Options Trading Basics: Strategies and Examples of How it Works

Options-Trading-Basics

I personally do not trade options. However, learning options trading basics can help you decide if you want to try options trading and to succeed if you do.

I want to start with options trading basics so you don’t get confused. I know that the jargon and strategies required for trading can leave some people intimidated, so I’m going to break it down for you.

Options trading is a little-understood sector of trading. Some traders are quick to dismiss it as a waste of money, whereas others find it too risky to pursue. However, as you’ll learn in this post, when chosen at the right time, options trading can allow you peace of mind and potentially unlimited profits.

Download a PDF version of this post as PDF.

I’m going to cover some of the fundamental key terms and strategies of how to trade options so you can follow along.

What are Options?

options-trading-1
By Oil and Gas Photographer/Shutterstock.com

What is options trading? Options are a specific type of security called a derivative. As the name suggests, it means that option prices are derivatives of the stocks they represent.

Essentially, when you invest in options, you get the right — but not the obligation — to purchase or sell a certain amount of stock at a pre-arranged price and on a specific date. That price is derived from the stock’s price.

There are lots of examples of derivative investments. They’re a type of financial security that is 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.

Options, though, are basically contracts, just like any other type of investment. They’re different from regular stock plays and futures because you can decide not to go through with the contract.

There’s always a cost of doing business, though, based on the premium. I’ll get into that more later.

You might know that futures are contracts that require the buyer or seller to carry out the contract. Additionally, futures differ from options in that futures rarely reach their expiry dates, while options typically do.

Even if you’re skilled at trading futures, you’ll discover that the basics of options trading are a bit different.

How to Trade Options and How it Works

options-trading- how-to
By SergeyP/Shutterstock.com

Think of  how stock options trading works in terms of selling a car to a private party. You meet, the buyer looks over the car, and he or she 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 he 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 a lot more complicated than that, but it’s easy to understand when you have an example from outside the stock market options.

I want to stress that you have to learn the basics of options trading before you execute any contracts. Otherwise, you’ll lose money like thousands of other traders who jumped in without the requisite knowledge.

Types of Options

Let’s get some jargon out of the way. There are two key types of options: call options and put options.

If you believe the price of a stock will rise above the strike price at the time of expiry, you exercise a call option. On the other hand, if you believe the stock will fall below the strike price, you’ll use a put option.

Let’s look at those two positions in more detail.

Call Option

You can think of a call option as a potential investment in the future. For example, say Investor X wants to purchase an asset valued at $100,000 at some point in the future, but only if certain criteria are met. He or she can potentially purchase a call option on the asset to make a purchase at any point within a finite period of time. For instance, it might be within two years. Basically, they lock in the rate now.

The owner of the asset doesn’t necessarily just want to accept someone calling “dibs” without some sort of incentive, though, so the option buyer must put down a premium, which is the price of the options contract. This down payment might be a few thousand dollars.

The benefit is that if the asset goes up in value, the buyer still has the ability to make the purchase at the agreed-upon price as long as he does so during the contract period. The down payment is accepted as just that.

However, if the date of the expiration of the option passes and the potential buyer doesn’t move forward, the down payment is not returned.

Put Option

Where the call option is kind of like prospecting, the put option is more like hedging your bets. A put option is a contract wherein a buyer has the right to sell the asset in question at any time within a predetermined, finite period.

In this type of option, a “strike price” is set. Say Trader Y sets the strike price at $5. This means with the put option, he or she can exert their option to sell that stock at $5 per share at any point before the expiration date of the option.

The benefit of this method is that even if the stock value goes down dramatically, Trader Y can still gain this agreed-upon price within the set time period. If the price of the stock goes below the strike price, then they can stand to profit from this type of trading.

You can sell the option or cash in when the expiration date comes around. It’s up to you.

Once again, exercising a put option doesn’t come without a little bit of risk. 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.

Benefits of Trading Options

Why do successful traders love options? They might carry a lot of risk, but they’re also exciting and potentially profitable.

options-trading-profit
© 2018 Millionaire Media, LLC

Some of my students have had excellent result from trading options. They’ve studied the market, recognized the potential pitfalls, and traded options with their own risk tolerance in mind.

If you’re going to learn how options trading works, I encourage you to follow in their footsteps. Learn as much as you can to avoid big losses.

Flexibility

As you may have gathered from reading about call and put options above, one of the benefits of trading options is that you enjoy a high level of flexibility. Yes, you must invest with a down payment or “premium,” but it affords you the flexibility to make the decision of whether or not to actually exercise the option later.

You don’t have to exercise the option if you choose not to; there is no punishment, per se. 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.

Additionally, since options are a type of derivative, options can be used for all sorts of financial securities, including bonds, commodities, and foreign currencies, to name a few.

Limited Risk for Buyers

options-trading-risk
By OWN23/Shutterstock.com

As frequent readers of this site know, I’m all about cutting losses. Options are a fantastic way to minimize risk in an investment.

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 this payment. So, in that way there is considerable risk involved depending on the number of shares you intend to buy or sell.

However, that risk is nothing compared to the potential losses you might have suffered if you had committed to a non-option investment, such as investing in futures.

The put option is a good way to reduce potential losses. The buyer is only obligated to execute the trade if the asset reaches a desired level of value or meets certain criteria within the call option; if it doesn’t, then all they will lose is the premium.

Speculation

Yep: if options sound a bit like prospecting, you’re right. There’s a certain level of speculation involved in purchasing options.

