It’s important to know about all sorts of trading strategies. So let’s take a little time to talk about some options trading examples and how it all works.
Even though I don’t do options trading, that doesn’t mean you can’t or shouldn’t.
Why am I taking the time to do this? Because I understand that trading isn’t one size fits all.
I made my fortune trading penny stocks, and that’s what I teach my students. But I also think it’s important to learn all about the different trading strategies out there so you can decide for yourself what you want to pursue.
Becoming a self-sufficient trader is all about finding out what works for you and refining your methods over time.
For some traders, options have proven a successful strategy. Could it be a good fit for you? Read on to learn more — I’ll cover some fundamental basics, key terms, and strategies for options beginners.
Table of Contents
- 1 What Is Options Trading?
- 2 Options Trading Rights and Obligations
- 3 Options Trading Examples: How Can You Succeed?
- 4 How Does Options Trading Work?
- 5 Options Trading Brokers
- 6 Types of Options
- 7 Benefits and Advantages of Trading Options
- 8 How to Read an Options Table
- 9 Assessing Risks in Options Trading
- 10 How to Make Money Trading Options
- 11 Successful Options Trading Strategies Explained
- 12 Common Options Trading Mistakes
- 13 The Final Word on Options Trading
What Is Options Trading?
Options are a specific type of security called a derivative.
There are lots of examples of derivative investments. They’re a type of financial security that’s valued based on either a single or a group of underlying assets.
Some examples of these underlying assets include bonds, commodities, currencies, stocks, and market indexes.
Derivatives can be traded like stocks, either OTC (over the counter) or via an exchange. Their price can and will fluctuate based on the value of the underlying stock. That’s where the inherent risk comes in.
Option prices are derivatives of the stocks they represent.
Options Trading Rights and Obligations
With options, you get the right — but not the obligation — to purchase or sell a certain amount of stock (or other securities) at a pre-arranged price and on a specific date. That price is derived from the stock’s price.
Options are contracts, but they give you the rights to buy or sell — not an obligation. They’re different from regular stock plays and futures because you can decide not to go through with the contract.
Options Trading Examples: How Can You Succeed?
Before I answer that question, I gotta say this: I’m not an options trader and I’m in no way giving you trading or financial advice. All trading is risky. Never risk more than you can afford. Do your due diligence.
To succeed as an options trader, your education is vital. You need to know how it works and how trades play out.
Keep reading to learn options trading basics along with some examples to help you start to put it all together.
How Does Options Trading Work?
Think of how options trading works in terms of selling a car to a private buyer.
- You meet the buyer who looks over the car and gives you a deposit to hold the vehicle.
- You get to keep the deposit even if the buyer decides not to return with the full purchase price by the agreed-upon date.
- The prospective buyer has bought the option to buy the car by whatever deadline you set.
- If the buyer doesn’t, you can sell the car to someone else — maybe even for a higher price — and you already have the deposit in your pocket.
Options trading is far more complicated than that, but it can be easier to understand when you have an example outside of stock market options.
I really want to stress that you need to learn the basics of options trading before you execute any contracts.
Otherwise, you’ll lose money like thousands of other traders who jump into options trading without the right knowledge.
Options Trading Brokers
Just like with stocks, you need a broker to trade options. However, not all brokers offer options trading.
If you’re happy with your current broker, check with them first to see if they offer options trading. And if they do, find out what their requirements are.
If your broker doesn’t offer options trading, you’ll need to find one that does. Remember: don’t take this decision lightly. Be sure to do plenty of research on options brokers before settling on one.
While this post focuses on choosing a stockbroker, many of the tips are relevant for choosing an options trading broker too.
Types of Options
With options, you have … well, options. Let’s talk about some of the different types.
Long vs. Short Options
With stocks, you can go long or take a short position. With options, you can trade either call or put options. Here’s a brief synopsis of what they are and how they work…
A call option is a potential future trade.
For example, say you want to purchase 1,000 shares of Stock X at $4.20 per share at some point in the future because you believe it’ll go up in price.
You can purchase a call option to make this purchase at any point within a finite period. You’re kind of calling dibs or locking in that price.
