Need options trading explained? Let’s start off by defining what options are. Options give you the right but not the obligation to buy or sell an asset at a specific price. Options have a reputation for being hard to understand. They’re great for trading for profit, speculation and hedging when they’re used properly. The versatility of options allows for great profit but also great loss. This is why paper trading options is so important.
Options Trading Explained
- Options trading explained:
- Right but not obligation to buy/sell security at specific price by certain expiration.
- Trade large caps without a lot of capital.
- Can make money in any type of market.
- A bit complicated to learn but worth the effort.
- Trade contracts not shares.
- Each contract = 100 shares.
- Basic components: calls, puts, strikes, expiration, open interest, greeks etc.
- Can trade just contracts or you can exercise for shares.
- Several different strategies: naked, debit spreads, credit spreads, iron condors etc…
A Bit Complex: Options Trading Explained
Options trading is complex. It can be very risky if not used properly. We will discuss the different aspects of options so it’s not so scary.
When you begin options trading, you need to know how to properly trade options. Properly trading options gives you a real advantage.
An options contract is made up of 100 stocks. This allows you to play higher priced stocks without paying for the 100 shares. Buying/selling calls and puts is a great way to get started. Read our post on put and call options.
Options have expiration dates. You can’t hold options forever if you got a bad entry in hope that price changes. If you gave yourself enough time, you may recover some loss.
There’s strike prices, which are the prices you believe a stock will move to. Strike prices are in the money, out of the money and at the money. In the money is when the strike price is below the market price of a stock.
Out of the money means a strike price is higher (call) or lower (put) then the market price. At the money means that the strike price and market price are the same.
It’s important to study the implied volatility formula and it’s meaning, time decay as well as intrinsic value. These can affect profit and loss as much as the movement of price. It’s important to know that options aren’t as cut and dry as stocks.
If you don’t have a ton of money and want to learn how to invest in the stock market with little money then options can be good. The risk with options is that you can lose your entire investment on a trade. With that being said, you need to make sure that you have good technical analysis basics and knowledge of candlesticks. Those two tools along with the knowledge of the different parts that make up options trading allows you to make good trades.
Speculation and Hedging
You can do options trading explained this way; speculation. When you use speculation, you’re making a bet on the outcome of future price movement. Hence the need to know technicals and candlesticks.
If you believe the price of a stock is going to go up, you’d buy a call hoping to profit. Buying a call option instead of stock is attractive because you get leverage. This is where trading weekly options becomes really fun.
A call option may only cost a few dollars as opposed to buying 100 stocks. It’s important to remember that this is very risky. If you’re wrong, you lose money.
You have to be correct in determining the direction as well as the timing and how much money the stock will move. You have to be right about whether it moves up or down and how long it takes to do so.
Now hedging while trading stock options reduces risk at a reasonable price. It’s like using options as insurance. You take advantage of stocks that are moving while reducing risk. It’s also cost effective (try our stock picks service for 7 days free).
Are Options Better Than Stocks?
- Are options better than stocks? If you don’t have the capital to trade shares of stocks then yes it’s better. Even if you do have the capital it can still be a better strategy because it allows you leverage to trade large cap stocks and profit without having to risk a lot of money. They are riskier than trading shares, however, they are worth it once you learn how to trade them.
Spreading is using two or more options. It basically combines speculation and hedging. It can limit the upside but they don’t cost a lot.
You’re basically sell one option to buy another. This is where the versatility in options trading explained is.
You can make a spread to profit in any market. Even a market that’s trading sideways. If you’ve ever been watching or in a stock that’s trading sideways, you know it can be frustrating. It’s like you can’t get in or out with anything good.
When you buy both a call and a put with the same strike price and expiration, you get what’s called a straddle. This allows you to make money whether the stock rises or falls. This is when knowing how to sell options becomes so important.
You will lose on one of the options though. If price stays the same, then you lose on both options contracts.
There’s something called a strangle. This is when you buy a call and then a put with a lower strike price. Strangles need more price movement to be profitable but are less expensive than a straddle.
Technical Analysis and Patterns
Now that you’ve had options trading strategies explained it might seem overwhelming and scary. It’s not when you know candlesticks and technical indicators coupled with patterns.
These tools give you a clear picture as to what a stock will do. If you’re looking at buying a put on a stock but it’s got hammer candlesticks forming, you’d know to wait on that put option.
If you see doji candlesticks, you’d know to wait for confirmation or see what pattern those dojis are apart of. Do you see bear flag patterns or is it apart of bull pennants?
Knowing technical analysis and patterns can help you profit and minimize loss. Take our options trading course.
Bottom Line on Options Trading Explained
This allows you it work out the kinks. You can see if options trading is for you. You may find in paper trading that you don’t like it and that’s ok.
It’s a great resource for you but with anything, you need to practice and study before jumping into it.