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 when trading options.

Hedging

While options buyers are often speculating 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 do it again: I hate risk. And you should, too.

Yes, there’s a certain amount of risk involved in any investment, but I like to keep my risk low. I only invest a small percentage of my trading account on a single play, and I always get out of a play if I think I might be on the losing end of the deal.

Like in the car sale analogy, an options premium creates a stopgap. It says, “This is the most I’ll lose on this deal if it goes south.”

Basically, you are guaranteeing that this would be the maximum amount that you would 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 or it’s too risky to even pursue. However, I tend to think that hedging can be an intelligent approach, because you can never know what factors will play into a stock’s or asset’s value. Hedging strategies can be extremely valuable for potentially large investments.

By using options, you ultimately have the ability to restrict the potential losses on a given investment, while optimistically trying to make the most of the potential gains. It’s really quite cost effective when you think of it in that way. You’re paying for peace of mind.

Successful Options Trading Strategy: Buy and Sell Options

options-trading-success
© 2018 Millionaire Media, LLC

‘Call’ and ‘put’ aren’t the entire story when it comes to trading options. It gets a little more complicated than that. Here are some expanded explanations of common options trading strategies.

Long Call

This is the most basic type of strategy for the call option. Basically, it begins with the buyer’s belief that the underlying asset will rise in value over time. Therefore, they buy a call option with a strike price that they believe the asset will exceed in value over time.

They must determine an expiration date, and this is something of a gamble because they are hoping the value will rise before that date. Furthermore, they risk losing potential profits by setting an expiration date too soon after the contract begins.

Compared to simply buying shares in full, the buyer gains leverage here because there is a potential that the value will go up quite dramatically, and then they can buy in for their predetermined price. However, if the value doesn’t go up by the time that the expiration date is up and they haven’t decided to buy into their option, they will not receive their down payment back.

Long Put

This is the most basic type of strategy for the put option. It begins with the buyer 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.

Similar to a long call, you must agree to an expiration date; once again, this is a gamble because you have to try to determine by which point the asset will go down in value.

Some traders believe that, in comparison to short selling a stock, a long put proves a bit easier for the investor. 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.

Call Backspread

This is where things get a little bit more complicated. A call backspread, also referred to as a ‘reverse call ratio spread,’ is a strategy that is a bit more bullish.

Here, you will sell a certain number of call options, then buy yet 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, and it’s particularly well suited when buyers 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.

Put Backspread

You can’t have a bullish approach like the call backspread without a matching bearish approach. The put backspread is the yin to the call backspread yang. It’s also referred to as 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.

Protective Put

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.

Basically, you have a previous purchase that you are protecting with a proverbial insurance policy. This is what differentiates it from a long put — the fact that the investment has already been made.

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; if it goes down, you can profit from the put.

How to Read an Options Table

options-trading-table
© 2018 Millionaire Media, LLC

The first time you try to read an options table, you’re likely to 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.

OpSym. 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).

Bid. 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.

Ask. 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.

Extrinsic Ask. 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 price of an option.

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.

Volume. Simply put, 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.

Open Interest. This column tells you how many contracts of a given option have been opened, but have not yet been cashed in or sold.

Strike. 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.

Options Risks

In addition to the above columns in an options table, you’ll often also see a series of columns with headings named after greek letters. One of the unique things about options is that they carry various values which help investors 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 different price-affecting factors 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 the risk and reward potential of an option.

Delta

Delta is a Greek value which 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 present with holding a call option with a delta of 100 is similar to holding the equivalent amount of stock shares.

Gamma

Gamma is a Greek value which tells you how many deltas the option will gain or lose if the underlying stock rises by one full point.

Theta

Theta is the Greek value that indicates how much value an option will lose with the passage of one day’s time based on ‘time decay’. This factors in the expiration date of the option.

Vega

Vega is a Greek value which 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

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.

Options Trading Example: How Can You Succeed

After reading the above information, are you curious about trying your hand at the basics of trading options? If so, I can help you take your trading to the next level.

Why Do You Need Expert Assistance?

options-trading-how-to-succeed
© 2018 Millionaire Media, LLC

Options trading can deepen and diversify your trading repertoire. However, options can quickly become complicated with the many different options available. Like any other sector of trading, it’s important to seek out an education before you attempt to invest in this way.

Who is Tim Sykes and What is His Trading Challenge?

While I’m most famous for being a penny stock teacher, that’s not the only subject I cover in my Trading Challenge. Ultimately, as a teacher, I want to help my students forge long-term, sustainable careers as traders.

To help you navigate the ever fluctuating market, I teach you about all sorts of trading styles, including options trading. This helps them diversify and remain nimble in the ever evolving market. Articles like this, my daily alerts, and my webinars help further the education that students gain in my Trading Challenge.

It’s not all about raking in dough. Many of my students are content to learn three, four, or five figures a year from trading. Others want to become millionaires.

I’m here to support that goal and help you reach it through risk-averse, conservative trading. Plus, my best students — those who have become millionaires themselves — join me in coaching my students.

 Will you be my next success story?

Conclusion

As you can see by reading this article, options market offers many opportunities for investors. It has strong benefits, including flexibility, limited risk, and the ability to gain profits based on foresight gained through study and research.

To further your knowledge on options trading and to see how it can help increase your trading prowess, join my Trading Challenge to continue your education. I’m excited to work with you and help you reach your financial goals, whatever they might be.

Have you ever traded options?

Share