Understanding Options
Know what options are. Options are contracts that confer to their holder the right to buy or sell an underlying security at a set price (the "strike price") within a set time period (the "term"). The strike price may be lower or higher than the current price of the underlying security (the "market price"). An option, just like a stock or bond, is a security. Options are traded on an exchange in the US or purchased/sold to a foreign broker. While an option allows one to leverage their cash (an option controls a greater value of stock), it is high risk because it eventually expires.
Understand the risks of options trading. Options can be purchased speculatively or as a hedge against losses. Speculative purchases allow traders to make a large amount of money, but only if they can correctly predict the magnitude, timing, and direction of the underlying security's price movement. This also opens up these traders to large losses and high trade commissions. This makes trading options risky, especially for novice traders. However, options can also be used as a strategy for protecting your investments. For example, you could purchase a put option to sell your shares of a stock if you are worried that the price might drop suddenly. This method of using options is somewhat safe, as you only stand to lose the contract price.
Read and understand the booklet entitled "Characteristics and Risks of Standardized Options." This booklet was written in compliance with the SEC regulations. Brokerage firms distribute the booklet to those who open an options-trading account. In that book, you'll learn more about options terminology, the various types of options that you can trade, exercising and settling options, tax considerations for options traders, and the risks associated with options trading.
Understand the basic types of trades. There are two major types of options trades: calls and puts. Both represent the right to either buy or sell a security at a certain price within a defined time period. Specifically, the two types are: A "call" is the option or right, but not the obligation, to buy an asset at a certain price within a specific period of time. The purchaser of a call expects the price of the underlying stock to rise during the term of the option. For example, the buyer purchases a call on a stock with a $100 strike. The buyer is predicting that the stock will increase (let's say to $105 per share), but he will be able to buy those stocks for $100. If he wishes, he can turn around and sell those stocks for $105, making a profit. Otherwise the buyer would loose the cost of the call bid. A "put" is the option or right, but not the obligation, to sell an asset at a certain price within a specific period of time. The purchaser of a put expects the price of the underlying stock to fall during the term of the option. In this case, the buyer can force the writer (seller) of the put option contract to buy the asset at the preset rate. You can open a position with the purchase or sale of a call or put, close it by taking the contrary action, exercise it, or let it expire.
Learn to talk the talk. Look up options-trading terminology, organize the terms in a spreadsheet, print them out and start studying. Here are some very basic terms: A "holder" is someone who has bought an option. A "writer" is someone who has sold an option. A "strike price" is the price at which the asset will be bought or sold (depending on whether it's a call or a put). This is the price a stock price must go above (for calls) or go below (for puts) before an option can turn a profit. The "expiration date" is the agreed upon date by which the owner of the option must exercise his right to buy or sell the underlying security. After this date is reached, the option expires and the holder loses his right. "In the money" is a phrase used to indicate that the market price of the asset is higher than the strike price (if it's a call) or lower than the strike price (if it's a put). "Out of the money" is a phrase used to indicate that the market price of the asset is lower than the strike price (if it's a call) or higher than the strike price (if it's a put).
Preparing to Trade Options
Open a brokerage account. If you want to trade options, you're going to need to open a brokerage to enter your transactions — this can be online with sites like www.iqoptionsbid.com or even a traditional account with a broker. Be sure that you understand what's involved in opening a brokerage account before doing so. Compare commissions on options trading between various brokerages. Some firms even offer no commissions on options trading. Do some online research and read reviews of the brokerage companies that are on your short list. Learn from other people's mistakes so that you don't have to repeat them. Watch out for scam trading sites and platforms. Always research a platform thoroughly before depositing any money. Avoid platforms with negative reviews or reported fraudulent activity. A cash account will only allow purchases of options to open a position. If you want to sell an option to open an account without having the underlying asset, you need a margin account. If you decide to trade online ensure that your online brokerage accepts safe forms of payment such as a secure credit card payment gateway, or a third party payment system such as skrill, PayPal, payoneer, bitcoin, etc.
