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Options Trading for Beginners

Options are a type of derivative contract that offer their holders the option to purchase or sell a securities at a specified price at a future date, but not the obligation to do so. The sellers of options charge a sum known as a premium for such a privilege. Option holders will let the option expire worthless and decline to exercise this right if market prices are adverse for them, limiting possible losses to the option premium. On the other hand, if the market shifts in a way that increases the value of this right, it uses it.

Typically, options are split into “call” and “put” contracts. When purchasing a call option, the contract’s buyer has the right to purchase the underlying asset at a later time for a fixed sum known as the exercise price or strike price. A put option gives the buyer the ability to sell the underlying asset at a future date and price.

Let’s look at some fundamental techniques that a novice investor might employ using calls or puts to reduce their risk. The first two entail placing a direction bet using options, which has a low risk of failure. The others include layering hedging tactics over already-held investments.

KEY LESSONS


For novice investors, options trading may appear hazardous or complicated, and as a result, they frequently steer clear.
However, some fundamental options methods might assist a rookie investor in hedging market risk and protecting their downside.

Here, we’ll take a closer look at four of these tactics: covered calls, protected puts, straddles, long calls, and long puts.

Options trading may be complicated, so before getting started, be sure you comprehend the dangers and benefits.

  • Purchasing of Long Calls


For individuals wishing to place a directional bet on the market, trading options has several benefits. You can purchase a call option with less capital than the underlying asset if you believe the price of an asset will increase. In contrast, your losses are capped to the premium paid for the options and nothing more if the price instead declines. The following traders could like this approach:

You want to reduce risk if you are “bullish” or confident in a specific stock, exchange-traded fund (ETF), or index.

want to use leverage in order to profit from rising prices

  • FACTS:

100 shares of the underlying securities are under the ownership of a basic equity option contract on a stock.

  • Example


Consider a trader who wishes to put $5,000 into Apple (AAPL), which is now trading at about $165 per share. They can spend this money on 30 shares for a total of $4,950. So let’s say that during the course of the next month, the stock’s price rises by 10% to $181.50. The trader’s portfolio will increase to $5,445 after deducting any brokerage commissions or transaction costs, giving him a net dollar return of $495, or 10% on his initial investment.

Let’s imagine that the cost of a call option on the stock with a $165 strike price that expires in roughly a month is $5.50 per share, or $550 per contract. The trader can purchase nine options for $4,950 using their allotted investment budget. The trader is actually executing a transaction on 900 shares because the option contract controls 100 shares. The option will expire in the money (ITM) and be worth $16.50 per share (for a $181.50 to $165 strike), or $14,850 on 900 shares, if the stock price rises 10% to $181.50 at expiry. When compared to trading the underlying asset directly, this represents a far higher return of $9,990 in net dollars, or 200%, on the money invested.

Purchase of Puts (Long Puts)


A put option offers the holder the option to sell the underlying at a certain price in place of the call option’s right to buy the underlying at a predetermined price before the contract expires. This is the recommended trading method for those who:

are pessimistic on a certain stock, ETF, or index but desire to avoid the risk involved with short-selling

Want to use leverage to benefit from declining pricing

When compared to a call option, a put option functions exactly the other way, increasing in value when the price of the underlying falls.

Example
Consider the scenario where you believe that a stock’s price will drop from $60 to $50 or lower as a result of poor earnings, but you don’t want to take the chance of selling the stock short in case you are mistaken. Instead, you can pay a $2.00 premium to purchase the $50 put. The maximum you will lose is the $2.00 premium if the price does not drop below $50 instead climbs instead.

However, you would profit $3 ($50 minus $45. less the $2 premium) if you are correct and the stock falls all the way to $45.
Risk/Reward

A long put’s potential loss is capped at the premium for the options.

Called Covered


A covered call is a strategy that is added on top of an existing long position in the underlying asset, unlike the long call or long put. In essence, it is an upward call that is sold in an amount equal to the size of the current position. By doing this, the covered call writer restricts the upside potential of the underlying position while simultaneously collecting the option premium as income. This is the stance that traders favor who:

Expect the underlying’s price to remain same or slightly increase, earning the whole option premium.

prepared to trade some downside protection for a cap on possible upside

Purchasing 100 shares of the underlying asset and selling a call option in exchange for those shares is a covered call strategy. The cost basis of the shares is decreased and some downside protection is provided when the trader sells the call and collects the option’s premium. The trader’s upside potential is capped by agreeing to sell shares of the underlying at the option’s strike price in exchange for selling the option.

Example
At a cost of $0.25 per share, or $25 each contract and a total of $250 for the 10 contracts, let’s say a trader purchases 1,000 shares of BP (BP) at $44 per share and concurrently writes 10 call options (one contract for every 100 shares) with a strike price of $46 expiring in one month. Any decline in the underlying up to this point will be compensated by the premium obtained from the option position since the $0.25 premium decreases the cost basis of the shares to $43.75, providing very modest downside protection.
The short call option will be executed (or “called away”) if the share price increases over $46 before expiration, in which case the trader will be required to deliver the shares at the option’s strike price.

