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5 Steps to Start Trading Options in 2017

The idea of options trading makes a lot of investors nervous – until they start to understand how profitable options trading can be.

For example, anyone holding Amazon stock from May 16, 2016, until Jan. 13, 2017, would have made 13%. But using a simple options trade on that stock could have scored you nearly three times as much in the same time period. That's exactly what Money Morning Options Trading Specialist Tom Gentile did for his Power Profit Trades readers.

Options trading in 2017"Options, when used properly in short-term trades as well as long-term investments, aren't risky," Gentile said. "In fact, they can offer lower risk, higher reward scenarios, and when timed right also give you a built-in exit strategy."

There are two big reasons why many investors are turned off by options…

First, there are many options-specific terms that sound confusing. But once you start to learn the options vocabulary, you will find options trading isn't as complex as you first thought.

Secondly, options trading got a bad reputation in the stock market crash of 2008. People lost a lot of money because they were making trades that were way too risky for what their portfolio and trading tolerance should allow.

If those that lost large amounts of money had been using options correctly, they would have limited their risk. Many investors don't know this, but options were initially created to hedge risk.

All of these reasons are why we're walking you through everything you need to know about options trading. This "how-to" guide will help you see opportunities to rapidly grow your net worth and create monthly income while limiting your exposure to risk.

Now, the first step to start options trading is…

Step 1: Open an Options Trading Account

Before you can begin to trade options, you need to make sure you have the right account and the highest level of options trading clearance possible.

Don't worry. This isn't anywhere as tedious or time consuming as it sounds.

Basically, you will need to answer a few questions so the broker can absolve themselves of responsibility if investors lose large sums of money. Again, don't worry, we'll show you how to avoid those types of trades.

Not every online brokerage allows you to trade options. Even traditional brokerages that do let you trade options may not be the best fit for you.

Commissions are usually cheaper on options accounts than stock-trading accounts. Because of that, Tom Gentile recommends opening an options account that you can also trade equities (stock) with.

Even within options accounts, there are two different types: snapshot and streaming. The one you choose depends on your personal preference.

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Snapshot accounts are great for beginners or position traders (those who hold trades for 30 or more days). They are snapshots of the market instead of live information. This means the information you are looking at may be delayed a few minutes.

For a new trader, this should not pose any problems. The snapshots can help keep you from getting overloaded with information. The snapshot options broker that Tom Gentile recommends is OptionsXpress.

Options

Streaming accounts are great for traders with some experience and who want to enter and exit positions in shorter time frames (under 30 days). Orders and information come in at real time. The streaming platform that Tom Gentile recommends is ThinkorSwim (TD Ameritrade's active platform).

Options trading account

If you are unsure what type of account to choose, start with a snapshot account. You can upgrade to a streaming account once you have some experience and feel more comfortable trading options.

No matter which platform you choose, you will need to fill out an application and answer several questions to get your options trading level clearance. Don't worry. These are not trick questions and we'll walk you through what to expect.

The goal for any investor is to get the highest level possible. You may not want to do some of the more advanced techniques right away, but you'll want to have the clearance to do so when you are ready.

  • Personal Finances: These will be basic questions about yourself, your employment, yearly income, net worth, and your liquid net worth. While it may be tempting to fudge these answers a little bit to make it look like you have more money than you do, don't. They are all easy to verify.
  • Investment Objectives: These options for your objective will range from income on the conservative side to speculation on the aggressive side. If you want to qualify for something more than covered calls (trust us, you do) then apply for speculation.
  • Options Strategies: The broker is looking to see what types of strategies you are familiar with. The more you check off, the higher your options trading clearance. If you read this guide all the way to the bottom, you will be able to check off a lot of the boxes in this section.
  • Trading Strategies: This section is looking to see how many strategies you are familiar with. Again, the more you can check, the higher your trading clearance will be.
  • Trading Experience: This section sometimes makes people panic. You will be asked about your experience trading stocks and options. If you don't have much experience, it's okay. Think about what you plan on doing and add that to your experience section as well.

All of the questions you answer will help determine what level of options trading you will have clearance to participate in. The levels for trading are standard, but the wording each brokerage uses may be a little different.

Some of these phrases may be new to you. You'll know what they all mean when you're done reading this guide:

  • Level 0: This options trading level will allow you to write covered calls and protective puts.
  • Level 1: You can do all of the above AND buy calls or puts and open long straddles and strangles.
  • Level 2: You can do all of the above AND open long spreads and long-side ratio spreads.
  • Level 3: You can do all of the above AND uncovered options, short straddles and strangles, and uncovered ratio spreads.

