You have heard about Option trading.
Maybe you have even taken the steps to try to understand ho w you can profit from it yourself.
However, you are yet to fully graph how to go about it.
In this tutorial, I will explain Options Trading as you would explain a new concept to a child.
Table of Contents
Options Trading Explained: What Is a Stock Option ?
In this second option trading tutorial, we will explain Options Trading once for all so that you will not have to guess anymore about all the the myriad of questions.
An Option is a financial instrument derived from a given stock that trades on the Stock Exchange.
The origin of Options Trading can be explained by the need for investors to minimize risk or hedge.
Throughout the years, options have become fully pledged financial instruments.
A stock Option gives its buyer the right (but not the Obligation) to buy or sell a stock at an agreed price and date.
How To Explain Option Trading “To a Child”
Often option trading is considered too complex.
But it does not have to be.
We ought to be able to explain option trading to child without him or her rolling their eyes back to you.
Call options is a bet that a stock will increase in price.
Put Options is a bet that a stock will fall.
Let’s suppose Trader Jack thinks that stock XYZ will rise from its current value of $50 to $60 within the next month.
Then Joe can purchase the following month calls on the XYZ company. Jack will need to determine 2 things before buying XYZ calls.
- The date of Expiration : the date of Expiration of Jack’s right to purchase XYZ stock
- The Strike Price : the price at which Jack will be purchasing XYZ stock
These two factors (we will introduce other technical factors later on) will mostly influence the cost of the Calls Jack is willing to purchase.
Most Important Parameter in Option Trading | Time
The more time left on an Option relative to its Expiration date, the more value is has.
Options have weekly expiration and monthly expiration.
Some ETFs (Exchange Trade Funds) have daily Expiration now.
Once in possession of the Option, the trader can sell is at any time before the Expiration date (at least in the US, as it is a bit different in Europe).
Two popular type of trades to consider:
- Scalping which consists of holding the Options only for a very brief period of time (a few minutes, a few hours) depending on market conditions and
- Swing trading which consists of holding the position for a few days or even weeks depending on the time left before its expiration
Options Trading Explained: Stocks vs Options ?
Stock Options (there is also Binary Options we will not be addressing here today) are attractive because they are cheaper than the stock they are derived from also known as the Underlying.
One option gives its holder the right to 100 shares of the Underlying stock.
Why Is Buying Option More Profitable than the Stock Itself ?
Stocks like Apple (NVDA) , Netflix (NFLX) or TSLA are too expensive for most beginner traders with small accounts.
So, in order to acquire 100 shares of such stock, one must come up with over $50000.
Whereas if a trader purchases let say NVDA Calls with an expiration date that is still in the future, that trader could exercise (exercise their right to buy it at the strike price) their AAPL calls Options today and thus saving a great deal of money.
This method is really more like an investment.
For reference, here is the daily chart for Apple stock over the last 12 months plotted using TradingView charting tool.
Our goal in trading Options vs Stocks as outlined in Trade Stock Options discussion is to make money from the price movement of the underlying security and typically over a short period of time.
Why Isn’t everyone trading Options
Typical expiration will be weekly (dangerous to trade) or monthly even though intent is to be in the trade for a much shorter period of time.
Price moves from one thing and one thing only : Supply and Demand.
We do not care about the fundamental of the company we trade.
The Lack of understanding of Options trading is what makes most traders stay away.
However, with the proper knowledge, there are plenty of Options trading strategies traders can leverage to generate income or complement other type of investments.
Options Trading Strategies For Beginners
Stock Options strategies can be as complex as needed.
For the Purpose of this discussion, we shall simplify it to Calls, Puts, and the combination of these two that can be called Strangles and Straddles.
Also, we will position ourselves as the Buyer of the securities meaning we will purchase them from Market Makers.
Simple Option Trading Guide
Note that it is quite possible for someone to become a Market maker (writing Calls or Puts) but that requires certain requirements not addressed in here.
A Call option is considered when one expects the stock to go up
A put Option is considered when one expects the stock to go down
A (Long) strangle is a Call and a Put with different strike prices
A (Long) straddle is a Call and a Put with the same strike Price
Are All Stock Options Equal ?
We already know that Stock Options have different Expiration times.
Some Stock expiration are only monthly while most have weekly expiration dates.
What is an Option Expiration date
Traders like to stick with certain set of stocks sometimes known as Watchlist.
This helps them become very familiar with the way a specific stock behave thus providing an edge in knowing when to enter and when to exit a particular position.
The price of the Stock also influences the cost of its Option outside of movement.
Amazon (AMZN) is a a stock that trade over $3000
That price of the Options are way more expensive that Apple or NFLX.
This means there is a barrier to entry for trading certain Options.
This can lead one to wonder: How much capital one needs to start trading options ?
Well, the short answer is as little as $5.
Cost of Trading Option Has Gotten Cheaper
There is $0 commissions on trade since early October 2019 across all major brokers.
Therefore, the cost of buying an option becomes the cost of the contract plus the cost of the option itself.
Options can be bought for as little as 1 cent per contract.
Since that is for the control of 100 shares, the actual price for that option is $1.
One can take calculated risk with a relatively low budget.
Especially close to the expiration date of the options.
Because by their nature, Options will lose value as the expiration is nearer.
Where Can You Practice Option Trading ?
If you are a beginner trader who is looking to practice options trading, you will need a demo/Paper account.
Most brokers nowadays do offer a free practice account that traders can reset indefinitely.
E*TRADE trading Platform is one of the easiest options trading platform for beginners.
It comes with a free demo account after you create you account online.
This process takes less than 15 minutes.
Here is our recent video comparing E*TRADE vs Webull (this one does not offer an option demo account yet).
We just completed the definition of a stock Option.
We introduced the basic set of Options one can trade without restriction (Call, Puts, straddle and strangles) .
Next, we will explore some technical aspects of stock Options.
What makes one attractive over another one.
In the meantime, let me know on the comments section below how in depth you think I should go in the exploration of the technical aspects of Trading Stocks Options.
TBP | Becoming A Successful Stocks and Options Trader