Options Trading
What is an Option?
An option is a contract that permits the holder to buy or sell (without any obligation) an asset like stocks (bond, ETF, and mutual fund options are also available) within a specific timeframe at a predetermined price. It is considered to be a derivative financial instrument. There are two different types of options: a call option, and a put option.
A call option gives you the right to buy assets like stocks (usually 100 shares per contract) at a predetermined price within a specified timeframe. Conversely, a put option gives you the right to sell assets such as stock (likewise, usually 100 shares per contract) at a predetermined price within a specified timeframe.
The predetermined price is referred to as the “strike price”.
The specified timeframe is referred to as the “expiration date” of the option.
The cost of the option contract itself is called the “premium”.
Below are two examples to give you more of an idea about the distinction between call and put options:
You decided to purchase a call option. This specific call option has a strike price of 100 with an expiration date of 30 days. Therefore, owning this specific call option will permit you to buy stock in Company X for $100 a share at any point in the next 30 days. Even if stocks in Company X suddenly surge and are trading at say, $125 per share, owning this specific call option allows you to buy Company X stock at $100 per share within this 30-day timeframe.
Conversely, you decided to purchase a put option. This specific put option has a strike price of 100 with an expiration date of 30 days. Thus, owning this specific put option will permit you to sell stock in Company X for $100 a share at any point in the next 30 days. This is advantageous because say stocks in Company X suddenly plummet and are trading at $75 per share. By owning this specific put option, you are allowed to sell Company X stocks for $100 per share within this 30-day timeframe.
A call option can be regarded as a downpayment, of sorts. On the other hand, put options can be seen as insurance.
What is Options Trading?
Options are considered an asset class and are bought and sold on the options market. The buying and selling of these assets can only be done through a brokerage. Virtually all the companies that you are familiar with from Apple to Nike have options contracts available for purchase.
There are four choices available with options trading: Purchasing call options, selling call options, Purchasing put options, or selling put options.
Investors who purchase options are referred to as “holders”, while those who sell options are known as “option writers”.
In options trading, it is important to note that there is a crucial difference between holders and option writers. A holder (or buyer) of either a call or put option can choose whether or not they want to exercise their right to buy or sell their respective option.
Conversely, an option writer (or seller) has the obligation to follow through with the particulars of the specific option contract – either buying or selling.
Options Trading Examples
To get a better understanding, below are options trading examples:
You decide to purchase 100 shares of Company X at $100 per share, which amounts to a $10,000 investment. You also decide to purchase a put option with a premium of $500 and an expiration date of 30 days.
If the stock price of Company X rose to say, $110 per share, then your 100 shares would now amount to $11,000, thus a $1,000 profit. However, you also purchased the $500 put option which is essentially worthless. Therefore, your net profit on this investment is now $500.
Conversely, say the price of stock in Company X suddenly dropped to $90 per share. Therefore, your 100 shares are now worth $9,000, thus a loss of $1,000. However, because you purchased the $500 put option, you can now “exercise your option” (meaning you can take advantage of the particulars of the specific option) to sell your shares at $100 per share. Hence, you lost nothing on the stock – the only loss is the $500 spent on the put option.
Options Trading Without Owning Stock
An important element that must be understood about options trading, is that you are not required to actually purchase stock! You can simply trade options if you want.
Below is an example of when you may want to purchase a call option:
You are intrigued by Company Y and feel that its share price is going to go higher. Yet the stock is expensive and trading at $130 per share. Rather than invest in the stock of Company Y, you can purchase a call option for it, which would permit you to buy stock in said company at a later date. Therefore, you decide to buy a 130 strike call option with an expiration date of 30 days for a premium of $500. Thus, if you choose, you now have the right to purchase 100 shares of Company Y at $130 per share at any point in the following 30 days.
Say the stock in Company Y increases to $143 per share. You can now exercise your 130 strike call option if you choose, which would allow you to purchase 100 shares of Company Y at $130 per share. Therefore, you are up 13 points on the stock and because you own 100 shares, you are up $1,300. Yet, because you bought the $500 call option, your net profit will be $800.