Before you start trading real money, Tom Gentile recommends that you "paper trade," or practice your orders on paper before you do your first trade through your broker. This will ensure you understand everything involved.

To help you understand everything involved, let's cover some options basics…

Step 2: Options Trading Basics

Learning the basics about options trading involves mostly learning vocabulary.

The good news is that once you make it through this section, we can talk more about applying these strategies.

First things first. An option is a lot like renting a stock. When you buy an options contract, you purchase the right to buy or sell the stock and then try to sell that right to someone else for a profit.

There are two types of options: calls and puts.

A call gives the owner the right, but not the obligation, to BUY 100 shares of a particular stock at a predetermined fixed price. You buy a call when you think the price of the underlying stock will rise.

A put gives the owner the right, but not the obligation, to SELL 100 shares of a particular stock at a predetermined fixed price. You buy a put when you think the price of the underlying stock will fall.

Now that we have calls and puts straight, let's talk about an option symbol. The symbol gives you a lot of valuable information about the option.

Options trading strategiesThe first thing the symbol to the left gives you is the stock ticker of the underlying security. The underlying security is the stock, ETF, or security that the option gives you the right to buy or sell. It is sometimes referred to as the underlying. In this case, the underlying security is Amazon.com Inc. (Nasdaq: AMZN).

The six digits to the right of AMZN represent the expiration date. The expiration date is always the third Saturday of the month. The last day of trading for the option is usually the Friday before the expiration date, unless that Friday is a holiday. 150619 stands for 2015 June 19.

The letter following the expiration date is the option type. The C stands for a call. There would be a P there instead if the option was a put.

The last piece of information on the option symbol is the strike price. This is the price at which the underlying can be bought (in the case of a call) or sold (in the case of a put). In this example, the strike price is $435.

Editor's Note: Know Exactly What to Buy, What to Sell, and How to Protect Your Money in 2017

Now that you know how to determine what type of option you are looking at, the next step is to determine what goes into the cost of an option.

The premium is the amount you pay if you buy the option or the credit you receive if you sell the option. There are three main components that make up the premium:

  1. The first component of the premium is the distance between the strike price of the option and the current price of the underlying. If the strike price is very close to the price of the underlying security, or very favorable (above the strike for a call or below the strike for a put), then you will pay more of a premium.
  2. Secondly, the amount of time until expiration is factored into the price. The amount related to the time deteriorates more quickly as the expiration date nears. This is called time decay.
  3. Lastly, the amount of volatility, or uncertainty, about the underlying security is factored into the premium of an option. The higher the volatility, the higher the risk, and the higher the premium will be for an option.

Remember, if your call allows you to buy a stock at a price much lower than market, or your put lets you sell a stock for much higher than market, you are likely to exercise your option. Exercising an option simply means you will buy or sell the stock at the strike price before the expiration date.

Now that we know what goes into the price of an option, let's take a look at an options table.

An options table lists the different strike prices for calls and puts. The bid price is the price you can sell an option, and the ask price is the price you will pay for the option.

The bid-ask spread is the profit for the "market maker" who places the trades.

Check out this options table:

trading options

The left-hand column shows the option's strike price. The call bid and ask prices are next, followed by the put bid and ask prices.

Let's say you wanted to buy a put at a strike of 135. The ask price is $1.15, but remember the option represents 100 shares. Your actual cost will be $115 ($1.15 x 100).

The next part of options to tackle is how to trade them…

Step 3: Long Positions and Short Positions of Options

There are two positions you can take with every option: long and short.

Being long on an option simply means you bought the options contract. Being short on an option means that you sold the options contract without ever owning the option.

Don't worry if this seems confusing at first. We'll go through each scenario in detail, complete with clear examples to show you exactly how these work.

Long Calls. When you buy calls – or hold long calls – you buy the right to buy 100 shares of the underlying at the strike price.

If the Market Goes Up. If the price of the underlying security goes up, you can:

  • Sell your option for a profit
  • Exercise your option and buy the underlying shares under the current market price (the value of the option changes based on the price move of the underlying security)

Let's say the current factor for your call is 0.15. That means that for every dollar the underlying stock price increases, the value of your option will increase by $0.15.

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The other way to profit from this call is to buy the stock at the strike price by exercising your option, then sell those shares at the market price. The profit would be the difference between the strike price and market price minus the original cost of the call option.

Caution: If the price of the underlying goes up and you still own the option at expiration, you may be assigned the shares the option is written for and owe money of the purchase. If you do not want to purchase the shares, make sure to sell your call before the expiration.