However, the person selling doesn’t necessarily just want you calling dibs without getting something in return.
As the buyer, you’ve got to put down a premium — that’s the price of the options contract.
The benefit is that if the stock goes up in value, you can still complete the purchase at the agreed-upon price during the contract period. The premium you pay acts as a down payment.
However, if the option’s expiration date passes and you don’t move forward, you don’t get the premium back.
A put option is a contract where you as a contract holder have the right to sell the asset in question at any time within a predetermined, finite period.
Say you want to sell shares of a stock. You set your strike price — say it’s $5. With a put option, you can sell your shares for that price at any point before the expiration date.
The benefit of this method is that even if the stock value goes down dramatically, you can still get the agreed-upon price.
A put seller receives a premium or down payment in this case. A single put option represents a specific amount of the underlying asset in question. Frequently, it’s one put option to 100 shares of the underlying asset.
In other words, the “down payment” is 1/100th of the total purchase price.
Trading Call vs. Put Options
So, to review…
- A call option is best when you believe the price of a stock will rise.
- A put option is best when you believe the price of a stock will fall.
Benefits and Advantages of Trading Options
Some of my students have had excellent results with options trading. They’ve studied the market, recognized the potential pitfalls, and traded options with their own risk tolerance in mind.
Why do some successful traders love options trading? Here are some advantages.
Options can give you a ton of flexibility.
Yes, you have to plunk down that premium, but it affords you the flexibility to make the decision of whether to actually exercise the option later.
You don’t have to exercise the option if you choose not to. There’s no punishment. When the expiration date comes, the option becomes null and void.
Yes, this means that you lose the investment that you made for the option premium, but you won’t suffer any additional losses.
Also, since options are a type of derivative, you can use them to trade all sorts of financial securities like commodities and foreign currencies to name a few … It’s not just for stocks.
Limited Risk for Buyers
I’m all about cutting losses and limiting risk. Options can let you limit risk, which is a good thing.
Yes, you do have to put down that premium, and if you don’t exercise the option within a set period of time, you may forfeit that payment. So, in that way, there’s considerable risk depending on the number of shares you intend to buy or sell.
However, that risk can be minimal compared to the potential losses you might suffer if you made the trade without an options contract.
Yep … If you think options sound a bit like prospecting, you’re right. There’s a certain level of speculation involved in options trading.
For instance, if you purchase a call option, you probably have a strong belief that its value will go up in time and that you’ll be able to buy in at a low price. Employing a call option versus simply buying the asset or stock allows you additional time.
But remember the car sale scenario. The buyer puts down a deposit against the agreed-upon price. That’s all well and good. But the seller holds the cards here. If the buyer doesn’t come back, the seller keeps the cash.
It works the same with options trading.
While options buyers often speculate to a certain degree, one of the biggest appeals of options is that you can hedge your bets, so to speak. Hedging is a method of reducing risk.
I hate risk. Have I said that already? Let me say it again: I hate risk. And you should, too.
Like in the car sale analogy, an options premium creates a stopgap. It basically says, “This is the most I’ll lose on this deal if it goes south.”
Basically, you’re guaranteeing that this would be the maximum amount that you’d lose if things don’t go your way. It’s almost like an insurance policy. Yes, you have to pay for insurance, but if something goes wrong, you’re covered.
Some will say that if you’re not sure of a stock investment, you haven’t done enough research and it’s too risky to even pursue.
But some traders think that hedging can be an intelligent approach … you never know what factors will play into a stock’s or asset’s value. Hedging strategies can be extremely valuable, especially when the stakes get high.
Options give you the ability to restrict the potential losses on a given investment, while optimistically trying to make the most of the potential gains. It can be really cost effective when you think of it in that way. You’re paying for peace of mind.
How to Read an Options Table
The first time you try to read an options table, you’ll likely feel overwhelmed. I know I did.
With its staggering series of columns, it can be confusing.
However, once you break it down, it’s really not as complex as it seems. Here’s a cheat sheet of some of the common columns you’ll see in a table and what they mean.