On the other hand, say stock in Company Y suddenly plummets from $130 to $105 per share. Obviously, you do not want to exercise your 130 strike call option, as the stock is trading at $105 per share and you have no obligation to purchase it. Had you owned stock in Company Y, you would now be down $2,500 (100 shares X $130 = $13,000). Rather, your only loss is the $500 premium on this specific call option.
This is why purchasing options can provide less financial risk than stock, because you can withdraw at any time and invest less capital.
However, it is crucial to understand that options trading is speculative, has the potential for significant financial loss, and is NOT appropriate for all investors.
Options Trading Strategies
An essential thing to understand is that you don’t have to exercise your options when you trade them. You can simply purchase an option contract, then sell it for a higher price.
When it comes to options trading, there are three components to the strategy that must be factored:
- The direction a specific stock will take, whether up or down.
- The price of the specific stock.
- The period of time that the specific stock will move up or down in price.
Best Options Trading Brokers
In order to trade options on the options market, you must first set up an account with a brokerage firm. Because there are numerous options trading brokerages, the choices can be a bit overwhelming, especially for beginners. Here are some of the most popular and respected options trading brokers.
Charles Schwab Options Trading
Charles Schwab is one of the biggest and most revered financial services companies in the world. The company has received exceptional reviews as an options brokerage, and provides an excellent experience for both beginner and seasoned investors. In addition to the expert support provided from options specialists, Charles Schwab has a $0.65 per options contract commission and no minimum balance requirement.
Fidelity Options Trading
Fidelity Investments is one of the largest asset managers on Earth, in addition to being a brokerage firm, amongst other things. Fidelity is a popular choice for investors who are searching for a highly reputable options broker. In addition to extensive free research tools and stellar customer support, Fidelity has a $0.65 per options contract commission and no minimum balance requirement.
Robinhood Options Trading
For those investors who are searching for an options trading broker with $0 options commissions, then Robinhood is your best bet. Founded in 2013, this trading app has exploded in popularity, mainly because of its free trades of options, stocks, and ETFs. The mobile app is highly regarded for being intuitive, and the perfect choice for investors looking to enter the options market. It also has a no minimum balance requirement.
Options Trading vs. Stock Trading vs. ETF Trading
Here is a comparison table examining the different types of trading.
Type of Trading Best Suitable For Risk vs. Potential Return Control Over Investments Research and Legwork Needed
Options Active Traders Lower-level Risk
(When Done Correctly)The investor has complete control over which companies are selected, and what options contracts are chosen. All research and trading is done by the investor.
Stocks Beginners and Long-term Investors High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
ETFs Beginners and Long-term Investors Lower-level Risk Professionally managed investment vehicle. All research and trading is done by a financial professional. Investors are charged a fee called an "expense ratio".
Bonds Beginners and Long-term Investors Lower-level Risk If investing in individual bonds (rather than bond ETFs) the investor has direct control over all invest decisions. All research and trading is done by the investor, if investing in individual bonds.
Mutual Funds Beginners and Long-term Investors Lower-level Risk Professionally managed investment vehicle. All research and trading is done by a financial professional. Investors are charged a fee called an "expense ratio".
Futures Active Traders Medium-level risk (when done correctly) The investor has complete control over which futures contracts are chosen. All research and trading is done by the investor.
Swing Trading Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Day Trading Active Traders High risk, yet has the potential for larger gains if done correctly. The investor has direct control over all invest decisions. All research and trading is done by the investor.
Commodity Trading Beginners and Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Trend Trading Beginners and Active Traders High risk, yet has the potential for larger gains The investor has direct control over all invest decisions. All research and trading is done by the investor.
Options Trading Simulator
If options are something that you are interested in, give this free options trading simulator a try before leaping into the real-world options market. It’s fun and informative and will help you hone valuable skills and techniques to become an effective trader.
Options Trading FAQs
Options trading for beginners?
