A Beginner’s Guide to Option Trading

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By guest writer Kumarpal Shah

If you recently made the jump from pooled investing to DIY investing, then you are probably trading on a brokerage account. Therefore in addition to trading stocks, bonds and ETFs, you may have considered options to hedge your portfolio or to generate extra return. If you are new to option trading, this beginners’ guide will help you get started.

What is an option?

An option is a short contract, that when acquired, gives you the right to buy or sell a particular instrument (generally a stock) at a predetermined price (called the strike price) within a specified time horizon. A call option gives the right to buy the underlying stock whereas a put option gives you the right to sell the stock.

An option is generally exercised when conditions are favourable to trade the underlying stock at a profit. For example, if you think Facebook’s stock will fall (rise) within the next months, you may want to buy a put (call) option that will give you the right to sell (buy) the stock at a price higher (lower) than the market price, if that scenario actually occurs.

Generally one option contract relates to 100 shares. But it’s important to point out that you do not need to own the stock in order to trade an option on it. Also, by buying the option you have the right but not the obligation to buy or sell the underlying stock. If you decide not to exercise the option during its term (maybe because the stock price never hits the strike price), your option will just expire.

However, on the other hand if you are the seller of a call (put) option (that you bought from an earlier trade), you will be in the obligation to sell (buy) the underlying stock to the person who bought that option from you. So always make sure the option features (strike price, expiry date, etc) are in your favour when you do such a trade.

How to make money with option trading

Originally options where used are a sort of insurance to hedge the risk in portfolios. But today options are not only used as derivatives but as traded instruments with their own market price (called premiums) and fluctuation. There are essentially two ways you can make money when you have bought an option:

  1. By selling your option when it’s value increases: As a general rule, the further away the strike price is from the current stock price, the higher the premium (intrinsic value). Also the longer the time left before the contract expiration, the higher the premium (time value). Finally, the more volatile is a stock, the higher will be the premium.
  1. By exercising the option: For example, Walmart’s stock is presently at $80. Let’s say you bought a call option on Walmart’s stock with a strike price of $80, because you expect the stock price will rise. So if your bullish prediction occurs, you will be able to buy the stock at $80, a price lower than the market, and sell it right after at market price. The same logic applies if you buy put options because you think the stock price will go down. If that scenario occurs, you will make money by buying the stock at market price if you don’t already own it, and (short) selling it right after at the strike price of $80 (higher than market price).

This Isn’t Gambling!

Option trading requires a strategy and a technique if you want to make money. If you treat it like gambling, you will lose more than you gain and run out of money.

Master the Basics of Option Trading

There are a lot of terms that you will need to learn before you start. For example, an option is in-the-money when it can be exercised favourably (i.e. the stock price has hit the strike price) and is out-of-the-money when your expectation about the stock price has not yet occurred. Two other important terms are intrinsic value and time value, which were explained earlier.

It’s important to learn all the terms and master the basics before you get serious in tactic building. Learning and mastering the basics will help you develop the most successful tactics at a later time.

Get a Mentor

It’s important to have someone who can show you the ropes and the mistakes to avoid. Alternatively forums and websites dedicated to option trading can also help. Forums are great because you can talk to experienced and beginner options traders. You can get tactics and tips from multiple people to see what works best for you. The website Binary Option Shark could be a great place to get you started.

Download a Free Demo Account

When you develop tactics or hear about strategies, you want to make sure they work without spending a fortune. One of the best ways to do that is by downloading a free demo trading account. This also gives you the chance to try out a specific type of software to see if it suits your needs.

While you won’t get any real money, you won’t lose it either. The whole point of the demo accounts is to make a mistake and take the risks. Use it throughout the learning process to develop your own strategies that work for you. Once you’re ready, you can progress to the real accounts and start using your own money in option trading.

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