration date. This is the date that the options contract expires. And lastly, you want to look at the bid and ask prices. These will give you an idea of what people are willing to pay for an options contract and what folks are willing to sell them for.
The Anatomy of a Call Option
Let’s go back to our hypothetical Apple options trader. Because he thinks Apple’s share price is heading higher, he’s going to look for an options contract that is “out of the money.” This simply means that the strike price is higher than the current price of the underlying shares.
But he knows that the stock’s price isn’t going to go up overnight, so he decides on an expiration date three months in the future. And it’s worth noting that most options contracts expire on the third Friday of the month. If that Friday is a holiday, the options’ expiration date will be on the previous Thursday.
In this fictional scenario, Apple shares are at $50, so our fearless investor picks up an Apple call option with a strike price of $55 that will expire in three months. And he feels good because he paid somewhere between the bid and the ask price.
If Apple shares shoot up to $60 in the next two months, someone will be more than happy to buy that contract for a handsome sum. Because that will give the holder of the contract the ability to buy 100 Apple shares at a discount.
On the other hand, if Apple’s share price falls, the options contract will expire in three months completely worthless.
The Anatomy of a Put Option
Put options are similar in that they are designed to capitalize on a stock’s downward momentum.
Let’s go back one more time to our hypothetical Apple trader. This time he’s anticipating the next round of products is going to be a dud. And in turn, Apple’s share price should take a tumble. So he buys Apple put options with a strike price of $45 while shares are currently trading for $50. And again, he picks an expiration date three months in the future and pays for the contract between the bid and ask price.
If he’s right, and the share price falls, his put options contract will become more valuable. On the other hand, if Apple’s share price manages to go up, that put option will have less or no intrinsic value… Because nobody is going to want to sell the underlying stock at a discount.
Getting Started in Options Trading
This is just the tip of the options iceberg. There are all sorts of variables and strategies out there. Investors can also sell put contracts. Some use options strategies like straddles and strangles to profit from big moves in share price. But we’ll save that for another article.
In the meantime, now that you have a basic grasp on options trading, you might feel like you’re ready to get started. But before you do, it’s a good idea to practice first. We recommend paper trading. There are all sorts of stock trading simulators available that let investors test their strategies without the risk of losing any real money.
But just because you know what options trading is doesn’t necessarily mean it’s right for you. And that’s just fine. There are plenty of investment opportunities out there.
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About Matthew Makowski
Matthew Makowski is a senior research analyst and writer at Investment U. He has been studying and writing about the markets for 20 years. Equally comfortable identifying value stocks as he is discounts in the crypto markets, Matthew began mining Bitcoin in 2011 and has since honed his focus on the cryptocurrency markets as a whole. He is a graduate of Rutgers University and lives in Colorado with his dogs Dorito and Pretzel.