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How to Trade Options

What are options?

An option is a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price (also called the “strike price”) and by a certain date (also called the “exercise date”).

Elements in an options trade

You must decide, in an options trade, the following:

  • Which direction is the stock going to move?
  • How high or low will the stock price move from its current price?
  • How will the stock move during a particular time frame?

Option types

There are two types of options you can buy or sell: call option and a put option.

Call option: This option allows the buyer to buy the contract at the specified price on or before the expiry date and is exercised by the buyer when the market goes above the strike price.

Within the call option, there are two possibilities:

  1. Buy call: The buyer will buy the contract as it would yield maximum profits and limited loss, which is equivalent to the premium paid to the seller initially.
  2. Sell call: It is the obligation of the seller to sell when the buyer exercises his/her call option.

Put option: The buyer can sell the contract at the specified price when the market price moves below the strike price.

Within the put option, there are a couple of possibilities:

  1. Buy put: The buyer has the right to sell the contract when he/she thinks the prices will fall. He/she can sell the contract at his/her own will.
  2. Sell put: The seller has the obligation to buy the contract. The seller enters in such a contract anticipating earnings.

Understand the risks

Options can be purchased speculatively or as a hedge against losses. Speculative purchases allow for the potential to make a lot of money, but only if traders can correctly predict the magnitude, timing and direction of the underlying securities’ price movement. Doing this incorrectly can result in large losses and high trade commissions. Novice traders, beware.

Know the lingo

If you’re a new options trader, you’ll quickly realize there are lots of new, potentially bewildering terms. These terms also include some already covered (it’s important to review!):

Holder: A trader who has bought an option.

Writer: A trader who has sold an option.

Strike price: The price at which the asset will be bought or sold.

Expiration date: The already-agreed upon date by which the option owner must exercise his right to buy or sell the underlying security. After this date, the option expires.

In the money: The market price of the asset is higher than the strike price (in the case of a call) or lower than the strike price (in the case of a put).

Out of the money: The market price of the asset is lower than the strike price (in the case of a call) or higher than the strike (in the case of a put).

Choose a broker

Low commissions are just the tip of the iceberg when it comes to choosing the best broker for options.

Traders need to consider hidden fees, such as platform fees and data fees. Different traders have different skill levels, trading strategies and needs.

Options trading can be complicated, and beginners need to make sure to find a platform with plenty of educational resources and guidance. Advanced traders need to look for professional-grade features and research.

Some of our favorite brokers

Before choosing the right broker, each trader needs to consider his or her trading style and which features are most important in maximizing profitability. In addition, be sure to avoid scam trading sites and platforms. They exist all over the web.

For an overview of our choice for top brokers, check out Benzinga’s Best Brokers for Options Traders.

Get approval

Brokerage houses will have to give you permission to trade options; they set limits based on how much money and experience you have before they’ll allow you to trade.

Paper trading is essential

Paper trading is an important step for anyone serious about making a profit in the options market. It’s a way for beginning traders to perfect a trading plan before trading with real money. That said, paper trading cannot be approached lightly!

It’s possible for new options traders to not take “fake” money seriously, so they experiment in ways they might not with real money. Therefore, it’s possible for two things to happen:

  1. They win irresponsibly, believe the market is easy, throw in real money and lose it all.
  2. They lose irresponsibly, believe the market is a scam, and never try again.

It’s important to treat paper trading as if it’s real money, but some traders argue that paper trading can never replace the emotions you’ll experience when you’re using your own money.

Advanced trading options

Once you’re familiar with the ins and outs of limit orders and execution prices, you’ll likely be ready for advanced trading options. In addition, you’ll be experienced enough to know to reevaluate your strategy periodically, learn from your mistakes and also, your successes.

There are other, more advanced trading strategies you can look into, including:

Straddle options: These provide equal profit potential on either side of an underlying price movement.

Strip options: These are a market neutral bearish strategy and it provides double the profit potential on downward price movement compared to equivalent upward price move.

The Greeks: Metrics, including delta, gamma, theta and vega, that advanced options traders use.

These are only a few advanced terms; there are so many more that encapsulate all there is to the complex world of trading options.

Get a mentor

Seek a mentor through your brokerage firm for guidance if you’re a beginner options trader. It’ll be instrumental to your success as a trader, as there is lots of misinformation online. Many brokers have thorough education on options education. It’s complicated, so you shouldn’t go it alone.

For more information and further education, visit the official website of the Options Clearing Corporation, or OCC.

Final thoughts

More complex than trading stocks, it’s necessary to educate yourself. Take classes, pay attention to forums and blogs, watch tutorial videos and download books on trading. Track the news and know what’s going on in the world economy, and finally, talk to a real trader and ask him/her for guidance.