Options are considered an asset class and are bought and sold on the options market. The buying and selling of these assets can only be done through a brokerage.
There are four choices available with options trading: Purchasing call options, selling call options, Purchasing put options, or selling put options.
Investors who purchase options are referred to as “holders”, while those who sell options are known as “option writers”.
In options trading, it is important to note that there is a crucial difference between holders and option writers. A holder (or buyer) of either a call or put option can choose whether or not they want to exercise their right to buy or sell their respective option.
Conversely, an option writer (or seller) has the obligation to follow through with the particulars of the specific option contract - either buying or selling.
Is options trading better than stocks?
Options are advantageous because you invest less capital than stocks, and there is also less financial risk.
However, it is crucial to note that like any investment vehicle, options trading is speculative, still has the potential for significant financial loss, and is NOT appropriate for all investors.
How much money do you need for options trading?
Most options trading experts suggest having at least $2,000 to $3,000 set aside to begin effectively trading options.
However, many brokerage firms have no minimum balance requirement to set up an account.
Trading options on Robinhood?
Founded in 2013, Robinhood has exploded in popularity, mainly because of its free trades of options, stocks, and ETFs. The mobile app is highly regarded for being intuitive, and the perfect choice for investors looking to enter the options market. It also has a no minimum balance requirement.
This trading app is ideal for those investors who are searching for an options trading broker with $0 options commissions, in addition to the convenience of doing trades via your mobile device.
What is binary options trading?
A binary option is a financial instrument that enables one to make trades in the fluctuating prices on global markets. They differ from conventional options, because the payoff is a fixed amount, as is the loss incurred.
An example of binary options trading is as follows:
You believe Company X will be trading at $50 per share at 1:15 pm next Tuesday. You are willing to bet $100 on your hunch and agree to a payout of 75%. If the price of Company X is trading above $50 at 1:15 pm next Tuesday, then the binary options broker will credit your account with $75.
However, if Company X shares are trading below $50 at 1:15 pm next Tuesday, then unfortunately you lose your $100 investment.
Day Trading Options?
It is imperative to understand that options trading is speculative, has the potential for significant financial loss, and is NOT appropriate for all investors. Before you begin trading options, it is critical that you do extensive research on the topic and utilize reputable educational resources with proven long-term results.
Day trading options has both pros and cons, as with any investment vehicle. Always do your due diligence before investing your hard-earned money.
What are the best options trading strategies?
When it comes to options trading, there are three components to the strategy that must be factored:
- The direction a specific stock will take, whether up or down.
- The price of the specific stock.
- The period of time that the specific stock will move up or down in price.
Do you have to own stock to trade options?
No!
An important component to understand about options trading, is that you don’t actually have to own stock - You can simply trade options if you want.
You are intrigued by Company Y and feel that its share price is going to go higher. Yet the stock is expensive and trading at $130 per share. Rather than invest in the stock of Company Y, you can purchase a call option for it, which would permit you to buy stock in said company at a later date. Therefore, you decide to buy a 130 strike call option with an expiration date of 30 days for a premium of $500. Thus, if you choose, you now have the right to purchase 100 shares of Company Y at $130 per share at any point in the following 30 days.
Say the stock in Company Y increases to $143 per share. You can now exercise your 130 strike call option if you choose, which would allow you to purchase 100 shares of Company Y at $130 per share. Therefore, you are up 13 points on the stock and because you own 100 shares, you are up $1,300. Yet, because you bought the $500 call option, your net profit will be $800.
On the other hand, say stock in Company Y suddenly plummets from $130 to $105 per share. Obviously, you do not want to exercise your 130 strike call option, as the stock is trading at $105 per share and you have no obligation to purchase it. Had you owned stock in Company Y, you would now be down $2,500 (100 shares X $130 = $13,000). Rather, your only loss is the $500 premium on this specific call option.
Best options trading platform?
Options trading has exploded in recent years with the increase of online brokerages. Examples of some of the most reputable and best options trading platforms available include Charles Schwab, Fidelity, and Robinhood.