This is short for Option Symbol. This column offers the basics: The stock symbol, the contract date of maturity, and the strike price. It also defines whether it is a call or a put option (specified with a C or a P).
Referred to in points, the bid price is the most up-to-date price offered to buy the option in question. So, if you were to enter a market order to sell the call or put, this would be the price commanded.
Also referred to in points, the ask price is the most up-to-date price offered to sell the option in question. So, if you were to enter a market order to buy the call or put, this would be the price commanded.
This shows the premium of time built into the option price. Since all options lose their time premium when the option expires, this value showcases the amount of time premium currently playing into the option’s price.
Implied Volatility Bid/Ask
Also referred to as the IV Bid/Ask, this column shows the potential level of future volatility. This is based on factors including the option’s current price and the amount of time until the option expires. This value can be determined by a model such as the Black-Scholes Model.
According to “The Economic Times,” the “Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate.”
Ultimately, with a higher IV Bid/Ask, there’s more time premium included in the option’s price.
Historical vs. Implied Volatility
Not sure about the difference between historical and implied volatility? Let’s take a little time out to talk about it.
- Historical volatility is based on historical data –– like actual past price action.
- Implied volatility looks at the past but is forward-thinking. It uses the past to predict what might happen with volatility in the future.
This column tells you how many contracts of a given option were traded during the last market session. Often, options with larger movement and volume will have a tight bid/ask spread, since the competition to buy and sell these options is higher.
This column tells you how many contracts of a given option have been opened, but have not yet been cashed in or sold.
This column tells you the strike price of the option in question. This is the price that the buyer has set to buy or sell the underlying security if he or she chooses to take the option.
Assessing Risks in Options Trading
In addition to the above columns in an options table, you’ll often see a series of columns with headings named after greek letters. One of the unique things about options is that they carry various values that can help you determine the level of risk.
I’m talking, of course, about the infamous “Greeks.”
If you’ve been researching options or looking at options tables, you’ve probably heard about the Greeks — and are likely confused by them. The Greeks include delta, gamma, theta, vega, and rho.
These measure a variety of factors that can affect price regarding a given options contract and are calculated using a theoretical model.
Sound complicated? Stick with me.
In this section, we’ll discuss what the Greek letters mean in options trading and how they can better help you understand an option’s risk and reward potential.
Delta is a Greek value that represents the “stock equivalent position” for an option. The delta for a call option can range from 0 to 100 (and for a put option, from 0 to -100 … yes, that’s negative 100).
In essence, the of-the-moment risk and reward with holding a call option with a delta of 100 is similar to holding the equivalent amount of stock shares.
Gamma is a Greek value that tells you how many deltas the option will gain or lose if the underlying stock rises by one full point.
Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time based on what’s referred to as “time decay.” This factors in the expiration date of the option.
Vega is a Greek value that indicates the amount by which the price of the option would be affected, either positively or negatively, based on a one-point increase in implied volatility.
Rho is a Greek value which acts to measure an option’s sensitivity to a potential change in interest rate. So, for every rho, the percentage point in interest rates will increase the option value.
How to Make Money Trading Options
When it comes down to making money trading options, you rely on the same logic as trading stocks.
You want to commit to buying or selling prices that will put you in an advantageous position to collect profits. But “call” and “put” don’t tell the entire story…
Successful Options Trading Strategies Explained
There are a ton of different strategies for options trading. Here are some common ones.
Long Call – Options Trading
This is the most basic type of strategy for the call option. Basically, it begins with your belief that the underlying asset will rise in value over time.
You buy a call option with a strike price that you believe the asset will exceed in value over time.
The hard part? You’ve got to determine an expiration date. This is something of a gamble because you hope the value will rise before that date.
You risk losing potential profits by setting an expiration date too soon after the contract begins.
Compared to simply buying shares in full, you gain leverage here because there’s a chance that the value will go up quite dramatically, and then you can buy in for that sweet predetermined price.
However, if the value doesn’t go up by the time that the expiration date is up and you decide not to go through with the order, you won’t get that down payment back.
