Trading options is a great way to grow a small account, but its also a great way to blow up a trading account if you don’t know what you’re doing. As a result, we talk options trading for dummies.
In this post, I’ll answer all the questions that the typical “options trading dummy” asks – and maybe a few you didn’t know to ask. Of course, we also have a free options trading course on our website!
Options Trading for Dummies, Part 1
- Options trading for dummies part 1 is going to go into the basics of options. Did you know options trading is a fantastic way to build a small account so you don't have to jump into trading penny stocks? However, if you don't know what you're doing, then you can blow up your account. Hence options trading for dummies.
1. What are Options? Puts/Calls
Understanding calls and puts are options trading for dummies 101. Options contracts are agreements between two parties to buy or sell 100 shares of the underlying stock at a set price – known as the strike price – on or before a certain date, known as the expiration date.
The buyer of the contract has the option to “exercise the contract” any time before the expiration date. While the seller of the contract has the obligation to fulfill the contract if it is exercised.
There are two types of options contracts: calls and puts. A trader would purchase a call option if they believe price will move higher before the given expiration date.
For example, let’s say that the made-up stock ticker XYZ was trading today at $25/share, and you think it is going to go up in the next month.
You could buy 100 shares of the stock at $25, or you could buy a call option that expires in a month at the $25 strike price.
This gives you the same exposure to the stock (100 shares). But instead might only cost you $125 instead of the $2500 upfront money to buy the shares.
Options trading for dummies help you understand how premium works. This money you pay for the option is called “premium.” The seller of the option receives your $125 as soon as the order is executed.
A call option gives you the right to buy 100 shares of XYZ at $25/share, but if the stock price declines to $24, you wouldn’t want to. In this instance, the value of your option would decline until it expiration; when it would expire worthless.
You can sell the contract anytime before expiration and limit your loss. But you can’t lose more than the $125 you paid for the contract.
The seller of the contract, in this instance, would make their max profit - $125. However, an options seller’s losses are technically unlimited.
If you're right, and the price of the stock increases to $30 per share over the next month, the seller of the contract has to sell you the shares at $25. This would be a $500 loss. However, with the $125 premium collected, the total loss would be $375 – consequently the same amount as your profit.
What if the stock price went to $1,000,000/share? Unlikely, I know, but in theory, there is no cap to price a stock can trade for, meaning there is no cap to the profit a buyer of an options contract can make, or the loss the seller can make.
3. Put Options
A put option is the opposite of a call. You would buy a put if you expect price to decrease over the coming month (or whatever time frame you trade).
A put contract gives the buyer the right to sell 100 shares of stock at the strike price, and the contract seller the obligation to buy them. You wouldn’t sell stock for $25 if you could sell them for $30.
But if price decreases to $20, you can short sell the 100 shares short at $25, and buy them back at $20 for a $500 profit, less the premium.
Again, the premium you pay is the most you can lose. While the only limit to your gain is if the stock price goes to $0, where the contract seller will have to pay you $25/share for 100 worthless shares.
Hopefully you’ve noticed that the risk/reward profiles for selling an option vs buying an option are extremely different. An options seller takes on basically unlimited risk for a very limited gain.
While the buyer takes on a defined amount of risk for essentially unlimited profit potential. However, there is a reason for this.
According to Options Clearing Corporation statistics for 2015, only 7% of all options contracts are exercised. Over 70% of contracts are closed before expiration.
Many of the traders in our trade room day trade options every day! Join us in the trade room and we talk about options trading for dummies in there.
Options Grid for Dummies
- We have some ground to cover before you’re released from Options Trading for Dummies school. Below is an options grid for SPY, the most liquid trading proxy for the S&P500. You’ll notice that SPY has 3 expiration dates per week! This is very unusual. Most highly liquid stocks will have a weekly expiration, with the expiration date every Friday. Not all stocks have options at all, and some will only have a monthly expiration.
Volume is just as important for options traders as it is for trading shares of stock. We have a quick read on the importance of volume in trading.
The options grid begins at the left with a list of the available expiration dates. By clicking the drop down for the first available expiration, the grid shows calls on the left and puts on the right, separated by the strike prices.
I have the grid set up to show the % change that day, the most recent price the option traded for (this is “MARK” above, that is the premium paid for that option in the most recent transaction). Also shown is the current bid and ask for each contract displayed.
1. ITM, OTM, ATM, Oh My!
Before closing part 1 of options trading for dummies, lets look once more at the options grid above. You’ll notice a line in the center of the options grid, where the upper side of the calls side is shaded, and the lower side of the puts is shaded.
SPY was trading at $333.53 at the time of this screen shot. This means that all of the calls from $333 and lower are “in the money.” In other words, if the option expired at the current price, the option would still have value.
A $333 call option gives the buyer the option to purchase 100 shares at $333, which could be immediately sold at $333.53, for a $53 profit. The deeper in the money an option is at expiration, the more it is worth.
On the put side, all of the strikes from $334 and above are in the money. A $334 put gives the buyer the right to sell 100 shares at $334, which could be bought for $333.53, for a $47 profit.
The non-shaded contracts are called “out of the money” options. These will have no value at expiration; they will “expire worthless.”
You will commonly see in the money options written as ITM, and out of the money contracts are abbreviated as OTM. The strike nearest the current trading price of the underlying stock is said to be at the money – ATM.
In Closing, Options Trading for Dummies Part 1
Hopefully options trading for dummies part 1 has left you with a good understanding of what options contracts are and the terminology used by options traders.
Watch for Part 2 coming soon where we will learn more about how options are priced and some ideas of how to gain an edge in options trading. Don’t forget to sign up for our real time stock alerts!