This example, however, suggests that the trader does not anticipate BP to move considerably over $46 or below $44 during the course of the upcoming month. The trader will keep the premium free and clear and may continue selling calls against the shares if wanted as long as the shares do not increase beyond $46 and are not called away before the options expire.

Risk/Reward

The short call option can be executed, requiring the trader to deliver shares of the underlying at the strike price of the option, even if it is below the market price, if the share price increases above the strike price before expiration. For taking this chance,

Some Fundamental Other Options Techniques


Most inexperienced traders or investors can use the simple tactics described here. However, there are more sophisticated approaches available than just purchasing calls or puts. While many of these sorts of tactics are covered elsewhere, the following is simply a quick overview of some other standard options positions that are appropriate for individuals who are familiar with the ones covered above:

  • The married put strategy is purchasing an at-the-money (ATM) put option in an amount sufficient to cover an existing long position in the stock, much like the protective put approach. It imitates a call option (sometimes known as a synthetic call) in this manner.
  • Protective collar strategy: In a protective collar, an investor who has a long position in the underlying purchases a put option that is out-of-the-money (i.e., on the downside) and simultaneously writes a call option that is in-the-money (i.e., on the upside) on the same company.
  • The buyer of a strangle simultaneously goes long on an out-of-the-money call option and a put option, similar to the straddle. Despite having different strike prices, they will both have the same expiration date. The strike put

Benefits and Drawbacks of Trading Options


The primary benefit of purchasing options is the substantial upside potential and the little maximum loss of the option’s premium. The downside to this, though, is that if the stock does not rise sufficiently to be in-the-money, the options would expire worthless. This means that purchasing several solutions that are out of the money might be expensive.

Options may be a great tool for risk hedging and obtaining leverage. For instance, a bullish investor with $1,000 to invest in a business may be able to generate a far higher return by acquiring $1,000 worth of call options on that company rather than $1,000 worth of the company’s stock. The investor can leverage their position by raising their purchasing power by using call options, in this manner. Conversely, if the investor already has stock in the firm and wishes to lessen that exposure, they might hedging their risk by selling put options against the company.

Options contracts’ major drawback is that they are intricate and hard to value. Because of this, options are frequently seen as a more sophisticated investment tool, appropriate primarily for seasoned investors. They have gained more and more popularity recently among ordinary investors. Investors should make sure they completely comprehend the possible ramifications before investing into any options positions because of their potential for disproportionate gains or losses. Devastating damages may result from failure to comply.

Selling options carries a significant risk as well since you assume potentially infinite risk with gains capped at the premium (price) paid for the option.

  • What Are the Levels in Trading Options?


Based on the complexity and amount of risk, most brokers assign several levels of authorisation for trading in options. The two most fundamental levels,

level 1 and level 2, would encompass all four of the tactics mentioned here. Customers of brokerages will normally need to maintain a margin account and be approved for options trading up to a specific threshold.

Level 1: Protective puts and covered calls when the investor already owns the underlying asset
Level 2: Long calls and puts, including straddles and strangles.
Level 3: Options spreads, where one or more options are purchased while one or more other options of the same underlying are simultaneously sold.

Level 4: selling (writing) naked options, which are unhedged and have an infinite risk of loss.

Exactly how can I begin trading options?
The majority of internet brokers currently provide trading in options. Normally, in order to trade options, you must apply and receive approval. Additionally, a margin account is required. After receiving approval, you can place trade orders for options in a manner similar to how you would for stocks, but with the addition of utilizing an option chain to specify the underlying, expiration date, strike price, and whether the order is a call or a put. After that, you can use market orders or limit orders for that choice.

What Time of Day Do Options Trade?

During regular stock market trading hours, equity options (options on stocks) are traded. This usually occurs from 9:30 am until 4:00 pm EST.

Where Can You Trade Options?
Listed options are traded on specialist exchanges including the International Securities Exchange (ISE), the Chicago Board Options Exchange (CBOE), the Boston Options Exchange (BOX), and others. Orders sent through your broker will be forwarded to one of these exchanges for the best execution as these exchanges are now primarily electronic.

Is Free Trading of Options Possible?

Even while many brokers now provide commission-free trading in stocks and ETFs, there are still costs or charges associated with trading options. Typically, there will be a charge each transaction (for example, $4.95) in addition to a commission per contract (for example, $0.50 per contract). Therefore, your cost would be $4.95 + (10 x $0.50) = $9.95 if you purchased 10 alternatives at this price point.

The Bottom Line Options provide investors with additional methods for profiting from trading underlying equities. Different combinations of options, underlying assets, and other derivatives can be used in a number of different methods. Buying calls, buying puts, selling covered calls, and purchasing protected puts are fundamental techniques for newcomers. Options trading has benefits over trading actual assets, such as downside protection and leveraged profits, but it also has drawbacks, such as the need to pay the premium in advance. Selecting a broker is the first stage in the options trading process.

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