Options Trading Basics

Some ways you can be involved in the market are listed below.

• Stocks

• Bonds

• Futures

• ETFs

• Options

As you can see, there are many ways you can be involved in the market, but today we are going to be going over 'options.' Most people seem to know that you can buy stocks and sell stocks, but they have no idea what options are. I'm going to help better your understanding of options, and then you can make a choice yourself if you want to delve deeper into it and potentially buy or sell options.

What are Stock Options?

For those that have little to no understanding of stock options, you are in the right place. With stock options, I could give you this complicated, complex answer just like everyone else I see on the internet, but the goal is for my readers to understand options in the most simple way possible.In short, stock options are a type of derivative investment which it gives the option holder the right, to buy or sell 100 shares of a particular stock at or before the expiration date and price that was chosen at the time of buying the contract. The action of buying or selling the shares would require you to "exercise" your contract. You can do this anytime before the expiration date as long as you are in America, other markets differ in other countries, but you do not have to exercise the option. The buyer of the options contract pays a premium to the seller to be given the right or "option" to buy or sell the specified investment at a pre-determined price in the future.See the table below for a simple explanation of the types of options, including puts and calls.

Types of Contracts

As you can see from the table, not only are you able to buy puts and calls, but you can also be on the other side of the transaction and sell calls and puts as your opening trade. Selling options can be a bit riskier if you are not familiar with how it works, but it is still good to keep in mind all the things that go with the options market. I suggest you take a look at my other blog, "An Options Trading Strategy for Progressive Passive Income," if you want to learn more about selling options.

What does it look like?

Call Options

Let me help you visualize the whole transaction better. Imagine you are thinking of buying a call option on the hypothetical stock 'XYZ' because you think it will go up in the next 30 days. XYZ currently sits at $20 a share. Instead of buying 100 shares of XYZ, which would cost you two thousand dollars, you can just purchase a call option at a premium of, let's say, $2, and you decided to pick the $25 strike price because you think it will at least be at that price 30 days from now. Purchasing a call option for a $2 premium will really cost you $200. See below.$2 (premium) x 100 (shares) = $200Every contract you purchase is similar to owning 100 shares of the stock.Now let's look at how this may play out. XYZ moves up to $27 with one week to spare, and now your contract is two dollars in the money. You have the option to exercise this contract and own the 100 shares at $25 if you feel that may be better than selling your call option for a profit. Now, of course, you would need to have at least $2500 to be able to exercise this option. If you exercised this option, you would immediately be $200 in profit since now you own the shares at $25 per share. That is not all you can do though, keep in mind, that you can sell this contract and potentially make double or triple your money depending on how much the premium increases. You can calculate this by taking the 'Delta' into account, which will then tell you how much your contract will increase for every dollar that the stock price moves. We will get into that in the "Greeks" section.

Put Options

Let's say we switch up our thesis about this stock, and now we believe that stock XYZ will go lower in the next 30 days because the overall market seems weak, or maybe while doing technical analysis, we see a bearish trend starting. Instead of buying a call option, we will now buy a put option. This is the same concept as a call option; just flipped around going in the opposite direction, so don't confuse yourself!For example, we are buying an XYZ put with a $25 strike price and an expiration date that is 30 days out. Fast forward 3 weeks and XYZ is now trading at $23 a share, now we are two dollars in the money, and we can decide whether we want to ride it out longer and see if we can gain some more profit on our premium we paid or we can also decide to sell our put and run with our profits. We could even exercise our options contract, which then would give you the right to sell (short) stock XYZ at $25. If you only had one contract, you would now be short 100 shares of the underlying stock. Your profits would be sitting at $200, and you can now decide when you want to repurchase the shares, without an expiration, to cover your position. Keep in mind. Not all brokers will allow you to exercise a put option because some brokers do not allow you to short stocks.

The Greeks

Now we will get into a concept that is a bit more complex. The greeks are a bit harder to understand for some people, but if you study them, they will start to make sense if you study them. Do not get overwhelmed! It will take you a while to understand the greeks.You should keep in mind the main four greeks when buying or selling options: deltas, theta, gamma, and vega. The two I look at most are delta and theta. So what do these greeks mean?Delta: Measures the amount your contract will move for every one dollar the stock moves.Gamma: Measures the amount delta will change for every dollar that the stock moves.

https://www.optionsplaybook.com/options-introduction/option-greeks/Theta: A measurement that will tell you how much your contract will lose every day that you hold it (time decay). Time decay is not on your side when buying options. The quicker the stock moves, the more your contract will increase.

https://www.optionsplaybook.com/options-introduction/option-greeks/Vega: This is a measurement of implied volatility. This is usually only relevant if the company is anticipating a big catalyst that will move the stock.Some brokerages will charge you fees for trading options but not all of them. My preferred brokerage to use is Robinhood because of how user-friendly it is, and they do not charge any commissions on trades! When looking to trade options on Robinhood, search for the stock you are interested in, pick a date, and then pick your strike price. When you find one that you are interested in, you can click on the contract to check the greeks.The contracts with a shorter expiration date will usually have the highest 'theta' but will also have a higher 'delta' than a contract that is dated further out. If you want to buy a contract that is one or two weeks out, you best be sure that this stock will make that move quickly because the theta will eat up your contract. I usually stick with contracts that are about a month out, unless I am betting on a stock long-term (more than a year out).

Keep in Mind These Two Tips

If I could only tell you only two things about options, I would tell you to make sure that the contracts that you pick have a tight spread, and it has some decent volume. Usually, these both come hand in hand but not always! But you might be wondering what these terms even mean, don't worry, I will explain further.What do I mean by tight spread? When buying options or any derivative, you have a buyer and a seller. When the buyer and seller disagree on how much the derivative is worth, it causes a larger bid/ask spread. The bid is on the buyer's side, and the ask is how much the seller is asking for. If you buy a contract that has too wide of a spread, it will eat into your profits and could create bigger losses. Now you are probably asking yourself, "well, how much is widespread?", this can vary depending on the stock price! For a stock that is $10 or below, the spread should be 5 cents or less. Stocks $10-$100 should be no more than a 10-cent spread! Anything over $100, the spread could be anywhere from 10 cents to 25 cents. Let me note this is the spread of contracts with week expiration dates. The further you go out in expiration, the bigger the spread will be, and those contracts are a little more acceptable because you have a lot of time for those contracts to move.Now let's talk about volume because I was not very specific on what "decent volume" means. The easiest way to explain this is by just telling you to avoid contracts that have anything less than 5 volumes. The last thing you want is to try and sell your contract, and no one is there to buy it from you.

Where Should You Start?

Now that you have been introduced to options, let's talk about how and where you should start! The first thing you should do is apply for a brokerage account that offers options trading and is specifically free of commissions. This will allow you to make the most out of all of your trades or investments.When making your first trade or investment, I would look into longer-term option contracts, they are safer, and the theta will not affect your contract as much as shorter-term contracts. Remember, theta is the time decay on your contract. When buying longer-term contracts, I suggest finding a happy medium for the strike price. What I mean by that is picking a strike price that is not too far away from the current price and not too close to the current price, unless you can afford it. The closer the strike price is to the current price, the more expensive the contracts are to buy. You can also pick strike prices that are deep in the money, which means the strike price is under the current stock price—the deeper in the money the strike, the bigger the delta.So let's review how you should start. First, open a commission-free brokerage that offers options. Next, start with buying longer-term options that are not too deep in the money and not too far away from the current stock price. Once you get used to these options trades and the greeks, you can start playing around with shorter-term trades.Here is a good look at how it would look on the desktop version of my favorite commission-free brokerages, 'Robinhood.'