A move from ‘Options Dummy’ to options trader requires some fundamental knowledge. If you want enough basics to begin trading, this Options Trading for Dummies guide is a good start.
But understand, option trading is serious business. It is speculative and has the associated risk of loss.
With that said, let’s get started!…
Options 101 : Trading Options for Beginners
You’ll notice I didn’t title this article…Stock Trading for Dummies. That’s because Options are different. They are a form of contract that gives the buyer the right to buy or sell a stock asset. But, there is no ‘obligation’ to do either .
There are other common examples of options in life too. Maybe you saw some land you want to buy. But you won’t have the funds until a couple of months. If you find a motivated owner is they may agree to sell the land to you at an agreed price 2 months from now.
You don’t have to buy it in the 2 month period, but you have the ‘option’ to. The landowner does have an obligation. They must not sell the property for 2 months in case you do want to exercise your option to buy. Nobody else can buy it during that time.
And if the land value doubled, he still must sell it to you at the agreed price.
Stock option agreements function exactly the same. But, instead of land, the underlying security is stocks in a traded company. The option contract guarantees the owner owner will sell the stocks to the buyer at an agreed price (strike price), within an agreed time.
In the case of stock options there is a fee for granting the option. The fee (premium) is a cost to you whether you decide to exercise the option or not. I’ll discuss premiums further below.
What are ‘Calls’ and ‘Puts’
I could write a small book on this section, named ‘Call and Put Options for Dummies’. But I’ll summarize enough here for you to grasp the concepts.
Imagine you have an Apple option for a date 2 months in the future where the strike price is $150. So, are you allowed to buy at $150 or sell at $150?
So, you have the right to buy an Apple ‘Call Option’ for 100 shares at $150 per share. Or, you have the right to sell an Apple ‘Put Option’ of 100 shares of Apple at $150 per share. Deciding whether to Call or Put is determined by what you think the market for Apple stocks will do. Will Apple stock be above or below $150 per share on or before the strike date? If Apple stock improves in value it may be is $160 on the strike date. If you have a call option you can buy the Apple stocks at $150 and sell them at $160 for a profit of $10/share x 100 shares = $1,000.
So, if you believe Apple stock with dip to $140 by the strike date, you will take a put option for $150. Then when the strike date arrives you can exercise your right to buy the stocks at the agreed $140. Then sell them at $150 for a profit of $10/share x 100 shares = $1,000.
In other words a call option let’s you can buy low and a put option let’s you sell high.
Earlier I mentioned that to get an option there is a premium involved. The cost of buying the option contract.
The cost of an option is a combination of two primary factors. The difference between the current stock price (Intrinsic Value). And the strike price and the amount of time left until the expiry date (Time Value).
A call option has intrinsic value when the current market price is higher than the strike price. A put option intrinsic value depends on how much lower the current market price is than the strike price.
If the current market price of Apple shares is $100 and I pay $5/share for an Apple stock option. If the strike price is $103 then the intrinsic value is $3 and the time value is $2.
If the stock price remains at $100 until the expiry date the time value vanishes. But I can still sell the stocks at $103 because only the time value decays…not the intrinsic value.
What is a Binary Option?
Binary options are simple options contracts with a set risk and set reward.
From the trader’s perspective, they make a choice about whether a certain stock will go up or down over a set time. The trader is betting his or her money on their prediction.
The trader can see how much money money will is earned if their educated guess is correct. When a trader guesses correctly they receive the money they risked…and a return on top. The trader’s returns are usually big (70-85% is common).
Binary option contracts have three key ingredients (expiry time, strike price, and payout offers).
If you're already thinking about index options reading this article; you may be getting a little ahead of yourself. However, if you'd like to read up on them, we've prepared a quick guide for you: www.PI.org/index-options-101-beginners-guide
Due to the big financial risks involved in options trading a real Options Dummy needs to accept the title. They need to take responsibility for educating themselves about options trading; a great way to start would be to check out our list of the best options trading strategies. To avoid losing money while you learn, you can practice trading with an options trading simulator. Once you're confident in your ability to trade you'll need to create an account with an options brokerage, many of these companies are the same ones that offer trading simulators, so try and stick to what you're familiar with.
The information presented here is the tip of a big options trading iceberg. It gives a light introduction and some awareness of the complexities of options trading. If you're serious about learning how to trade options, you should consider enroll yourself in a comprehensive options trading training course.