Beginners Guide to Options Trading
Last updated on November 19th, 2018
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The stock market can be very overwhelming to new traders because it seems like a very risky way to handle your money. Most new market participants view the stock market as a way to invest their money in safe companies for the long haul and then be all set for their retirement years later. However, what many investors fail to realize is that there are products out there that allow you to do much more than just invest long term by buying a company’s stock. We can use products like stock options as a way to get involved in the markets for a fraction of the cost of buying shares of stock. When most people hear the term stock options they immediately think of a very high risk instrument. That opinion usually comes from a lack of understanding of how the product works. Let’s take a look at how you can actually use options to your advantage.
What is an option?
An option is a contract between two people to buy and sell stock at a fixed price over a given period of time. An option is a derivative, which means its value is derived from the value of the stock. The difference between the shares of stock and stock option is the stock option is only good for a set amount of time. It can be viewed like an insurance policy. To insure your car, you pay a monthly fee and if damage occurs to your car within the month the insurance company will fix the car. If no damage is done to your car within the month, the insurance company keeps your monthly premium that you paid. Well, an option works in a similar way. Traders pay for the right to control the stock for a set amount of time, but if the stock does not move in their favor before time runs out then they lose the premium paid for the option.
There are two types of options available for traders to use. We use call options to control the upside in a stock and put options to control the downside in a stock’s movement. A call option is a contract that gives the buyer the right, but not the obligation, to buy 100 shares of a stock at a specified price for a certain amount of time. A put option is a contract that gives the buyer the right, but not obligation, to sell 100 shares of a stock at a specified price for a certain amount of time.
Strike Price and Expiration
We just got done talking about how options give the trader control of the stock at a fixed price and for a set amount of time. Let’s walk through what this means in more detail. When we talk about options you will often hear the terms strike price and expiration. The strike price of an option is the fixed price that the owner can buy (call option) or sell (put option) the underlying stock or index. If a trader were to buy an Apple 500 call option, they would have the right to buy 100 shares of Apple stock at $500 per share regardless of how high Apple stock goes. This means the call option has a strike price of 500.
In the case of the Apple 500 call option, the buyer has control of Apple stock at $500 per share regardless of how high Apple goes, but they only have control of the stock for a set amount of time. The date the option is valid until is known as expiration. Standard options expire monthly on the 3rd Friday of the month. If the Apple 500 call was in October, then the buyer controls Apple stock at $500 per share until the 3rd Friday of October. There are also Weekly options which expire every Friday, but in most cases traders will deal with the standard monthly options.
What affects the price of an option?
There are many different factors that affect the price of an option which can be confusing to traders. It’s not difficult as long as you understand what to look for. The price of an option is determined by factors such as the price of the stock, volatility, time to expiration, strike price, interest rates and dividends. The main factors that a trader needs to keep track of are stock price, volatility and time to expiration. Obviously when we buy a call option we want the stock to go higher, which will cause the call options to increase in value. When we buy a put option we want the stock to go down in value, which will cause the put option to increase in value. When we buy an option we also want volatility to increase, which will cause the options to increase in value as well. If we were selling an option we would want volatility to decrease, which would cause the value of the options to drop. Each day that we hold on to the option it loses value. This is known as time decay. The closer to expiration that we get the faster that time decay gets. This means the closer to expiration that we get, the more that option will decrease in value. These factors are important to keep in mind when selecting the correct options position.
Which option is best?
While there are a number of different ways to play these setups, we will often time look to use the front month options. We also like to buy low volatility and sell high volatility. This means we could use different options trading strategies like naked calls and puts, iron condors, strangles or vertical spreads to name a few. We will select the correct strategy based on criteria such as overall market conditions, anticipated holding time and levels of implied volatility being priced into the options. We cover all of our favorite strategies and criteria to look for in the PTU Options Mastery Program.
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