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With discovering the benefits of options trading, the volume of options trading grows substantially. About 30 million options contracts were traded every day in 2020 just on the American centralized exchanges.
Read more on how to trade options, how it works, and how it allows you to make money and/or reduce risks.
Your capital is at risk. Investing involves risk of loss
What are Options?
Options (or options contracts) allow you to make a deal with a financial asset at the current price and after a certain time.
The important features are:
the option is linked to another basic asset; therefore, the option is a derivative contract;
an option gives a right, but not an obligation. If you have the right to buy the basic asset, and the price for it has decreased after the transaction conclusion, you do not have to buy the asset.
The advantages of options are:
The use of options allows more efficient use of capital;
They help reduce risks. Therefore, options are often used as a hedging instrument;
They provide more opportunities for creating nuanced strategies;
They exclude slippage and are less exposed to risks associated with volatility surges;
They have a high-profit potential.
Some disadvantages of options are:
Options trading requires the payment of premiums and commissions, thus increasing costs (depending on the brokerage’s service terms);
Not all basic assets offer liquid derivatives markets.
The put option allows you to sell the basic asset.
When concluding a deal with an option, the buyer pays a premium to the seller.
Example. How the call option works.
Let’s take a fictitious stock that is currently trading at $100 as the basic asset.
How Does Call Options Work
Let's say you paid a $5 premium and bought a call option (the right to buy this share after a time certain).
Then:
your break-even point is at $105;
if the price of the basic asset rises above $105, you will make a profit. The higher the growth, the greater the profit;
if the price is lower than $105, you will lose money, but not more than $5.
Let's say you sold a call option and got a $5 premium
Then:
your break-even point is also at $105;
but if the price rises, you will lose, and the loss is potentially unlimited.
however, if the price trades below $105, you will profit. But your earnings will not exceed $5.
Example. How the put option works.
Here, things are in just the reverse.
How Does Put Options Work
Let's say you paid a $5 premium and bought a put option (the right to sell the underlying asset over time)
Then:
your break-even point is at $95;
if the price of the basic asset falls below 95, you will make a profit. The stronger the fall, the greater the profit;
if the price is over $95, you will lose money. But not over $5.
If you sold a put option for a $5 premium
Then:
your breakeven point is also at $95;
Let's assume that the price rises. In this case, the loss will grow in proportion to the decrease in the price of the underlying asset.
And if the basic asset is traded at the price above $95, you will profit. But your earnings will not exceed $5.
Options trading opportunities
As you can see from the examples above:
The buyer of the option always pays a premium and has a fixed risk over the life of the contract;
The seller of the option always gets a premium but has unlimited risk until the option expires.
Buying an option is like buying car insurance. You pay a fixed cost of insurance, and the insurance company takes on the risks associated with what could happen to your car during the year.
Just get it and find the opportunities.
Option 1. You are in the oil derivatives market for the long term
You are confident in your long-term strategy, but you feel that the market may go into a short-term drawdown, because, for example, indicators show an overbought status, and experts predict negative news.
To feel more comfortable, you decide to buy a put option in an amount commensurate with your position size. You pay a $1.5 premium per contract.
If the oil price drops below $66 at expiration, the profit on the option will offset the loss on the basic position and allow you to make the drawdown more easily.
Option 2. You own stocks, and they "hang out" in a flat
But you do not want to sell shares, as you are holding them for investment purposes.
You sell call against your position and immediately get the premium as profit. The main thing is that the price doesn’t rise until the option is exercised. Although even in this case, things will not be so bad, since the profit on the shares compensates for the loss on the option.
Other options
The options described above have an important feature as you have both the basic asset and an option on it in your portfolio. That is, you hedged the main position with an option. More risky strategies are designed to buy/sell options in a portfolio that doesn’t have a position in the basic asset. Then we are talking about "naked" options.
The combination of options and basic assets in a portfolio opens up various ways (option strategies) to make money and reduce risk. For example, options allow you to make constructions such as buying a strangle.
The strategy of a strangle bought is to simultaneously buy a call option and a put option without owning the underlying asset. The point is that the market for the basic asset will be volatile, and its price will go far from the current values. This strategy can be used on the eve of important news series.
We will mention more strategies later in the text.
Risks of options trading
Risks in options trading are primarily associated with the sale of options since the seller's loss can be infinite. The important thing here is not to be an insurance company that sold a record number of real estate insurance before the earthquake.
