Getting Started with Options Trading
The average investor will routinely trade equities and bonds but will rarely trade options.
Why?
There are indeed drawbacks to options. They confer no equity in a company. They become worthless on their expiration date. And options strategies can be complicated … sometimes very complicated.
Some even avoid options trading because they are intimidated by the jargon. Terms like put, call, strike price, iron condor, and in-the-money leave such investors scratching their heads.
But to avoid trading options because they are different than buying equities or because they are too complex is to miss out on an investment vehicle that can complement a long-term investment strategy.
First, let’s define what an option is and discuss why they’re worth trading. Then we can review the two types of options. Last, we’ll introduce both simple and advanced option trading strategies so that you have the information you need to get started.
What Is an Option?
An option is a contract that gives an investor the right (but not the obligation) to buy or sell stock at a fixed price before a certain date. In most cases, an option represents 100 shares of stock in a company.
Trading options is slightly different than other types of trading. When an investor purchases shares of an equity, for example, they are buying a piece of the company. As a stockholder in a company, they gain certain privileges, like the right to vote in company elections. They can also hold on to their shares for as long as they want. Although the price of shares may go up, down, or remain virtually the same, they will retain monetary value (unless the company goes bankrupt).
When an investor purchases an option, however, they are only buying the right to trade 100 shares of a company’s stock at an agreed-upon price (the strike price or exercise price) before a certain date (the expiration date or exercise date). The investor has no stake in the company because they are not buying the stock itself (only the option to buy or sell it). After the expiration date, the option has no value and ceases to exist.
Options trading has several advantages:
- Compared to stocks, buying options require less cash upfront.
- Because they cease to exist after the expiration date, they’re low commitment.
- When used strategically, options can minimize risk in an investment portfolio.
- Options allow investors to profit in virtually any kind of market. Market volatility can be a good thing for an options trader.
The Basics of Buying and Selling Options
Investors buy options when they have a hunch that the share price of an equity will go up, down, or stay the same in the near future, and they want the ability to profit from that hunch without having to commit to buying or selling stock of an equity.
There are two types of options: calls, shortened from call options, and puts, shortened from put options. If an investor buys a call, they have the right to buy 100 shares of an equity at the strike price before the expiration date. If an investor buys a put, they have the right to sell 100 shares of an equity at a strike price before the expiration date. Remember that for both call and put contracts, the investor is not required to buy the shares in the equity that they have optioned.
In the real world, here’s how a call might work. An investor has researched the market and has good reason to believe that the share price of XYZ Corp. is going to rise after the company releases a new product. Instead of buying 100 shares of XYZ, which would be pricey as the share price is currently $80, the investor buys an option for XYZ at a strike price of $90.
If XYZ’s share price jumps to $100, the call will allow the investor to buy the shares at the cheaper price of $90 and make a profit. (Investors who didn’t purchase a call are now stuck paying $100 for a share of XYZ.) Here, the investor is in-the-money (ITM)—that is, the strike price is less than share price.
But what if the investor is wrong? What if XYZ’s new product is a flop and the share price tumbles to $60? In that scenario, the investor can simply decline to purchase XYZ stock and walk away. They have only lost the amount of money that they paid for the call (the premium), which is less than they would have lost if they had bought the shares outright. In this case, the investor is out-of-the-money (OTM)—that is, the strike price is more than the share price.
The opposite of a call is a put. In a put scenario, an investor may have stock in ABC Inc., a company whose success is tied to the global commodities market. Say the investor believes that there is going to be a global commodities downturn. To minimize risk, the investor purchases a put with a strike price of $120 for a limited time.
If the ABC’s share price does plunge to, say, $100 before the put’s expiration date, the investor has the option to sell their ABC shares at the higher share price of $120. If the investor is wrong about the commodities market’s effect on ABC and the stock price stays about the same or even rises, they will not use their option and are only out the cost of the premium.
So far, we’ve only discussed buying calls and buying puts. But know that for every purchase of a call and every purchase of a put, someone is selling them. Their angle is different than options buyers. While buyers of a call want the share price to rise, sellers want the opposite. Likewise, while buyers of a put are betting on share price to fall, sellers of a put hope that the share price increases (or at least stays roughly the same).
Covered Calls: The Simplest Way to Get Started
The easiest (and most conservative) way to begin options trading is to sell covered calls. To do this, the investor must own at least 100 shares of an equity that they are not committed to keeping for the long term.
Then, they can sell a call on that equity (referred to as writing the call). If the share price of the equity stays below the strike price, the buyer will not use the call, and the seller can pocket the premium that the buyer paid. If the share price goes up above the strike price and the buyer decides to exercise the option, then the investor must sell the stock. Although this is not the ideal outcome, the investor will still receive the premium.
Covered calls are an effective strategy for the investor who senses that the share price of their equity will stay the same or will slightly rise in the immediate future. While they play the long game and wait for the equity’s stock to rise, they can profit off premiums that they earn from optioning the stock.
The covered call strategy works for equities that are expected to remain fairly stable. It is not an effective strategy when the share price of the underlying equity is expected to drop or rise drastically.
Advanced Options Trading Strategies
Selling covered calls is an excellent way for an investor new to options trading to begin. Later, after gaining experience with covered calls, they may want to try out more advanced options trading strategies, of which there are numerous. Here we’ll discuss two of the main ones: selling puts and creating iron condors.
Michael C. Thomsett, the author of Getting Started with Options, called selling puts the “overlooked strategy,” one that an options trader shouldn’t forget to use in the right circumstances. Recall that when an investor buys a put, they are buying the option to sell 100 shares of an equity at a certain price within a specific timeframe. Selling puts is the opposite of this. While the put buyer is bearish and wants the share price to fall, the put buyer is bullish and wants it to stay higher than the strike price.
It’s important to note that an investor should only consider selling a put if they already own or they are open to buying stock in the underlying equity. If they don’t want to own the stock, they shouldn’t sell a put—as they may have to buy it if the option is exercised. To that end, the investor should set a strike price that seems reasonable to them, a price that they would feel comfortable paying for the stock. Besides, it’s recommended to sell puts only if the outlook for the equity is bullish and to pick an expiration date that’s sooner rather than later.
As will soon become clear, iron condors are a more advanced options strategy than selling puts. It’s a market-neutral strategy—that is, the strategy has neither a bearish nor bullish preference, and it’s a way to profit from a market that isn’t particularly volatile.
In an iron condor, an investor makes four moves simultaneously: they 1) buy a put, 2) buy a call, 3) sell a put, and 4) sell a call. This strategy allows the investor to reap a large premium from the four options contracts while, at the same time, limiting risk. Admittedly, it’s a complex strategy that requires a thorough understanding of options—but, for the advanced options trader, it can be a low-risk method to cull a profit from an otherwise quiet market.