Long Call Example – When the Underlying Rises:

Let's say you bought a call for XYZ Company for $1.00 (actual cost $100 since you buy control of 100 shares and the quote is per share). The strike price is $10.00, which is also the current market price of XYZ Company. We will use a factor of 0.15 to calculate the price change of your call like we did in the explanation above.

Now, say the current market price for XYZ Company went up and is now $11 (with the strike price of the call still at $10). This means that you bought the call for $1.00 and can now sell it for $1.15 for a total profit of $15 (($1.15-$1.00) x 100).

If you want to exercise the call instead of selling it, you would buy 100 shares at the strike price of $10 each ($1,000). Then you would sell those shares at the market price of $11 a share ($1,100). In this case, you would break even ($1,100 (sale price) – $1,000 (purchase price) – $100 (original call option)).

Our example shows you breaking even because it made the math simple to see. You wouldn't exercise the call to buy the stock and then sell those shares at market price unless you were going to make a profit from the trade.

If the Market Goes Down. If the price of the underlying security goes down, below the strike price of your call, you are only risking the money you used to buy the call. The option price will go down by the same factor per dollar as we saw in the previous example.

There are three things you can do if the price of the underlying security goes down:

  1. Hold onto the option in hopes that the price will rise before expiration (don't hold on too long, though, otherwise you will lose your investment)
  2. Sell the call at a loss so you don't lose the total purchase price
  3. Let it expire worthless

Long Call Example – When the Underlying Falls:

Using the above example, you have a call you bought at $1.00 and the strike price is $10. We'll use the same factor of 0.15 for price changes of your call. If the market price of XYZ Company is now $9, your call will be worth $0.85 ($1.00 – $0.15). You can sell the call for a $15 loss (($1.00 – $0.85) x 100).

Long Puts. When you buy long puts, you buy the right to sell 100 shares at the strike price.

If the Market Goes Up. If the price of the underlying security goes up, you are only risking the money you used to buy the put.

The option price will go down by a factor per dollar increase. Let's stick with the example we've been using with a factor of -0.15. This means the price of your option goes down $0.15 for every $1.00 the underlying security increases.

There are three things you can do if the price of the underlying security goes up. You can:

  1. Hold onto the put in hopes that the price of the option will rise before expiration (don't hold on too long, though, otherwise you will lose your investment)
  2. Sell the put at a loss so you don't lose all of your initial investment
  3. Let it expire worthless

Long Put Example – When the Underlying Rises:

Let's pretend you bought a put for XYZ Company for $1.00 (actual cost $100 since you buy control of 100 shares and the quote is per share). The strike price is $10.00, which is also the current market price of XYZ Company.

Now let's pretend that the current market price for XYZ Company went up and is currently $11 (with the strike price of the put still at $10). This means that you bought the put for $1.00 and can now sell it for $0.85. That's a loss of $15 (($0.85 – $1.00) x 100).

If the Market Goes Down. If the price of the underlying security goes down, you can:

  • Sell your put for a profit
  • Exercise it to sell your shares of the underlying security at the higher than market price

The profit of the put changes as a factor of the price move of the underlying security. If the current factor for your put is -0.15, that means that for every dollar the underlying stock price decreases, your option will increase by $0.15.

The other way to profit from this put is to buy the stock at the market price and sell it at the strike price. The profit would be the difference between the market price and strike price minus the original cost of the put option.

Caution: If the price of the underlying goes down and you still own the option, shares could be sold for you automatically. If you don't want to sell shares, make sure to sell your put before the expiration.

Long Put Example – When the Underling Falls:

Using the example above, you have a put you bought at $1.00 and the strike price is $10. We'll use the same factor of -0.15 for price changes of your put.

Now let's pretend that the current market price for XYZ Company is $9 (with the strike price of the put still at $10). This means that you bought the put for $1.00 and can now sell it for $1.15 for a total profit of $15 (($1.15-$1.00) x 100).

Instead of selling the put, you can also exercise it. You bought the put for $100. The strike price on the put is $10. To buy the shares of XYZ Company, you would buy them at market ($9 x 100 shares = $900) and then exercise your put, selling 100 shares at $10 each ($1,000). In this case you would break even ($1,000 (sale price) – $900 (buy price) – $100 (original put option)).

Our example shows you breaking even because it made the math simple to see. You wouldn't buy the stock and exercise the put unless you were going to make a profit from the trade.

Short Calls. With short calls, you sell someone else the right to buy the underlying stock – but you don't own the option (although you might own the stock, but don't have to). If the option is exercised, the buyer will have the right to 100 shares of the underlying security at the strike price, so you will have to sell them 100 shares to fulfill that contract. If you don't own those shares, you have to buy them at market.

