How to Trade Options: 3 Basic Strategies | MagnifyMoney

How to Trade Options

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Trading options can be one of the most lucrative ways to participate in the financial markets, but it requires more from investors than stock investing. Investors looking to get started in options need to learn a new set of concepts as well as how options work. But once you get started, trading options can become an even more fascinating world than stock investing.

What is options trading?

Options trading is the buying and selling of options, which are the right to purchase or sell a stock for a specified price (the strike price) by some future date. Trading takes place on options exchanges, and each option contract represents 100 shares of the stock it’s based on.

The option contract allows the buyer to “lock in” the price at which she can buy or sell a stock up to the expiration of the contract. If the stock moves how the investor expects — up or down — the option can become very valuable. But it’s critical to remember that the option is valuable only if the anticipated move happens before the option expires. Otherwise, it becomes worthless.

The appeal of options is that they allow traders to participate in a stock’s price move without investing a lot of money. For the relatively small price of a contract — the premium — traders can earn a much higher return on their money than they would by owning the stock directly. So options can drastically magnify the price movement of a stock on both the upside and the downside.

Opening an options trading account

Setting up an options trading account is more complex than opening a stock trading account, for both you and the brokerage. You’ll want to compare trading costs, which can vary substantially depending on the brokerage, and the brokerage needs to vet you to determine which kinds of options strategies you can use.

What investors should look for

One of the most important considerations for investors is not spending too much money on trading fees. That’s especially true for options traders, who must pay a per-contract fee in addition to a base fee per trade. So unlike stock trading that caps the fee at a flat rate — for example, $5 — options fees can continue climbing based on how many contracts you trade.

For example, an investor might pay $5 per options trade plus $0.80 per contract. So buying one contract would cost $5.80, but buying two would cost only another $0.80, or $6.60 total. But move to 100 contracts, and you’re suddenly up to $85. Selling also would cost you the same. If you’re trading lots of contracts, those fees can add up quickly, so it makes sense to minimize costs.

The trade fee is the single most obvious thing investors should evaluate when choosing a brokerage. But they also should consider some less obvious questions:

  • How easy is it to use the trading platform?
  • Do you have to pay extra for data? Some of the brokerages with the cheapest trades charge extra for this service.
  • Does the brokerage offer you other free resources, such as educational tools?

What the brokerage is looking for

The brokerage is looking to find clients who are financially able to trade options and who have the expertise to do so. So before approving customers for options, the brokerage vets them on their overall trading experience and their trading objectives.

After collecting your data, the brokerage rates you and provides access to options strategies based on your assigned level. While the number of levels differs by brokerage, there are usually four tiers of permission. Each higher level enables increasingly complex and risky trades.

If you have limited experience trading stocks, you might not be approved for options at all. Even if you have enough experience, the brokerage might not approve you for specific types of options trades — typically the more risky kinds — because you don’t have the right objectives.

For example, if your objective is to generate income, you’ll likely gain the ability to sell covered calls but the brokerage probably won’t let you try your hand at the more exotic strategies.

Understanding an options quote

Unlike stocks, options have more moving parts, and investors need to know each part so they can understand exactly what they’re buying. As you’re trading options, you’ll want to be mindful of the following elements:

  • The bid and ask: As for stocks, these are the prices market participants will buy (bid) and sell (ask) for.
  • Strike price: This is the price at which the option finishes in the money or out of the money.
  • Expiration: This is the date when the option expires.
  • Put and call: These are the two major types of options. Calls become valuable when the stock rises; puts become valuable when the stock falls.
  • Underlying stock: This is the stock the option is based on.
  • The options symbol: This symbol incorporates all the relevant information about the option (call/put, strike price, expiration and the underlying stock) into a symbol.

One key thing to watch out for: The options quote gives you all the important information about the option you’re buying. That’s significant since many new investors accidentally buy exactly the opposite option from what they intended — for example, buying a put instead of a call or buying a call instead of selling it. That can lead to some potentially disastrous consequences if it goes unnoticed.

Understanding options pricing

Options prices change dynamically based on how the underlying stock moves. When the stock price rises, calls rise and puts fall in value. When the stock price falls, calls fall and puts rise. It’s also useful to understand when a stock is “in the money” and “out of the money.”

An option is in the money in two scenarios:

  • For calls: if the stock price is above the strike price
  • For puts: if the stock price is below the strike price

An option is out of the money in two scenarios:

  • For calls: if the stock price is below the strike price
  • For puts: if the stock price is above the strike price

If a stock is out of the money at expiration, it becomes worthless. If a stock is in the money at expiration, it retains some value, potentially a lot.

An option’s price has two components: intrinsic value and time value. Intrinsic value is a measure of how much the option is in the money. Time value is the remaining amount, and it measures how much investors are willing to pay for the time left on the option. The longer the time to expiration, the more investors will pay for time value. That’s because more time to expiration gives the stock more opportunity to rise and push up the call option.

For example, imagine a $53 stock with a $50 call option trading for $5, and the option expires in a year. The intrinsic value of the option is $3 ($53 minus $50), while the time value is what’s left: $2. Investors will pay $2 for the right to enjoy any stock price appreciation over the next year.

Now imagine the same $53 stock with a $50 call option trading for $4, and the option expires in three months. The intrinsic value is still $3, while the time value is $1. Because there’s less time to expiration on the option, investors will pay less for that lower potential.

Finally, imagine the same stock now trading for $49 with a $50 call option trading for $3. The option expires in a year. The intrinsic value is $0 because the option is not in the money, while the time value is $3. Because there’s time left on the option, investors are willing to pay some amount for the potential that the stock will surpass the strike price and make the call valuable.

Three basic options trading strategies

There are a variety of options trading strategies, from the most basic to the mind-numbingly complex. But when you’re beginning to trade options, it’s best to master the basic. Here are three options strategies for beginners and what you should watch for.

1. The long call

With the long call, an investor buys a call option with a strike below where she expects the stock move. For the option to be profitable at expiration, the stock must be above the strike price by more than the cost of the option. This can be a good choice if you expect the stock to rise a medium to large amount before the option expires.

The pros: uncapped gains and no future financial commitment if the trade goes badly
The con: potential total loss of the premium

2. The covered call

This strategy is the opposite of the long call but with a twist. Here you sell a call — normally a risky strategy — while you own the equivalent shares of underlying stock.

If the stock stays below the strike price at expiration, you keep the premium and can do the strategy again. If the stock rises above the strike, you’ll have to sell the stock at the strike price but you’ll get to keep the premium. While you’ll miss the gains you otherwise would have made, you don’t have to put up any extra money. Many investors use this relatively low-risk strategy to generate income. It works well if the stock is flat or doesn’t move down too much.

The pros: low risk, no future financial commitment
The cons: must hold 100 shares for each contract sold (expensive), potential lost upside if the stock moves higher, and the investor retains all the stock’s downside

3. The long put

This strategy is like the long call, but it makes money when the stock falls. With the long put, an investor expects the stock to decline, so she buys a put option with a strike above where the investor expects the stock to move. For the option to be profitable at expiration, the stock must be below the strike price by more than the cost of the option. This can be a good choice if you expect the stock to fall a medium to large amount before the option expires.

The pros: virtually uncapped gains and no future financial commitment if the trade goes badly
The con: potential total loss of premium

Bottom line

Trading options can be lucrative and emotional. While smart investors can use options to enhance the total return of their portfolio, sometimes it can take an iron stomach to deal with the ups and downs — they’re more volatile than stocks. So it makes a lot of sense to begin slowly while you get your bearings and continue learning until you master the subject.