A real-life example is the sellers of call options on so-called memes stocks. When the share price of Game Stop (NYSE: GME) was growing irrationally in early 2023, some professional traders sold call options, since they didn’t believe that the collusion of Reddit forum users could push to increase the stock of a fundamentally weak company so strongly (over + 2000% in half a month).
Game Stop (GME) Options Chart
As a result, the bullish trend pushed professionals to buy stocks to reduce the risks of selling call options, which in turn led to an even greater increase in the price of the basic asset. This phenomenon is called gamma squeeze. As a result, the rise in shares of the small company GME in January 2023 became the headliner of the main media and the subject of litigation at the level of the US authorities.
Step 1. Choose your options trading broker
All you need to know when choosing a broker to trade options:
Open an account with a trusted verified broker with a valid license from reputable regulators;
Check if the broker provides access to option markets;
Download the platform. Options contracts are traded through options boards. A user-friendly clear board interface and tools for calculating risks shall be considered an extra advantage;
Check if there is a demo account. Test your options trading strategies without using real money and avoid unnecessary losses;
Find out if the broker provides up-to-date analytics from specialists in the options markets. Are tutorials and online help available;
Please note that many options markets are characterized by low liquidity. Since there must be a buyer and a seller in every trade, perhaps you will not get a counterparty to conclude a deal on the selected instrument at a certain price.
Best apps for stock trading
We recommend the following brokers for options trading:
The brokers listed above providing official access to US centralized exchanges are subject to strict investor protection laws and regulatory requirements. Therefore, the procedure for opening an account with a broker regulated by the SEC and also a member of FINRA, SIPC, NASDAQ, and the NYSE exchanges can appear to be too complicated at first glance.
However, in reality, every step in the account opening procedure is justified and serves to save users from making rash, crude transactions.
Answer all the questions on the purposes of opening an account, sources of your income, your experience of conducting operations in financial markets, and provide other information and documents. Thereafter, the broker's specialist will consider your application for opening an account. Only after its approval, can/should you fund your account.
Step 3. Fund your account
Having an approved account with a broker, you can replenish your account in your personal account. Please find below the interface for depositing an account with the Webull broker.
Account Funding on Webull
As a rule, bank transfers and deposits via ACH (Automated Clearing House) are available for US customers. In a number of other cases, customers can replenish brokerage accounts using credit/debit cards, Neteller e-wallets, and other methods. A commission may apply when making a deposit.
How does it work?
You need a platform provided by a broker to trade options. Use the special page on the broker's website to download the platform for your operating system.
Webull Trading Platforms
The standard installation takes just a few clicks.
When you log into the platform using your account details, you will have access to the options board. For example, in the Webull Desktop platform you should:
1
Open the chart of the underlying instrument (for example, AAPL);
2
Click on the Options tab.
How to Choose Options on Webull
This allows you to buy/sell AAPL stock options.
How much money do I need in order to start?
There is no specific answer to the question of how much money you need. It depends on your personal circumstances, the brokerage service terms, and the strategy you are using. The experience of trading on a demo account will provide you with valuable information about the minimum amount of required capital. It is free and could allow you to check if you are ready to enter trades on a live account.
But ultimately, for the profit to make economic sense and compensate for your training costs and psychological stress, you should have ready $2,000 or more of starting capital to begin trading options.
Step 4. Choose your options trading strategy
We have already mentioned the bought strangle strategy when you buy call and put options at the same time with the expectation of a surge in volatility, which will push the price out of the existing narrow range.
The Sold Strangle Strategy
The sold strangle strategy has the opposite logic. For example, if you expect that the market for the basic asset will be inactive, then you should sell both call and put options at the same time. The sold strangle will bring you profit if by the time the two contracts expire, the price of the basic asset doesn’t change much.
The Long Call Butterfly strategy
The Long Call Butterfly strategy also applies when you expect a surge in volatility.
This strategy includes:
buying a call option with one strike below the current price (“in the money”)
selling two call options about the current price (“at the money”)
and buying one call option above the current levels (“out of the money”)
All options must have the same expiration date. This strategy allows you to profit from a bleak market at a relatively low cost.
The Bull Call Spread strategy
The Bull Call Spread strategy involves buying two call options with different prices, but the same expiration date. For example, you expect the price of the basic asset to rise moderately. Then two call purchased options will give you the advantages of a low cost of ownership and a high risk/reward ratio.
We have only mentioned a few combinations. As you can imagine, there are a lot of options for trading strategies. The description of these strategies, with their advantages, disadvantages, and features, goes far beyond the article format.