Long Put – Options Trading
This is the most basic type of strategy for the put option. It begins with you either believing or hedging on the fact that the underlying asset will lose value over time. You buy a put option with a strike price that you believe the asset will sink below over time.
Like with a long call, you have to agree to an expiration date. Once again, this is a gamble because you have to try to determine by what date the asset will go down in value.
Some traders believe that, in comparison to short selling a stock, a long put is easier. For one thing, you don’t have to find shares to borrow, which can prove tricky, especially if you’re into pennystocking.
However, unlike simply selling short, your losses are finite. Selling short carries unlimited profit — but also unlimited losses. So comparatively, the losses can be controlled here.
What I want to point out, though, is that options trading is a zero-sum game. In other words, it’s you against the buyer or seller.
Trading regular stocks opens up the field, kind of like in a horse race. Everyone is betting against one another, which means you have stronger data and a greater opportunity to profit.
This is where things get a little bit more complicated. A call backspread, also referred to as a “reverse call ratio spread,” is a more bullish strategy.
Here, you sell a certain number of call options, then buy more call options of the same underlying asset with a higher strike price.
This is a little bit more aggressive of an approach for purchasing options. It’s most appropriate when you really think that the asset will experience huge growth in the near future.
The call backspread profits when the price goes up sharply and the profits are virtually limitless for the buyer.
The put backspread is the yin to the call backspread yang. It’s also referred to as the “reverse put ratio spread.”
Basically, you sell a certain number of put options, then buy more put options of the same underlying asset, but with a lower strike price.
There are virtually limitless profits available with this strategy, but it also demands greater risk tolerance. The put backspread profits when the price goes down sharply, and the profits are virtually limitless for the buyer.
For buyers who are worried about their assets, the protective put, also referred to as a “put hedge,” is a method of hedging.
When you’re worried about a market downturn or crash, or a change in the value of an asset, you may invest in a protective put to protect from limitless losses.
Here, it’s like you have a previous purchase that you’re protecting with a proverbial insurance policy. This is what differentiates it from a long put — the fact that you’re already in the trade.
In this way, it’s almost like refinancing a house you already own versus buying a new one. But when it comes down to it, the risk is still similar to a long put.
Bear Split-Strike Combo
This is one of the most complicated strategies … and definitely the one that sounds most like a circus sideshow. Here’s how it works.
You have one long put with a lower strike price and one short call with a higher strike price. Yup, you have options in both directions with the same underlying asset and expiration date, but with different prices.
You could call this the ultimate in hedging because you’re putting a wager on whether the asset will go up or down. So if it goes up, you can profit from the call. And if it goes down, you can profit from the put.
Common Options Trading Mistakes
Choosing the wrong strategy. Like with trading, not all strategies are a perfect fit for all traders. It may take trial and error, but it’s important to stick with a strategy that matches your style.
Wrong expiration date. Picking the right expiration date for options contracts is hard … so ask yourself these things first:
- What’s the market liquidity like?
- How long do I think it will take for the price to move higher/lower?
- Do I want to hold this contract through seasonal fluctuations like earnings season?
Going all in. It can be tempting to take a huge position since you only have to pay the premium … but resist the urge. Remember: you can still lose money. Never trade more than you can afford to lose!
Why Do You Need Expert Assistance?
You could learn things the hard way, or you could speed up your learning curve by seeking out assistance.
I won’t be your mentor for options trading. But if this is a strategy you’re interested in, do yourself a favor: find a program or mentor where you can learn all you can before risking your cash!
My goal as a teacher is to help my students forge long-term, sustainable careers as traders.
I focus on all sorts of strategies for trading low-priced stocks. I want you to be adaptable, diverse, and most of all intelligent in your trading.
Articles, daily alerts, webinars, and an extensive video collection are just a few of the many perks you’ll get as a student.
I’m here to help you become a smarter trader who knows how to cut losses and refine successful techniques to keep getting better. You game?
The Final Word on Options Trading
Options trading is appealing to many traders … and with good reason.
However, options trading isn’t without its fair share of risk. It’s so important to become educated on any style of trading you want to pursue. Never just throw your money at the market!
What do you think? Do you trade options? What strategies do you like best?