Your Complete Beginner’s Guide to Trading Options
When it comes to investing, there is simply no better way to ramp up your profit potential than to trade options. With options, you can collect big gains in just a matter of days, or even hours.
Now, you might think options trading is scary. And if you've never done it before, there are a few tricks of the trade we'll show you today. But once you've learned the basics and gotten some trades under your belt, you'll probably find it's just as easy as traditional stock investing.
That's why we're bringing you the complete guide to options trading for beginners to help get you started today…
Plus, options trading can be a lot more fun – especially when the profits start rolling in.
What Is Options Trading?
When you buy options, you're not buying shares of a company. You're paying for the right to buy (or sell) shares at a certain price on a certain date. So you only have to pay pennies on the dollar relative to the share price.
Instead of buying 10 shares of a stock, you could buy options for 100 or 200 shares. Instead of buying 100 shares, you could trade options on 1,000 or 2,000 shares.
Then, when the share price goes your way, you end up with a much bigger gain than if you had just bought shares in the company. Let’s see an example of how to trade options and how much bigger of a profit this could mean.
How Does Options Trading Work?
Let's look at Yelp Inc. (NYSE: YELP), which rose from $44.83 to $47.92 between April 18 and May 9 last year.
If you just owned shares in Yelp, that's a 6.9% gain. Not much to write home about. Even worse, if you had held onto those shares, you would have watched that gain get wiped out a few months later. As of early August 2019, shares in Yelp are trading more than 20% below that April 18, 2018 price.
That's pretty disappointing. But if you had followed a tip from Money Morning's options trading specialist, Tom Gentile, you would have fared much better.
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Tom didn't see Yelp as a stock to buy and hold. But he saw that its shares had a history of moving just before its earnings date, which was coming up on May 10. So it was a good bet to do that again.
The idea here is buy the rumor, sell the news. Yelp's price often climbed in anticipation of an earnings beat. But even if it did beat expectations, enthusiasm often waned soon after, and the price fell back down. So the key for Tom's pick was to get out on May 9, before earnings were announced and before the gains were lost.
And what really made the pick a major profit opportunity was that he recommended buying an option on Yelp rather than buying shares directly. Tom predicted the shares might rise a modest 5% or 10%. But an option could give you a 50% gain or more.
Sure enough, the call option Tom recommended was trading around $3 a share on April 18. By May 9, the exit date, it was up to $4.92.
That's a 64% gain in just three weeks!
Pull off a trade like that just once a month and you could turn $500 into nearly $10,000 in six months – or $190,000 in a year.
That's the profit power of options trading.
How Do You Trade Options?
Before we get deeper into the money to be made from trading options, you'll want to know some of the details of how to trade options.
Fortunately, these aren't as tough to grasp as you might think…
An option is just what it sounds like: it's the option to buy (or sell) a certain amount of shares in a company on a certain date and at a certain price.
The trick, of course, is that no one really knows what those shares will be worth when that date comes around. So the option goes up and down in value based on the specified buy or sell price (called the "strike" price) relative to the current trading price of the stock.
Say, for example, you have an option to buy a stock on Sept. 30 for $50 a share. If that date comes around and the stock is trading for $100 a share, that's $50 of built-in profit for each share when you exercise the option.
Of course, option contracts come in bundles of 100 shares a piece. And rather than go through the trouble of buying $5,000 worth of stock just to immediately sell it for $10,000, it's easier to sell the option – that is, close your position – before it expires.
According to the Options Clearing Corp., nearly 70% of options are closed before expiration. Only about 12% are exercised. The rest expire without being exercised.
So in most cases, you will be closing out your options position before the expiration date.
Before we move on to the different types of options, let's get a few key terms out of the way…
- The strike price is the price at which the option holder can buy or sell the shares in question at the expiration date.
- "In the money" means the price of the stock is favorable to the option holder. So if you have an option to buy a stock at a strike price of $50, and the current share price is $55, you are in the money.
- "At the money" means the share price is the same as (or very close to) the strike price. And "out of the money" means the share price is unfavorable to the option holder.
- The premium is the price of the option: it's the "premium" you pay for the right to buy the shares at the strike price. The premium will be higher for in-the-money options than for out-of-the-money options. And as the option's position gets better, the premium goes up, allowing you to sell for a higher price before expiration.
Note that the premium is the price per share of the stock in question. Since most options are sold in bundles of 100 shares, you have to multiply the premium price by 100 to get the actual price of an option contract.
