Options Trading 101

Options Trading 101

Introduction to Options Trading

Investing, Investing Strategy

Introduction to Options Trading

Investing, Investing Strategy
Male freelancer use notebook sitting in modern loft interior with big windows, confident business man busy using laptop at office desk, young student texting on computer while sitting at wooden table

Puts, calls, strike prices, premiums, derivatives, bear put spreads and bull call spreads — the jargon is just one of the complex aspects of options trading. But don’t let any of it scare you away.

Options can provide flexibility for investors at every level and help them manage risk. To see if options trading has a place in your portfolio, here are the basics of what options are, why investors use them and how to get started.

What are options?

An option is a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price and by a certain date.

Just as you can buy a stock because you think the price will go up or short a stock when you think its price is going to drop, an option allows you to bet on which direction you think the price of a stock will go. But instead of buying or shorting the asset outright, when you buy an option you’re buying a contract that allows — but doesn’t obligate — you to do a number of things, including:

  • Buy or sell shares of a stock at an agreed-upon price (the “strike price”) for a limited period of time.
  • Sell the contract to another investor.
  • Let the option contract expire and walk away without further financial obligation.

Options trading may sound like it’s only for commitment-phobes, and it can be if you’re simply looking to capitalize on short-term price movements and trade in and out of contracts — which we don’t recommend. But options are useful for long-term buy-and-hold investors, too.

Why use options?

Investors use options for different reasons, but the main advantages are:

  • Buying an option requires a smaller initial outlay than buying the stock.
  • An option buys an investor time to see how things play out.
  • An option protects investors from downside risk by locking in the price without the obligation to buy.

If there’s a company you’ve had your eye on and you believe the stock price is going to rise, a “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out you get to buy the stock for less than it’s selling for on the open market. If it doesn’t, your financial losses are limited to the price of the contract.

You also can limit your exposure to risk on stock positions you already have. Let’s say you own stock in a company but are worried about short-term volatility wiping out your investment gains. To hedge against losses, you can buy a “put” option that gives you the right to sell a particular number of shares at a predetermined price. If the share price does indeed tank, the option limits your losses, and the gains from selling help offset some of the financial hurt.

How to start trading options

Elsewhere we cover options trading lingo, the mechanics of trading and some strategies, because a strong grasp of the basics is important before you dive in.

Every brokerage firm screens potential options traders to determine their experience, their understanding of the risks in options trading and whether they’re financially prepared. Based on your answers to questions about income and net worth, account size and investing knowledge, the broker assigns you an initial trading level (typically 1 to 4) — essentially a permission slip that allows you to place 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.

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

This post has been updated.

Options Trading 101

How to Trade Options

Investing, Investing Strategy, Investments

How to Trade Options

Investing, Investing Strategy, Investments
How to Trade Options

When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price. The process is more complicated for options trading.

When you buy 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’ll buy. 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 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.

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

This is the strike price — the agreed-upon share price at which you would buy or sell the stock if you exercise the option. So, for example, if you believe the share price of a company that is currently trading for $100 is going to rise, you’d buy a call option with a strike price that is less than the $100 you’d pay for shares on the open market right now. If the price does indeed rise above the strike price, you make a profit. Similarly, if you believe the company’s share price is going to dip, you’d buy a put option (giving you the right to sell shares) at a strike price above $100. If the stock price drops, your contract has locked in your right to sell shares for more than they’re fetching on the open market.

You can’t just choose 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 difference between the strike price and the share price is part of what determines an option’s intrinsic value. Time is the other part of the valuation formula, which leads us to the final choice you need to make before buying an options contract.

  1. 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.

The amount of time (called time value) and the intrinsic value (the difference between the strike price and the open market price of the shares) determines the cost of the contract, known as the option premium.

Anatomy of an options trade: Call option example

Let’s go through one of the more basic options trading scenarios that an investor might use: buying a call option.

You believe that XYZ’s stock price is going to increase in the next month, and you want to lock in the option to buy shares at a lower price. You decide to buy a call option on XYZ with a strike price of $90 that expires in one month. The premium on that option is $3 per share. Here’s how much you’ll pay:

  • The per-share cost, or premium: Remember, each options contract typically contains 100 shares. So you’ll pay $300 (the $3 premium multiplied by 100 shares) for the right to buy 100 shares of XYZ stock at $90 per share before the expiration date.
  • Trading costs: Many brokers price options trades in two parts: a base rate (an option commission) and a per-contract fee. If your brokerage charges a $7.95 base rate and a 75 cent per-contract fee, you’ll pay $8.70 in commissions.

That brings your total tab for the call option on XYZ to $308.70.

» MORE: Options trading terms and definitions

The upside: What you can do if your prediction is correct

Let’s say you’re right, and XYZ’s stock price rises to $100. Your option is, in options-speak, “in the money.” For a call option, that means the share price on the open market is higher than the option’s strike price. (For a put option to be in the money, the share price must be lower than the strike price.)

Now you have another choice to make. You can:

  • Exercise the option and hold the shares. If you think the stock will continue to rise, you can exercise the option (buy the shares) and admire them in your portfolio. Your total cost to acquire the shares comes to $9,308.70. (The math: The $90 strike price multiplied by 100 shares, plus $308.70 for the original contract.) Right off the bat, you’ve gotten the equivalent of a 7.4% return compared with investors who waited to buy shares at $100. Note that partial trades are not allowed; options traders must exercise all 100 shares in a contract.
  • Exercise the option and sell the shares. In this scenario, you’d buy the shares at the $90 strike price for $9,000 and sell them right away at $100 per share, for $10,000. Factoring in the $308.70 trading costs, you would make $691.30 — a 124% return on the initial price of the contract.
  • Sell the options contract to another investor. If you don’t want to spend the money to buy the shares, you can always close out your position and sell the contract to another investor. If this is your plan from the outset, ideally the stock price moves shortly after you purchase the contract. The more time there is before the contract expires, the more the contract is worth. Let’s say the premium on your XYZ call increases to $12 from the $3 you originally paid. If you close out your position, you’ll pocket $891.30 ($1,200 as the recipient of the option premium minus the $308.70 you paid for the original contract).

The downside: What happens if your prediction is wrong

First, the good news: When you buy a put or call option, you are in no way obligated to follow through on the trade. If your assumptions about the time frame and direction of XYZ’s trajectory are incorrect — if the stock never rises above $90 or if it drops below your strike price — your losses are limited to a maximum of the $308.70 you paid for the contract and trading fees.

Had you been speculating and bought shares of XYZ on the open market before the price took a dive, your financial loss would cut a lot deeper.

The bad news, as you probably guessed: When your prediction doesn’t pan out during the time frame specified in your contract, the option expires worthless. Or, in the gentler terms of option traders, it’s out of the money.

However, if you’re a quick enough draw, you may be able to salvage a little of your initial investment. The option’s intrinsic value may have tanked, but you could limit your losses if you sell the contract before it expires, while it still has time value.

» MORE: Options trading strategies

Before you can start trading options …

If anything you’ve read so far gives you pause — the amount of capital required to trade options, the complexity of predicting multiple moving parts, the reliance on timing — that’s a good thing. That’s exactly what brokers require potential options investors to do before awarding a permission slip to start trading options.

Every brokerage firm screens potential options traders to determine their experience and understanding of the inherent risks of options trading and whether they’re financially prepared to handle them.

Account minimums and trading costs are important considerations for investors looking for the best brokerage firm to use. But even more important, especially for investors new to option trading, is finding a broker that offers the tools, research, guidance and support you need.

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

Updated Nov. 17, 2016.

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.