Trading Options for Dummies by Joe Duarte
The Bible of Options Strategies by Guy Cohen
Options as a Strategic Investment by Lawrence McMillan
Option Volatility and Pricing by Sheldon Natenberg
Fundamentals of Futures and Options Markets by John Hull
Options Trading Crash Course by Frank Richmond
Step 5. Conduct research
Let's say we are considering the AAPL stock market. The chart shows that the market is in an uptrend, and with its last action, the price broke through the consolidation triangle (1) on growing volume (2). Moreover, the market crossed the psychological threshold, closing above $150 for the first time.
Apple (AAPL) chart
From an options trader's point of view, we can purchase a call option with the expectation of a continuation of the bull market while anticipating the new iPhone model presentation.
Step 6. Make your trades
Then we open an options board, choose the contract that we consider the most preferable to us. Note that the lower the price (the strike) of the call contract, the fewer risks it bears, the higher the amount of the premium you will get for it.
Let's say we buy options to buy 1,000 shares with a strike of $146 (the central axis of the triangle in the picture above).
Options Trading
How to trade options successfully? Manage your risks!
The Webull platform interface will help to see the risks and prospects of our purchase of a call option.
Options Trading Risks
In the worst-case scenario, if the share price goes below $146, the loss will be $5,400 (but not more). At the same time, the profit is potentially unlimited. Let's say if the AAPL price reaches $160, the profit on the position will be $8,600.
Expert’s opinion
An option is a derivative instrument that gives the buyer the right (but not the obligation!) to buy or sell the basic asset by a specified date (expiration date) and at a specified price (strike price).
Options contracts can be traded both to hedge risks and to make a profit. Different options strategies are applied depending on the expectations of the investor – whether the market for the basic asset will rise, fall or remain flat.
The demo account service from trusted brokers allows you to find out how options trading works without the risk of losing real money.
Antony Robertson,
Traders Union Financial Analyst
FAQs
Do I need a margin requirement for options trading?
When you buy an options contract, you don’t need to pay margin as your losses are limited. Instead, you need to pay a premium. Your potential losses will be limited to the amount of the premium. When you sell an option contract, you need to pay the margin because unlimited loss and limited profit are possible. The size of the margin is set by the exchange.
What is the strike price?
This is the price for a call option at which the basic instrument can be bought. And for a put option, it is the price at which the underlying instrument can be sold.
What are American and European options?
An American option is an option contract that can be made, i.e., bought or sold at any time before the expiration date. European options are settled strictly at expiration.
What are out-of-the-money (OTM) options?
These are options incurring a loss, not a profit. For example, a call option shall be considered out of the money (OTM) if the strike price is above the current market price of the basic instrument. When such a contract is executed, the buyer loses the premium paid when purchasing the contract, and the seller makes a profit.
Accordingly, in-the-money options are those bringing profit to their owner.
A broker is a legal entity or individual that performs as an intermediary when making trades in the financial markets. Private investors cannot trade without a broker, since only brokers can execute trades on the exchanges.
Trading involves the act of buying and selling financial assets like stocks, currencies, or commodities with the intention of profiting from market price fluctuations. Traders employ various strategies, analysis techniques, and risk management practices to make informed decisions and optimize their chances of success in the financial markets.
Options trading is a financial derivative strategy that involves the buying and selling of options contracts, which give traders the right (but not the obligation) to buy or sell an underlying asset at a specified price, known as the strike price, before or on a predetermined expiration date. There are two main types of options: call options, which allow the holder to buy the underlying asset, and put options, which allow the holder to sell the underlying asset.
Volatility refers to the degree of variation or fluctuation in the price or value of a financial asset, such as stocks, bonds, or cryptocurrencies, over a period of time. Higher volatility indicates that an asset's price is experiencing more significant and rapid price swings, while lower volatility suggests relatively stable and gradual price movements.
The break-even point in trading is when your trade brings neither profit nor loss. As a rule, traders move the stop loss to the breakeven point when the trade starts to make profit.
Mikhail Vnuchkov joined Traders Union as an author in 2020. He began his professional career as a journalist-observer at a small online financial publication, where he covered global economic events and discussed their impact on the segment of financial investment, including investor income. With five years of experience in finance, Mikhail joined Traders Union team, where he is in charge of forming the pool of latest news for traders, who trade stocks, cryptocurrencies, Forex instruments and fixed income.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO).