If the Market Goes Up. If the price of the underlying security goes up, you can buy the call to close out your short position for a loss. This will protect you from having to sell the 100 shares of the underlying stock if the call is exercised.

If you keep your position and it is exercised, you will have to sell shares to the option buyer at the strike price. This option is best used if you don't mind selling shares of the stock you already own.

Short Calls Example – When the Underlying Rises:

Let's pretend you sold a call for XYZ Company for $1.00 (actual income of $100 since the contract controls 100 shares and the quote is per share). The strike price is $10, which is also the current market price of XYZ Company. We will use a factor of 0.15 for calculating the price change.

Now let's pretend that the current market price for XYZ Company went up and is currently $11 (with the strike price of the put still at $10). This means that you sold the call for $1.00 and can now buy it for $1.15. That's a loss of $15 (($1.00 – $1.15) x 100).

If the Market Goes Down. If the price of the underlying security goes down, you can keep the money you received for the sale of the call and don't need to worry that the option will be exercised. If the call buyer can buy the shares for cheaper at market, there's no reason for the buyer to purchase shares at the strike price.

If you wanted to secure profits before the market went back up, you could buy the call to close out your short position at a profit. To realize maximum profitability, you will want to let the call expire worthless.

Short Calls Example – When the Underlying Falls:

Let's say you sold a call for XYZ Company for $1.00 (actual income of $100 since you buy control of 100 shares and the quote is per share). The strike price is $10.00, which is also the current market price of XYZ Company. We will use a factor of 0.15 for calculating the price change.

If you let the call expire instead of closing your position, you would make $100 (the price you sold the call for initially).

Now let's pretend that the current market price for XYZ Company went down and is currently $9 (with the strike price of the put still at $10). We will assume you want to buy to close the call. This means that you sold the call for $1.00 and can now buy it for $0.85. That's a profit of $15 (($1.00 – $0.85) x 100).

Short Puts. With short puts, you sell someone the right to sell a stock at a certain price. If they exercise the option, you are obligated to buy 100 shares of the underlying security at the strike price from the put buyer.

If the Market Goes Up. If the price of the underlying security goes up, you can keep the money you received for selling the put and don't need to worry that it will be exercised. The put buyer wouldn't sell the stock at the strike price if the stock's market price is higher than that.

If you wanted to secure profits before the market went back down, you could buy the put option to close your short position at a profit. To realize maximum profitability, you will want to let the call expire worthless.

Short Puts Example – When the Underlying Rises:

Pretend you sold a put for XYZ Company for $1.00 (actual income of $100 since the contract controls 100 shares and the quote is per share). The strike price is $10, which is also the current market price of XYZ Company. We will use a factor of 0.15 for calculating the price change.

If the put expires instead of you closing your position, you would make $100 (the price you sold the put for initially).

Now let's pretend the current market price for XYZ Company went up from $10 to $11 (with the strike price of the put still at $10). We will assume you want to buy to close the put. This means that you sold the put for $1.00 and can now buy it for $0.85. That's a profit of $15 (($1.00 – $0.85) x 100).

If the Market Goes Down. If the price of the underlying security goes down, you can buy to close the put for a loss. That will protect you from having to buy the 100 shares of the underlying at the strike price if the put is exercised.

If you keep your position and it is exercised, you will have to buy the 100 shares at the strike price.

Short Puts Example – When the Underlying Falls:

Let's pretend you sold a put for XYZ Company for $1.00 (actual income of $100 since the contract controls 100 shares and the quote is per share). The strike price is $10.00, which is also the current market price of XYZ Company. We will use a factor of 0.15 for calculating the price change.

Now let's pretend that the current market price for XYZ Company went down and is currently $9 (with the strike price of the put still at $10). This means that you sold the put for $1.00 and can now buy it for $1.15. That's a loss of $15 (($1.00 – $1.15) x 100).

Now that we've talked about calls and puts, and long and short positions, there are two very important risk-management strategies we need to talk about: covered calls and insurance (protective) puts. Both assume you own the 100 shares of the underlying security….

A covered call means you already own the underlying stock and are selling calls against those shares. Ideally, the strike price will be higher than the market price. That way you are not at risk of having to sell your shares.

This strategy is best used against shares you don't mind selling if the market price does rise substantially. You should stick to one- to two-month expiration dates to limit your risk of large market changes.

Covered calls can help you generate monthly income, because you will receive the premium every time you sell calls. The only downside is the risk of having to sell your shares. Depending on the price you paid for them and the strike price you would sell them at, this might not be all that bad. You could end up selling your shares at a substantial profit.

