Options Trading 101

Options Trading 101

How to Trade Options

Trading options requires three strategic choices: deciding which direction you think a stock will move, how high or low the price will go and during what time frame it will all take place.
Investing, Investing Strategy, Investments

How to Trade Options

Trading options requires three strategic choices: deciding which direction you think a stock will move, how high or low the price will go and during what time frame it will all take place.
Investing, Investing Strategy, Investments
How to Trade Options

Options trading can be complex, even more so than stock trading. When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price or at a limit price. Trading options not only requires some of these elements, but also many others, including a more extensive process for opening an account.

Indeed, before you can even get started you have to clear a few hurdles. Because of the amount of capital required and the complexity of predicting multiple moving parts, brokers need to know a bit more about a potential investor before awarding them a permission slip to start trading options.

Opening an options trading account

Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks in options and their financial preparedness.

Before you can start trading options, a broker will determine which trading level to assign to you.

You’ll need to provide a prospective broker:

  • Investment objectives such as income, growth, capital preservation or speculation
  • Trading experience, including your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year and the size of your trades
  • Personal financial information, including liquid net worth (or investments easily sold for cash), annual income, total net worth and employment information
  • The types of options you want to trade

Based on your answers, the broker assigns you an initial trading level (typically 1 to 4, though a fifth level is becoming more common) that is your key to placing certain types of options trades.

Screening should go both ways. The broker you choose to trade options with is your most important investing partner. Finding the broker that offers the tools, research, guidance and support you need is especially important for investors who are new to options trading.

For more information on the best options brokers, read our detailed roundup to compares costs, minimums and other features. Or answer a few questions and get a recommendation of which ones are best for you.

Consider the core elements in an options trade

When you take out an option, you’re purchasing a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price by a certain date. In order to place the trade, you must make three strategic choices:

  • Decide which direction you think the stock is going to move.
  • Predict how high or low the stock price will move from its current price.
  • Determine the time frame during which the stock is likely to move.

1. Decide which direction you think the stock is going to move

This determines what type of options contract you take on. If you think the price of a stock will rise, you’ll buy a call option. A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price (called the strike price) within a certain time period.

If you think the price of a stock will decline, you’ll buy a put option. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.

2. Predict how high or low the stock price will move from its current price

An option remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for puts it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.

For example, if you believe the share price of a company currently trading for $100 is going to rise to $120 by some future date, you’d buy a call option with a strike price less than $120 (ideally a strike price no higher than $120 minus the cost of the option, so that the option remains profitable at $120). If the stock does indeed rise above the strike price, your option is in the money.

Similarly, if you believe the company’s share price is going to dip to $80, you’d buy a put option (giving you the right to sell shares) with a strike price above $80 (ideally a strike price no lower than $80 minus the cost of the option, so that the option remains profitable at $80). If the stock drops below the strike price, your option is in the money.

You can’t choose just any strike price. Option quotes, technically called option chains, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.

The price you pay for an option has two components: intrinsic value and time value.

The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike. Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while time value is $5.

This leads us to the final choice you need to make before buying an options contract.

3. Determine the time frame during which the stock is likely to move

Every options contract has an expiration date that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out.

A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price. An option’s time value decays as expiration approaches, and options buyers don’t want to watch their purchased options decline in value, potentially expiring worthless if the stock finishes below the strike price. If a trade has gone against them, they can usually still sell any time value remaining on the option — and this is more likely if the option contract is longer.

More about the types of options trades

James F. Royal, Ph.D., and Dayana Yochim are staff writers at NerdWallet, a personal finance website. Email: jroyal@nerdwallet.com, dyochim@nerdwallet.com. Twitter: @JimRoyalPhD, @DayanaYochim.

This post has been updated.

Options Trading 101

5 Tips for Choosing an Options Broker

Brokers, Investing, Investments

5 Tips for Choosing an Options Broker

Brokers, Investing, Investments
5 Tips for Choosing an Options Broker

Options trading can be complicated. But if you choose your options broker with care, you’ll quickly master how to conduct research, place trades and track positions.

Here’s our advice on finding a broker that offers the service and the account features that best serve your options trading needs.

1. Look for a free education

If you’re new to options trading or want to expand your trading strategies, finding a broker that has resources for educating customers is a must. That education can come in many forms, including:

  • Online options trading courses.
  • Live or recorded webinars.
  • One-on-one guidance online or by phone
  • Face-to-face meetings with a larger broker that has branches across the country.

