How Does Options Trading Work: A Detailed Breakdown for Beginners

March 17, 2023

How Does Options Trading Work: A Detailed Breakdown for Beginners

Options trading can be a lucrative way to make money in the stock market. With the ability to use leverage, an options trader is allowed to control a much larger position size than their own capital would otherwise allow. This means that even small movements in the price of a security or underlying asset can result in substantial gains or losses for the investor. Additionally, options traders have access to a wide range of strategies which can help them to maximise their profits and mitigate risk. Furthermore, with the right understanding and knowledge, an options trader can take advantage of market opportunities more quickly than other investors. All in all, options trading can be a great way for investors to capitalise on price movements and generate profits.

What is an option?

Before going too in depth about options, we should probably discuss the basics – what is an option?  An option is a financial contract between two parties, the buyer, and the seller. The buyer has the right to buy or sell an underlying asset at a predetermined price on or before a specified date. Options are typically used by traders to leverage investments and hedge against risks in volatile markets. Options can be purchased either on individual stocks, indices, or commodities, and are bought and sold through brokerages. The buyer pays a premium to the seller for this right. If the option is exercised, the buyer has the right to buy or sell at the predetermined price. Because of this, options can be a very powerful tool when used correctly.

Options provide investors with flexibility because they can either use the option to obtain exposure to an asset in a cost effective manner (through buying calls) or as a tool for hedging against losses and limiting downside risks.

Why are options profitable?

As with any other investment strategy, you really need to understand your craft before consistently making a profit.  Options are profitable because they allow investors to control large amounts of stock with a relatively small amount of money. One of the main benefits of options trading is that it allows traders to leverage their investments and take advantage of price movements without having to commit huge amounts of capital upfront. With an appropriate risk management strategy, investors can mitigate losses and potentially generate significant profits from their investments. Additionally, options trading allows for flexibility and control over the investor’s risk exposure, as well as increased liquidity of capital.

Through various strategies such as spreads, straddles, and covered calls, investors can also greatly reduce the overall risk associated with option trading compared to other investment vehicles such as stocks or bonds. Finally, investors can use options as a hedge against potential losses or to capitalise on volatile markets. By taking advantage of price movements and hedging their positions, investors can potentially realise larger gains from their investments than they would by trading stocks alone.

What is a call option?

A call option is a contract that gives the buyer the right, but not the obligation, to purchase an underlying asset at an agreed-upon price (the strike price) on or before a specified date (the expiration date). The seller of the call option agrees to sell the asset to the buyer for that price. Call options are considered bullish strategies, meaning they are often used when the investor expects the underlying asset's price to rise.

By entering into a call option contract, the buyer can limit their risk and potentially profit more than they would on just purchasing the stock outright. Call options also give buyers access to assets that may be too expensive for them to purchase in full. This is due to the leverage that comes with options, which allows for a greater return relative to the amount of money invested. It is important to note that call options are not free and come with expiration dates, as well as possible losses if the stock price moves against you.

What is a put option?

A put option is an agreement between a buyer and a seller that gives the buyer the right, but not the obligation, to sell a specific quantity of an underlying asset at a predetermined price within a specified period of time. The purchaser of the put option has the right to “put” or sell the underlying asset at any time before the expiration date.

Put options are most used as a hedge against declining prices in the underlying asset, allowing an investor to potentially reduce losses or protect gains that have been made on that asset. They may also be used for speculation, in which case investors purchase put options with the hope of profiting from a decline in price of the underlying asset.

What is a long call?

A long call is an options trading strategy that involves buying a call option with the hope that it will increase in value before the expiration date. The goal of this strategy is to profit from a rise in the underlying stock's price, which typically requires less capital than owning the actual stock itself.

This type of strategy can be used to generate income from stocks that you believe will have a positive price trend in the future and can be used as an alternative to buying the stock outright. When executing a long call, it's important to understand the risks involved and make sure you are comfortable with them before entering a position.

What is a covered call?

This is an options strategy designed to provide income for investors who already own a stock. It involves selling (or "writing") call options on the underlying equity, with the investor retaining ownership of the stock throughout. This means that if the option buyer exercises their right to buy the shares, the seller has enough in their account to cover the purchase.

The risk in writing a covered call is that if the stock rises significantly, the investor may miss out on part of their potential profit since they are obligated to sell their shares at the strike price, which may be lower than market value.

Long puts

A long put is a bearish options trading strategy that involves buying puts with the belief that the underlying asset will decline in price. The maximum profit of a long put is generally achieved if the underlying security drops to zero, and the maximum loss is limited to the cost of purchasing the option.

A long put can be used as an alternative to short selling to profit from a downward price move. It is also used as an alternative to buying stock if an investor wants to hedge against a potential decline. It provides the investor with more flexibility than short selling since they are not exposed to margin requirements or potentially unlimited losses.

Short puts

This is an options trading strategy involving the sale of a put option, typically when an investor believes that the underlying asset's price will remain steady or increase. The goal of the strategy is to generate income from selling the put option for a premium and benefit from collecting any dividends associated with owning the underlying asset. A trader can also benefit if the underlying asset stays above the strike price of the put option.

The potential risk associated with a short put strategy is that the trader will have to buy back the option at a higher price than they sold it for, which would result in a loss. To mitigate this risk, traders often use protective stop losses or engage in spread strategies involving multiple options. To successfully implement a short put strategy, an investor should understand the underlying asset's technical and fundamental analysis, how options work, and the risk associated with trading options.

How to become a better options trader

  1. Start with the basics. Before you can get into advanced trading strategies, you need to understand the fundamentals of what options are and how they work. Take some time to read up on different types of options, their features, benefits, and risks associated with each type.
  2. Understand the markets. Options are derivatives which means they are derived from the underlying stock. It’s important to have a good understanding of how the markets work, including technical and fundamental analysis techniques, so you can make informed decisions when trading options.
  3. Practice with paper trading. Before you dive into real money options trading, take some time to practice with a paper trading or virtual trading account. This will help you become familiar with the various platforms and strategies you'll use when trading in real time.
  4. Educate yourself on options strategies. A good way to become a better options trader is to educate yourself on different option strategies and understand how they work, their risks, and when it might be beneficial to deploy them.
  5. Get access to data and forecasting tools that give you insights into how a stock is likely to perform based on historical data.  Tools have the ability to analyse multiple data points within fractions of a second and can be very valuable when trades need to happen quickly.
  6. Manage your trades effectively. Once you have developed a strategy and placed your trade, it’s important to monitor it closely and adjust as needed. This will help you maximise your profits and minimise losses.
  7. Establish a trading plan. Create a step-by-step plan for each trade you enter so you know exactly what you are doing when you open, manage, and close out positions. Having an effective plan in place will help you stay organised and disciplined when trading.
  8. Stay current on market news. Staying informed about what’s happening in the world of options trading is essential to becoming a successful trader. Keep up with the latest news, analysis, and strategies from industry experts so you can make more informed decisions when trading.
  9. Utilise Risk Management Tools. Part of being a successful options trader is managing risk effectively. Use tools like stop-loss orders and hedging to help you protect your capital while taking advantage of market opportunities.
  10. Track your results and adjust accordingly. The best way to become a better trader is to track your results and adjust your trading strategies based on what’s working. Analyse your trades and look for opportunities to improve so you can increase your profits over time.

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