How to become an Expert in options trading
What is option trading?
Option trading is a special type of financial investment or trading in which investors or traders buy and sell options at different settlement prices using various financial instruments. It is a primary housing measure that allows investors to gain an advantage in the market by using the potential for price changes to occur. Becoming a master at studying options trading demands time and practice. I will discuss the basics of options trading, trading rules, strategies, and essential skills that will help you master options trading.
In options trading, investors buy and sell a company or financial instrument using options, which are called ‘options'. A person or organization acquires the right to buy or sell an asset at a certain price by a specific date. Thus, options trading allows investors not only to profit from changing market prices but also protects them from losses.
Rules of option trading:-
Basic Knowledge – For options trading it is important that you understand the fundamentals of financial markets and options. This includes options types, call values, floor prices, Greek properties, and market rules.
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Selfishness – Selfishness plays an important role in options trading. This will help you understand and control financial market risks. Selfishness is a measure of risk versus expected return.
Strategy – It is important to choose and follow a good trading strategy. The strategy will help you make a plan keeping in mind the timing of buying and selling, amount of investment, desired profit, and loss limits.
Technical and Valuation – Technical and valuation have great importance in options trading. This will help you understand the market trend through high and low levels, chart patterns and volume.
Risk Management – Risk management is very important in options trading. You should set selfish and loss limits through the use of stop losses etc. to control your capital.
Practice – Practice is very important for options trading. Before trading in the real market, you should practice trading on a demo account. This allows you to learn how to trade safely in the real market.
Concept and Margin – Understanding the concept and margin is important in options trading. You need to keep adequate margin for your trading and be aware of margin calls.
Regular Updates – The options trading market can be very fickle, so you need to stay updated with market and economic news on a regular basis. Observing the latest market and industry news will help you in taking trading decisions.
To become a master in option trading the most important thing is that you study well before investing, practice different strategies and stay updated with the market concepts regularly. With patience and experience, you can become adept at options trading and through the struggles and successes become a MORE capable and self-reliant investor.
How to trade options in four steps
1. Open an options trading account
Before you can start trading options, you'll have to prove you know what you're doing. Compared with opening a brokerage account for stock trading, opening an options trading account requires larger amounts of capital. And, given the complexity of predicting multiple moving parts, brokers need to know a bit more about a potential investor before giving them a permission slip to start trading options. Wendy Moyers, a certified financial planner at Chevy Chase Trust in Bethesda, Maryland, says people who know the market well, and have time to watch it, are better suited to options trading than busy, beginner investors.
“It's definitely more complicated, and you have to be on top of it all throughout the trading day,” she says.
One way to get some practice trading options is to try a paper trading account. These are free accounts where you can trade with fake money until you have your options-trading strategy down pat.
Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks and their financial preparedness. These details will be documented in an options trading agreement used to request approval from your prospective broker.
You'll need to provide your:
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Investment objectives. This usually includes income, growth, capital preservation or speculation.
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Trading experience. The broker will want to know 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.
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Personal financial information. Have on hand your liquid net worth (or investments easily sold for cash), annual income, total net worth and employment information.
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The types of options you want to trade. For instance, calls, puts or spreads. And whether they are covered or naked. The seller or writer of options must deliver the underlying stock if the option is exercised. If the writer also owns the underlying stock, the option position is covered. If the option position is left unprotected, it's naked.
Based on your answers, the broker typically assigns you an initial trading level based on the level of risk (typically 1 to 5, with 1 being the lowest risk and 5 being the highest). This 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.
2. Pick which options to buy or sell
As a refresher, 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. (Learn all about call options.) A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires. (Learn all about put options.)
Which direction you expect the underlying stock to move determines what type of options contract you might take on:
If you think the stock price will move up: buy a call option, or sell a put option.
If you think the stock price will stay stable: sell a call option or sell a put option.
If you think the stock price will go down: buy a put option, or sell a call option.
Frederick says to think of options like an insurance policy: You don't get car insurance hoping that you crash your car. You get car insurance because no matter how careful you are, sometimes crashes happen.
“You buy options hoping you don't need them,” he says.
This is just a very basic overview. For a look at more advanced techniques, check out our options trading strategies guide.
3. Predict the option strike price
When buying an option, it 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 put options, 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.
You can't choose just any strike price. Option quotes, technically called an option chain or matrix, 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, 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.
4. Determine the option time frame
Every options contract has an expiration period 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.
There are two styles of options, American and European, which differ depending on when the options contract can be exercised. Holders of an American option can exercise at any point up to the expiry date whereas holders of European options can only exercise on the day of expiry. Since American options offer more flexibility for the option buyer (and more risk for the option seller), they usually cost more than their European counterparts.
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. As such, the longer the expiration period, the more expensive the option.
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.