Covered Call Example:

As an example, let's say you own 100 shares of XYZ Company. The current market price is $100 per share. You decide to sell calls against your shares in order to make a monthly income. To do that you would sell a call with a strike price of $110 with an expiration of one month from today for $1.00. You want to make sure the strike price is higher than the market price so that the call you sell isn't likely to be exercised.

If the call is exercised, you will need to sell the shares of XYZ Company at $110 (the strike price). If the call is exercised, your total profit would be $1,100. You would receive the $100 sale price of the call – plus you would be selling your shares at a $10 per share profit. The only downside here is you will not have the shares to write a call against next month.

If the call is not exercised, you will have a profit of $100 from selling the option against your XYZ Company shares. While this is a smaller profit than if the call were exercised, you get to keep your shares. This means you can sell calls against your shares next month to create a regular stream of income.

Insurance puts are puts you buy if you think the price of a stock you currently own will decrease. You will be out the amount you paid for the puts if the price of the shares goes up, but you will protect yourself from large losses (on the shares you already own) if the price of the underlying security goes way down. You are guaranteeing that you can sell your shares at a certain price, so you know what your maximum losses are.

Buying puts when major news is about to break about the economy (i.e., the Federal Reserve may announce that interest rates are going up), the industry the company operates in (i.e., new regulations), or the company itself (i.e., earnings reports, trial results) can help ensure that you minimize your loss if the news is not favorable.

The puts will allow you to sell your shares at the strike price if you decide to sell instead of holding onto the underlying stock. This is important if you think the company will not be solvent if the pending trial results (medical or court) are not in the company's favor.

Insurance puts will allow you to get out of the stock after the negative news breaks with minimal loss, but also let you keep your shares so you still have them if the news is positive.

Insurance Put Example:

Let's say you own XYZ Company. The market price of the stock is $100 per share, and you own 100 shares ($10,000). XYZ is getting ready for FDA approval on a new vaccine, but you're not sure the approval will be granted. You can buy a put with a strike of $95 for $1.00 (total cost of $100 because it controls 100 shares).

If the approval is granted, you can sell your put for a loss or let it expire. You are only out the $100 for the put. With the FDA approval, you are likely to make that $100 back plus more with an appreciation of the stock price.

If the approval is denied and the stock falls well below $95, you are able lock your loss in at $600. The first part of the loss is the $100 you paid for the put. The other $500 is what you lose by exercising the put to sell your shares at $95 (($100 (original price) – $95 (sale price)) x 100).

One more thing – options are usually short- to medium-term investments. LEAPS, however, are long-term investments.

LEAPS stands for long-term equity appreciation securities. Basically they are options that expire three years out as opposed to a few months out.

LEAPS are good if you are worried about long-term market volatility or if you want to bet on the long-term upswing or downswing of an expensive stock.

With the long investment timeframe, you don't need to be right about the way a stock moves today or next week. LEAPS allow you to sit on your position in hopes that in the future, the market will head in a profitable direction.

LEAPS also give you a way around the pricing issue that expensive stocks have. You may want to buy and hang onto a stock long term in order to profit from the continued price increase. For a cheap stock, this isn't a problem. You buy shares and wait until they have gone up in price to sell them at a profit.

For expensive stocks, the buy-and-hold method may not be an option. Alphabet Inc. (Nasdaq: GOOG), formally Google, for example is $787.74 a share. This makes buying 100 shares cost prohibitive at a price tag of $78,740.00.

With LEAPS, you can take advantage of the stock's upswing for pennies on the dollar. Buying LEAPS and selling them before they expire allows you to make profits on the stock price's increase without owning the stock.

Remember, because you are making a longer-term bet, LEAPS are more expensive than shorter-term options.

Stock vs. LEAPS Example:

Currently, a LEAPS of Alphabet expiring on Jan. 19, 2018, is selling for $11.50, making the purchase price $1,150 to control 100 shares of GOOG. That means you're spending 99.85% less than if you bought 100 shares.

If Alphabet rises in price by $1, you would make $100 (0.01% gain) by owning the stock. However, a $1 increase in the stock will be a $0.15 increase in value of your LEAPS for a profit of $15 (1.3%). Since you invested less capital by buying a LEAPS, you can make a larger percent gain in small movements of the underlying stock.

Whether you go long or short on an option, there are ways to help minimize your risk. One of those ways is order types. Another is combining options…

Step 4: Combining Options to Limit Risk and Maximize Profits

Join the conversation. Click here to jump to comments…

  1. R. J. | May 6, 2017

    Just remember, readers: you'll need to have 'buying power' in your account to cover your trades — either long or short, in the event that you exercise or are assigned. Unless you're working with margin, that means you need to fund your account to cover.

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