As we mentioned earlier, sometimes an option gives you the right to buy a stock at a certain price, and sometimes it gives you the right to sell a stock at a certain price. And for every option holder, there's also someone on the other end who's on the hook if the holder exercises the option to buy or sell at the expiration date. Those are the basics of how to trade options.
That brings us to puts and calls…
What Are Puts and Calls in Options Trading?
There are two basic types of options…
- A call option gives the holder the right to buy shares at a specified strike price. Generally you would buy a call option if you expect the stock's share price to rise between now and the expiration date. When that happens, the value of the option rises and you can sell for a profit.
- A put option gives the holder the right to sell shares at the strike price. You would buy this kind of option when you expect the share price to fall. As the share price falls below the strike price, the option will increase in value and allow the holder to profit.
So it's pretty simple: If you're betting on a stock to rise, buy a call option. If you're betting on a stock to fall, buy a put option.
As we said, most options are closed out before expiration. But when an option does reach expiration, and the holder wants to exercise it, who do they buy the shares from (or sell the shares to)?
That would be the option writer.
What Is an Option Writer?
An option writer sells an option contract with the hope that it won't be exercised. If it's not, they collect the premium paid without ever having to put up any money themselves.
Sounds like a great gig, and anyone can do it. But before you think about getting into option writing, you should be aware that the risk involved is very different than simply buying options.
When you trade options, you can't lose more than you pay up front. And it's pretty unlikely that you'll lose it all, since even if the option goes bad you can typically close out before it becomes worthless.
Your potential reward, however, is limitless. The more the share price moves in your favor, the more money you'll collect.
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For the option writer, the risk-reward ratio is exactly the opposite. The most money they can collect is the premium paid for the option. The option writer is hoping the option will be worthless, so they can keep the premium and not have to pay anything in return.
But if the share price goes against the option writer, the potential losses are limitless.
That doesn't mean you should avoid option writing at all costs: it can be highly profitable. But if you're just starting out, you'll probably want to stick to basic buying and trading until you get comfortable.
With that out of the way, it's time to start making serious money…
How to Trade Options to Make Money
There is one simple rule for making money in options: Keep your emotions out of it.
That means you want to set your exit points at the beginning.
If the stock hits a certain price on the way up, you sell your option. If it hits a certain price on the way down, you sell your option.
Yes, for any one trade, you might miss out on bigger gains. Or you might take a bigger loss than if you had held on longer.
But over time, and over many trades, setting your exit points and sticking to them will work out in your favor.
Conversely, if you find yourself letting emotion take over, you are virtually guaranteed to run into trouble. It might work out in your favor once or twice. But sooner or later the odds will catch up to you, and you'll be kicking yourself for not being more disciplined.
So with that mindset, the obvious question is: What options should you buy?
The short answer is: You should buy options on stocks that are ready to move.
And finding those stocks that are ready to move isn't all that different from traditional investing. Every trader is going to find the strategy that works best for them. And you can feel free to experiment with small amounts of money as you learn the ropes.
If you want a simple strategy to get started, try to trade options during earnings season…
Earnings season is a prime time for stock price movements. These movements are often irrational but predictable.
The situation with Yelp we described earlier is a perfect illustration. Yelp had a history of earnings beats. Investors would push the share price up in anticipation of the earnings announcement, and then sell after the announcement. This was true even when Yelp beat expectations.
Here's a great example of how important it is to set your exit point and stick to it. If you get excited by the share price moving in your favor and decide to hold onto it longer hoping for bigger gains, you could end up quickly losing your gains instead.
But as long as you stay disciplined, this is a relatively easy and low-risk options strategy for the beginning trader.
If you want to get a little more complicated, you can use a straddle. This technique lets you profit from a stock that you're pretty sure is going to make a big movement, but you're not sure whether it's going to be up or down.
To execute the straddle, you buy both call and put options on a stock, with identical strike prices. That way, as long as the share price moves significantly, you can profit regardless of the direction.
When it comes time to close, you'll close out one losing position and one winning position. If you've picked well, the winning position will more than cover your losses.
All this might seem daunting at first. But you'll probably find after a few trades that it's not so difficult to get the hang of options trading. And when you do, you'll find that you can make a lot more money in a lot less time than you can with traditional investing.
We won't leave you hanging, either. Keep checking in with Money Morning for more tips on how to trade options. And follow along with Tom Gentile for his expert advice.
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