Understand Option Trading Before You Get Started
Incorporating options trades into your portfolio can be a great way to boost your earnings (and sometimes reduce your losses). But it's important to know exactly what you are buying or selling and what rights or obligations you are assuming before you start trading.
Options are complicated, but I'll explain the basics for you as simply as possible.
What an Option Contract Is
When you trade options, you are:
buying or selling
rights or obligations
to buy or sell stock.
Sometimes you pay for a right and sometimes you get paid to assume an obligation.
The Beginning (Opening) and Ending of the Contract
At the beginning of the contract, money always changes hands.
At the end of the contract, sometimes stock and money change hands and sometimes they don't.
The Difference Between Stocks and Options
Stocks are pretty simple. When you buy them, you own them. You can keep them or sell them or even pass them on to your heirs.
You can buy shares of them
You can sell shares of them.
A broker matches sellers to buyers, so you never really know who you are buying from or who you are selling to.
You aim to buy at a good price and sell for a higher price.
You can own them for a short time or a long time.
Options, on the other hand, are contracts with an expiration date. They are contracts to buy or sell shares of stock. Each contract has its own expiration date and an agreement about the price at which shares could potentially change hands. That agreed-upon price is called the strike price.
When you trade options you are buying or selling contracts or agreements to buy or sell stock. While the prices of options contracts are affected by the underlying stock, they are priced separately.
Two Types of Options, Four Ways to Trade
Since calls and puts can be both bought and sold, there are actually four types of options contracts. You can sell a put, buy a put, sell a call or buy a call. I’ll explain all four, then I’ll show you the information again in a table.
If you Sell a put- You get money up front. Someone who bought the put has the right to require you to buy 100 shares of their stock at the strike price you have agreed to, any time until the option expires.
If you Buy a put- You pay money up front. You can then force a seller of the put to buy 100 shares of your stock at the strike price, any time until the option expires.
If you Sell a call- You get money up front. Someone who bought the call can require you to sell 100 shares of your stock, at the strike price, any time until the option expires.
If you Buy a call- You pay money up front. You can then force a seller of the call to sell you 100 shares of the stock, at the strike price, any time up to expiration date.
Take a look at the information I just gave you, organized a little differently. The two strategies on the right side of the table are the ones I teach Novice Options Traders- selling puts and selling calls.
Why I Only Teach Novice Options Traders to Sell (Not Buy) Options
The safest strategy, especially for beginners, is selling options, not buying them. Selling options brings cash into your account right away. Selling options also sometimes results in you having to buy or sell shares of stock. But as the seller of the options contract, you can choose your strike price. Your chosen strike price lets you control how much you pay for the stock, or the price at which you are willing to sell shares you own.
If you buy an option, on the other hand, you pay for something that may become completely worthless by the expiration date.
Trade Safely: Keep Collateral in Your Account
You have a better chance of making money as an options seller than as a buyer. You get paid up front to sell an options contract. but you need to be prepared in case the contract is executed and you are assigned to buy or sell stock.
Some contracts expose you to unlimited risk if you do not have the collateral to secure them. So make sure you understand the possible outcomes of any trade you are placing and that you have the collateral in your account to protect yourself.
Questions to Ask Yourself Before You Sell an Option Contract
Questions to Ask Yourself When Selling a Put
Is this a stock I want to buy?
What is the current share price?
How much would I be willing to pay for 100 shares of this stock?
How much can I get paid for selling an option with my preferred strike (buy) price?
Do I have the cash available to buy 100 shares if I’m assigned to buy the stock?
Will I be glad if I’m assigned to buy it?
Will I be glad if I’m not assigned to buy it?
Questions to Ask Yourself When Selling a Call
Do I have at least 100 shares of this stock in my account?
How much did I pay for the stock?
Am I ready/willing to sell the shares if the contract is executed?
What price would I be willing to accept for this stock?
How much can I get paid for a call at my strike price?
Will I be disappointed if, at the expiration of the contract, I’m not assigned to sell the stock?
Should I just go ahead and sell the shares now, without the call?
If I’m assigned (to sell the stock) at the strike price, will I be glad of that outcome?
Want to Learn More?
I have given you a brief overview here, but you might not be ready to trade yet.
There are many resources online to help you understand how options contracts work and how you can use them. It can be hard to know where to look first. Before you start trading, make sure you understand:
Different levels of option trading privileges.
The importance of collateral to secure your trades.
How to read an options chain and select a contract (there are a lot of them!)
What the possible outcomes of any trade will be.
Why you need to multiply all the numbers by 100.
As you read and research, look up any terms you don't understand on Investopedia.
And if you'd like a step by step guide, designed especially for novice options traders, I hope you'll check out my courses on Udemy.
Get Ready to Trade Options Safely, Basics for Beginners (Includes instructions for securing options trading privileges from your online broker.)
How to Sell Cash Secured Puts; Safe Options Trading (With a step-by-step guide for placing your first trade.)
How to Sell Covered Calls (Learn to make extra cash while you wait for your stock to appreciate.)
If you decide to move forward, I hope you will let me know what you decide to do and the outcome of your first option trade!