Get approval to trade options. You'll need to get approval from your brokerage house before you can start buying and selling options. The brokerage firms handling the account sets limits based upon experience and money in account, and each firm has its own requirements aimed at ensuring the customer know what he is doing. You can't write covered calls without an options account. Brokerage firms wants to be sure customers understand the risks before trading. Covered call writing involved selling the right to buy your stock at a strike price during the option term. The buyer has the right, not the seller. The stock has to be in the brokerage account and cannot be sold or transferred while the call is outstanding.
Understand technical analysis. Options are typically short-term investments, so you'll be looking for price movements of the optioned security in the near future to earn a healthy return. To properly predict those price movements, you'll need to understand the basics of technical analysis. Learn about support and resistance levels. These are points at which the stock rarely falls below (support) or rises above (resistance). Support is the level at which significant purchase of the security have occurred historically. Resistance is the price level where significant sales of the security have occurred in the past. Understand the importance of volume. When a stock is moving in a particular direction with a lot of volume behind it, that typically signifies a strong trend and may be a money-making opportunity. Understand chart patterns. History tends to repeat itself, even with stock prices. There are specific patterns that you should look for in stock price movement that may signify where the price is headed. Learn about moving averages. It's often the case that when a stock price crosses above or below a specific moving average of previous prices. A 30-day moving average is considered more reliable than a 10-day moving average.
Getting Started with Trading Options
Start by "paper trading." Avoid the temptation to risk your hard-earned money on a technique that you just learned. Instead, opt for practice or paper trading. Enter "pretend" trades using a spreadsheet or practice trading software. Then, evaluate your returns for at least a couple of months. If you're making a decent return, slowly work your way into real trading. Paper trading is not the same as real trading since there is no psychological pressure or commissions involved. It is a good way to learn mechanics, but not a predictor of real results. Actual options trading is very high risk and can lead to large losses for the trader. Only trade with money you can afford to lose.
Use limit orders. Avoid paying market prices for options because the execution price may be higher than expected. Instead, name your price with limit orders and maximize your return.
Reevaluate your strategy periodically. Determine if there's anything you can do to improve your return. Learn from your mistakes, but also repeat your successful strategies. And keep your strategy focused; traders focus on a few positions, rather than on diversifying. You should have no more than 10 percent of your investment portfolio in options.
Moving on to Advanced Options Trading
Join an online forum of like-minded options traders. If you're dabbling with advanced options trading techniques, you'll find that valuable source of information (and support, after some heartbreaking losses) is an online forum of traders just like you. Find a forum so that you can learn from the successes and, sadly, failures of others.
Consider other options trading strategies. Once you've accomplished some successful trades, you can get approved for more complex options trading strategies. However, start by paper trading them as well. This will allow you to more easily carry them out in real trading. One such strategy is the "straddle," which involves trading both sides of the market, buying a put and call option with both the same strike price and maturity date, so that you limit your exposure. This strategy is most effective when the market is moving up and down, rather than single direction. It also runs the risk that only a single side will be exercisable. A similar strategy is the "strip," which is like the straddle, but is a "bearish" strategy with double the earning power on a downward price movement. It is similar to the straddle in its execution, but with twice as many options bought on the downside (put options).
Learn about the Greeks. Once you've mastered simple options trading and have decided to move on to more complex options trading, you need to learn about the so-called "Greeks." These are metrics that options traders use to maximize their returns. Delta - the amount an option price moves relative to the price movement of the underlying asset. An option with a delta of .5 will have an movement of half that of the underlying asset. If the stock moves $1.00, the option price will move $0.50. Gamma - the rate that delta will change based on a $1 change in the stock price. Theta - the so-called "time decay" of the option price. It measures how much the price deteriorates as the option gets closer to expiration. Vega - the amount the option price will change based on the volatility of the underlying asset.
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