A Beginner’s Guide to Options Trading

A Beginner’s Guide to Options Trading

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If you’re curious about options trading, you’re in the right place. The options market is a versatile and flexible arena that can offer a way to generate income, manage risk, or simply explore new opportunities.

But options aren’t just for professional traders; with a little knowledge and understanding, beginners can learn to navigate the exciting world of options. In this beginner’s guide, we’ll cover what you need to know to start exploring options with confidence.

Options Defined

An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price and date. Options are often used to speculate on future price movements, hedge against existing positions, and generate income through premiums. Options are classified as derivatives, as their value is derived from the underlying asset.

There are five components to any options contract:

• Underlying Asset: The asset on which the option contract is based, like a stock, commodity, or currency.
• Option Type: A call or put, which determines whether the buyer has the right to buy or sell the underlying asset.
• Strike Price: The price at which the underlying asset can be bought or sold, as agreed upon in the options contract.
• Expiration Date: The date that the options contract must be exercised (buying or selling the underlying asset). It will expire worthless if not exercised.
• Premium: The price paid by the buyer (the holder) to the seller (the writer) for the contract.

Options are leveraged products, meaning traders can use limited capital to gain exposure to a large position. Typically, an options contract is equivalent to 100 shares of stock. This leverage is especially useful for hedging. For example, if you own $10,000 worth of a particular stock, you might only need $500 to open options contracts that cover downside risk.

Types of Options

The two primary types of options contracts are call and put options.

Call options give the buyer the right to buy an underlying asset at a predetermined price, while put options give the buyer the right to sell an underlying asset at a predetermined price. In simple terms, a call option is used to speculate on an asset's price increase, while a put option relies on an asset falling in price to generate a return. These two types are the basis for all other variations of options contracts.

Options contracts also come in two distinct flavours: American and European. American options can be exercised at any time before the expiration date. European options can only be exercised at the expiration date.

How Options Pricing Is Determined

The price of an option, or the value of an option (premium), is largely centred around two main features: intrinsic and extrinsic value. The two aforementioned values are generally determined based on the three following inputs: implied volatility, expiration time and the difference between the strike price and underlying asset.

Distance to Strike Price:

Options are either in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM).

• ITM: The contract has intrinsic value - the strike price is favourable compared to the underlying asset's current price.
• ATM: A contract where the strike price equals the asset’s current price.
• OTM: A contract with no intrinsic value, where the strike price is unfavourable compared to the asset’s current price.

If the underlying asset’s price is $100, a call option with a strike price of $95 would be ITM. If the strike price is $100, it’d be ATM. If the strike price were $105, the contract would be OTM.

Buying an options contract already ITM costs more upfront (more premium) since there’s a stronger likelihood it’ll expire above or below the strike price for a call or put option, respectively. In contrast, options contracts that are OTM will be cheaper, as the probability of the underlying moving beyond the strike price is lower.

This works dynamically as the price of the underlying changes. All else being equal, the price of an OTM contract will increase as it moves closer to the strike price and will be in profit once it becomes ITM.

Time Until Expiration:

The longer the time until expiration, the more time the underlying asset has to reach the strike price, which can increase the probability of the contract becoming ITM. As a result, options contracts with longer time to expiration generally have a higher time value, which can impact the overall price of the option. For example, a contract that expires in a month will have less time value and may be cheaper than a contract that expires in two years.

Implied Volatility:

Implied volatility, often abbreviated to IV, will also influence the price of an option. The higher the volatility in a given market, the more chance it has of making wild swings up and down. This then increases the likelihood of the option reaching its strike price before the expiration date, and as a result, the option will be more expensive.

How Options Trading Works

Putting it all together, buying calls means speculating that an asset increases in value, while buying puts is betting that an asset decreases in value. The distance from the strike price, the contract’s time until expiration, and the underlying asset's volatility all influence the option's current and future price.

For every options contract, there must be a buyer and a seller. Buyers are formally known as ‘holders’, while sellers are called ‘writers’. The buyer must pay a premium (to the writer) to purchase a contract, but their risk is limited to the premium paid. The seller collects the premium but must buy or sell the asset if it expires ITM. This makes selling options much riskier, as sellers can incur substantial losses if the underlying moves unfavourably.

While single-call and put options (long [short] call and long [short] put) are the most basic option types, which include things like a covered call (selling a call option while owning at least 100 shares of the underlying stock), many advanced strategies combine the two to create specific outcomes, such as spreads and straddles.  

Benefits of Options Trading

Trading options can be a powerful way to profit from market movements, generate income, and manage risk. Let’s take a look at some of the key benefits of options trading:

• Flexibility: There are dozens of options trading strategies out there that can be used to profit from different market conditions, regardless of whether an asset is rising, falling, or stagnating.
• Potential for High Returns: Options contracts provide leverage, which can amplify profits. The probabilistic nature of options also means that options with high risk, like a short-term expiry, can generate significant returns.
• Limited Losses: For the most part, the maximum potential loss is the premium paid for an option, which can help traders avoid large losses.
• Hedging: Traders can use options to offset their losses and manage their overall risk exposure.
• Income Generation: Selling contracts to other traders for stocks you already own, known as covered calls, can be an effective way to generate consistent income from your existing investments.

Risks in Options Trading

However, options trading isn’t without its downsides. There are many risks when trading options, including:

• Risk: Options are leveraged, which can amplify profits if successful. However, they can also magnify losses. Selling contracts can be riskier; a naked call, where the seller doesn’t own the underlying asset, can lead to substantial losses.
• Time Sensitivity: The value of an option can rapidly decline as it approaches expiration, also known as time decay. If they’re not careful, traders can lose a lot of profit through time decay, even if their prediction is correct.
• Complex Strategies: Without prior experience, the increased number of variables in a complex options trading strategy can be incredibly confusing and lead to disaster for new traders.
• Liquidity Issues: For popular stocks, like AAPL or MSFT, you probably won’t run into inadequate liquidity. But for low-volume stocks, you might struggle to get filled at your preferred strike price and expiration date. This can cause wild swings in the price of the option itself.

The Bottom Line

In conclusion, options can be a worthwhile tool to help you explore and take advantage of opportunities not found elsewhere. By understanding the basics and researching further, you can set yourself up with the confidence to enter the options market.

While trading options can be risky, especially for those not well-versed in the market, with careful planning and consideration, the benefits can be far-reaching. Options may seem intimidating initially, but with the right attitude and knowledge, it can be a rewarding and exciting avenue for trading and investing.