It’s a good idea to spend a while in student-driver mode and soak up as much education and advice as you can. Even better, if a broker offers a simulated version of its options trading platform, test-drive the process with a paper trading account before putting any real money on the line.

2. Put your broker’s customer service to the test

Reliable customer service should be a high priority, particularly for newer options traders. It’s also important for those who are switching brokers or conducting complex trades they may need help with.

Consider what kind of contact you prefer. Live online chat? Email? Phone support? Does the broker have a dedicated trading desk on call? What hours is it staffed? Is technical support available 24/7 or only weekdays? What about representatives who can answer questions about your account?

Even before you apply for an account, reach out and ask some questions to see if the answers and response time are satisfactory.

3. Make sure the trading platform is easy to use

Options trading platforms come in all shapes and sizes. They can be web- or software-based, desktop or online only, have separate platforms for basic and advanced trading, offer full or partial mobile functionality, or some combination of the above.

Visit a broker’s website and look for a guided tour of its platform and tools. Screenshots and video tutorials are nice, but trying out a broker’s simulated trading platform, if it has one, will give you the best sense of whether the broker is a good fit.

Some things to consider:

  • Is the platform design user-friendly or do you have to hunt and peck to find what you need?
  • How easy is it to place a trade?
  • Can the platform do the things you need, like creating alerts based on specific criteria or letting you fill out a trade ticket in advance to submit later?
  • Will you need mobile access to the full suite of services when you’re on the go, or will a pared-down version of the platform suffice?
  • How reliable is the website, and how speedily are orders executed? This is a high priority if your strategy involves quickly entering and exiting positions.
  • Does the broker charge a monthly or annual platform fee? If so, are there ways to get the fee waived, such as keeping a minimum account balance or conducting a certain number of trades during a specific period?

4. Assess the breadth, depth and cost of data and tools

Data and research are an options trader’s lifeblood. Some of the basics to look for:

  • A frequently updated quotes feed.
  • Basic charting to help pick your entry and exit points.
  • The ability to analyze a trade’s potential risks and rewards (maximum upside and maximum downside).
  • Screening tools.

Those venturing into more advanced trading strategies may need deeper analytical and trade modeling tools, such as customizable screeners; the ability to build, test, track and back-test trading strategies; and real-time market data from multiple providers.

Check to see if the fancy stuff costs extra. For example, most brokers provide free delayed quotes, lagging 20 minutes behind market data, but charge a fee for a real-time feed. Similarly, some pro-level tools may be available only to customers who meet monthly or quarterly trading activity or account balance minimums.

5. Don’t weigh the price of commissions too heavily

There’s a reason commission costs are lower on our list. Price isn’t everything, and it’s certainly not as important as the other items we’ve covered. But because commissions provide a convenient side-by-side comparison, they often are the first things people look at when picking an options broker.

A few things to know about how much brokers charge to trade options:

  • The two components of an options trading commission are the base rate — essentially the same as thing as the trading commission that investors pay when they buy a stock — and the per-contract fee. Commissions typically range from $3 to $9.99 per trade; contract fees run from 15 cents to $1.25 or more.
  • Some brokers bundle the trading commission and the per-contract fee into a single flat fee.
  • Some brokers also offer discounted commissions based on trading frequency, volume or average account balance. The definition of “high volume” or “active trader” varies by brokerage.

If you’re new to options trading or use the strategy only sparingly you’ll be well-served by choosing either a broker that offers a single flat rate to trade or one that charges a commission plus per-contract fee. If you’re a more active trader, you should review your trading cadence to see if a tiered pricing plan would save you money.

Of course, the less you pay in fees the more profit you keep. But let’s put things in perspective: Platform fees, data fees, inactivity fees and fill-in-the-blank fees can easily cancel out the savings you might get from going with a broker that charges a few bucks less for commissions.

There’s another potential problem if you base your decision solely on commissions. Discount brokers can charge rock-bottom prices because they provide only bare-bones platforms or tack on extra fees for data and tools. On the other hand, at some of the larger, more established brokers you’ll pay higher commissions, but in exchange you get free access to all the information you need to perform due diligence.

» MORE: NerdWallet’s top brokers for options trading

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim.