Options: A Complete Overview for Beginners

Options are contracts that allow the buyer the right, but not the obligation, to buy or sell a security at a specific price within a given timeframe. The buyer pays a premium for this right. If market conditions turn unfavorable, the option holder can let the contract expire worthless, thus minimizing their losses to just the premium paid. On the other hand, if the market moves in their favor, they may exercise the contract.

Options are generally classified into “call” and “put” contracts. A call option gives the buyer the right to purchase an underlying asset at a set price, known as the strike price, at some point in the future. A put option grants the buyer the right to sell the underlying asset at a predetermined price.

Key Takeaways

• Options trading can seem risky or overly complicated, leading many beginner investors to avoid it. However, specific basic strategies can help newcomers protect their downside and hedge market risks.
• Four strategies include long calls, long puts, covered calls, protective puts, and straddles.
• Options trading requires a clear understanding of the risks and potential rewards.

How to Trade Options in 5 Steps

1. Assess Your Readiness: Options trading is inherently riskier than stock trading. It demands a solid understanding of market trends, data analysis, and volatility. Be honest about your risk tolerance, financial goals, and the amount of time you can commit to learning and managing trades.
2. Choose a Broker and Get Approved to Trade Options: Find a broker that supports options trading, offers competitive fees, and provides a user-friendly platform with educational resources. Complete an options approval form to disclose your financial situation and trading experience.
3. Create a Trading Plan: Develop a detailed trading strategy that includes the types of options trades you plan to execute, criteria for entering and exiting trades, and risk management techniques. Paper trading can help you test strategies without risking actual capital.
4. Understand the Tax Implications: Options trading can have unique tax considerations. Consult a tax professional to understand the implications for your situation.
5. Keep Learning and Managing Risk: Stay informed about risks and use proper risk management techniques to make informed decisions and protect your capital.

Pros and Cons of Trading Options

Pros

• Potential for substantial gains
• Losses can be limited to the premium paid
• Leverage allows for more significant returns with smaller capital
• Can be used for hedging risk

Cons

• Complex and more complicated to understand than stocks
• Difficult to accurately price
• Requires advanced knowledge
• Leverage can also amplify losses
• Selling options can lead to unlimited risk

Buying Calls (Long Calls)

Call options can be attractive for those looking to make directional market bets. If you believe that the price of an asset will rise, buying a call allows you to control the underlying asset for less capital than buying the asset outright. If the price drops, your loss is limited to the premium paid for the call.

Example

Imagine a trader who wants to invest $5,000 in Apple (AAPL), priced at $165 per share. With that capital, they could buy 30 shares. If the stock increases by 10%, they would make a 10% return. Alternatively, they could purchase nine call options at a strike price of $165, costing $550 each. With options controlling 100 shares per contract, this represents a bet on 900 shares. If the stock rises by 10%, the trader could see a 200% return. This is just one example of how a long-call strategy can be used.

Risk/Reward

• The maximum loss in a long call strategy is the premium paid.
• The potential upside is theoretically unlimited as the payoff increases with the asset price.

Buying Puts (Long Puts)

Buying a put is the opposite of buying a call. With a put option, you profit when the price of the underlying asset drops. This is a safer alternative to short-selling, where losses can be unlimited. If the stock price rises, the maximum loss is limited to the premium paid for the put.

Example

Suppose a stock trading at $60 will drop to $50. You buy a $50 put for a premium of $2. If the stock does not fall, the most you lose is the $2 premium. But if the stock drops to $45, you make a $3 profit.

Risk/Reward

• Losses are limited to the premium paid.
• The potential gain is capped at the difference between the strike price and zero minus the premium paid.

Covered Calls

A covered call involves selling a call option against an existing long position in the underlying asset. This strategy allows you to collect premiums while capping your upside potential.

Example

Suppose you own 1,000 shares of BP at $44 per share and sell ten call options with a strike price of $46 for a premium of $0.25 per share. The premium offsets some downside risk. If the share price rises above $46, the shares are “called away,” and you lock in a profit of $2.25 per share.

Risk/Reward

• This strategy provides limited downside protection via the premium received.
• Risk of having to sell your shares at the strike price, capping your potential gains.

Protective Puts

A protective put strategy involves buying an option to hedge against your stock’s downside risk. It acts like an insurance policy, limiting losses if the stock price falls.

Example

If you own 1,000 shares of Coca-Cola (KO) at $44 and buy a $44 put for $1.23 per share, you are protected from any drop below $44. If the stock rises, the option expires worthless, and you only lose the premium paid. However, your losses are capped at $44 if the stock falls.

Risk/Reward

• Losses are limited to the premium paid.
• If the stock falls, the put increases in value and offsets your losses in the underlying stock.

Long Straddles

A long straddle allows you to profit from market volatility in either direction. You buy a call and a put with the same strike price, profiting if the price moves significantly, either up or down.

Example

Suppose you expect a stock trading at $100 to move dramatically after an earnings report. You can buy a $100 call and a $100 put for a combined premium of $10. You would profit if the stock price moves above $110 or below $90.

Risk/Reward

• Your maximum loss is the premium paid for the straddle.
• Potential profits are theoretically unlimited on the upside and capped on the downside at the strike price.

Other Options Strategies

• Married Put: Like a protective put but used alongside a long stock position to mimic a call option.
• Protective Collar: Combines a long put and a short call to hedge a stock position.
• Long Strangle: Similar to a straddle but with different strike prices for the call and put options.
• Vertical Spreads: Involves buying and selling options of the same type (call or put) but at different strike prices.

Is Options Trading Better than Stocks?

Whether options trading is better than investing in stocks depends on your goals and risk tolerance. Options can offer higher potential returns and downside protection but are more complex and can be riskier than traditional stock investing.

Is Options Trading Right for Me?

Before diving into options, assess your goals, risk tolerance, market knowledge, and willingness to keep learning. If you’re committed to continuous education and careful risk management, options trading could be a valuable addition to your investment strategy.

Levels of Options Trading

• Level 1: Covered calls and protective puts
• Level 2: Long calls and puts, straddles, and strangles
• Level 3: Spreads involving buying and selling options
• Level 4: Selling unhedged (naked) options, which involves unlimited risk

Where Do Options Trade?

Options are traded on specialized exchanges, such as the Chicago Board Options Exchange (CBOE), Boston Options Exchange (BOX), and the International Securities Exchange (ISE).

Can You Trade Options for Free?

Most brokers charge fees for options trading, often a flat fee per trade plus a commission per contract. These fees can add up if you’re trading many options.

The Bottom Line

Options provide investors with alternative ways to profit from or hedge against price movements in underlying securities. While basic strategies like buying calls or puts are relatively simple, options trading can quickly become complex.