A firm grip on the options trading basics will help you each and every day in your new career as a trader. Once you have mastered the basics, options trading is like riding a bike – you’ll never forget how to do it.
What is an Option?
An option contract is exactly as it sounds. That is, one option contract gives you the right to buy a contracted amount (100) shares of stock at a certain price. These are, of course, the option to buy, not the requirement to buy. Should a stock be lower or higher than your strike price and not advantageous for you to purchase at that price, you can let your options expire without taking any action.
Calls and Puts
Starting at the very beginning of the options trading basics are calls and puts, which are like longing (buying) or shorting (short) a stock. Calls are the option to buy a stock at a specific price in the future. Puts, on the other hand, are the option to sell a stock at a certain price and time in the future.
When you buy either, you’re essentially making an obligation with another investor that allows you to buy or sell the stock they own from them any time before expiration. Options are not stocks; neither calls nor puts represent any ownership of the company being traded.
The Strike Price
Next in the list of options trading basics is the strike price. This is the price at which you have decided you wish to buy or sell in the future. For instance, a MSFT March 2010 call with a strike price of $50 will give you the option to buy Microsoft stock at a price of $50 from the current owner some time before March expiration in 2010.
Unlike stocks, the amount of options “open” at any one time rises and falls as traders write new calls on their existing shares. Therefore, carrying on with the options trading basics tutorial, the open interest is the amount of contracts that are available from other investors writing the calls or puts.
Open interest is not volume, nor is it the amount of contracts that are changing hands. Rather, it is the amount of contracts that have yet to be exercised. If there was open interest of 1200 lots, this would mean there are 1200 lots that have yet to be closed or exercised for the delivery of stock.
Getting the Options Trading Basics
You will encounter the four options trading basics above each and every time you go to make a trade. You’ll need to know what a call and a put is when placing a trade. You’ll need to select a strike price to determine how much you’ll pay for the option and its potential value. And finally, you’ll need to ensure there is enough open interest to make your trade.
Although options may seem complicated at first, once you have established your options trading basics, the knowledge will last you a lifetime.
A Primer for Online Options Trading
You’ve heard about the huge profits traders make every day in the options market, and you’re ready to take your piece of the pie. For some, online options trading success comes almost instantly, but for the majority, it requires an investing background to start making money. Here are just some of the qualities of successful investors who use online options trading to bring in big money.
Some Experience Required
Online options trading requires a few skills, most of which you’re likely to possess with even the most rudimentary education in the capital markets. Option traders are generally, but not always, experienced in trading stocks, as options are a derivative of stock prices.
In addition, those getting into online options trading should have at least some experience in using a online brokerage account and understanding the lingo of the business. If you’ve never heard of market orders, stop losses, or moving averages, it would be best to refine your understanding of the stock market before moving forward.
An Appetite for Risk
Options are arguably the most risky, but most rewarding, type of speculative investment. Because they are the option to buy stock, these contracts can move quickly with very small changes in the price of the stock.
Luckily, with options, the most you can lose is the amount you paid for the premium, but when it comes to profits, the sky is the limit. Of course, there are additional risks when selling puts or calls naked, or against your own positions, but straight options bets are limited only to amount of capital invested.
However, you should never begin in online options trading unless you have an appetite for risk, as the options market is very unforgiving.
Leave Your Emotions at the Door
Emotional investors lose money and do so quickly. It is important to remember to never get attached to a position and never become emotionally invested in your portfolio. After depositing your money with an online options broker, you’ll have to trade as if the numbers are digits, not dollars, and prepare yourself mentally for the upswings of success and the downfalls of failure.
Far too many traders become irrational after a series of wins and losses, and after failing to leave their emotions at the door, they lose their shirt when they try to play catch up with a big bet or become egotistical after a string of successes. There is no room for emotion in options investing, as your own mind can often turn yourself against a sound investing strategy.
Don’t Invest More than You Can Afford to Lose
The best way to get started in online options trading is to start small and work your way up. This way, you’ll be able to test your own abilities in the market without losing an amount of money that could affect your standard of living. With options accounts starting at just $1000, you’ll be able to test out the markets and see if it’s for you before going in with both feet. As with any investment, never invest more than you can afford to lose. Losses can, do and will happen.
Option Trading Strategies
The sheer number of ways to trade options has opened the door for a varied list of option trading strategies. From the basic fundamental option trading strategies like the option straddle to your own imaginative strategic plans, forming a solid strategy begins with square one: being consistent.
Stick to the Strategy
The only reason a trader will ever fail with any strategy is that they fail to stick to the strategy. Often, new traders enter the game with several strategies they hope to use and hop from one to the other, racking up losing trades and finding themselves with a depleted account balance.
To be successful, you must allow your option trading strategies to take root and grow profits. Shifting courses too often will result in an account that has nothing to show except for commissions and fees.
Implement Money Management
All option trading strategies begin and end with proper money and risk management. This includes diversifying your options portfolio for success by minimizing the risk an individual trade has on your portfolio. Depending on the option trading strategies you choose to employ, you may choose to risk 1%, 5%, or even 10% of your portfolio on each individual trade.
With options, diversification and money management are even more important than it is with stocks, as the amount of volatility each option sees each day can ruin an under-diversified account balance.
Options can be so wild, in fact, that just a few years ago, one contract outperformed the whole history of the Dow Jones Industrial Average in just one day after a solid earnings release. While those returns aren’t average, they aren’t infrequent. However, it’s important to think: what if you were on the other side of the trade?
Define your Strategy
The best of the options trading strategies in existence are the ones that tailor to your individual needs. Do you wish to protect your stock holdings with put options? Or do you want to leverage up with naked puts to make a profit on a dip in a stock’s price? Or would you like to sell covered calls against your retirement portfolio to give it an extra boost? These are all questions that need be answered – not by you, but by your option trading strategies.
Your Gut Feeling Isn’t a Strategy
The old saying “if you fail to plan, you plan to fail” couldn’t be more true in the world of stock option trading. Failing to plan with solid stock option strategies that can work for you and opting to bet your portfolio on “gut feelings” is the surest way to lose in the market. When you allow yourself to trade by the seat of your pants, you open up new risks, including inconsistencies. You are just as likely to lose at option trading as you would at the slot machines.
The option market is incredibly friendly to solid stock market strategies, rewarding investors with profits. But when you opt to invest by your own gut feelings, you’re sure to get burned.
4 Fundamental Option Trading Strategies
Option trading strategies allow investors to get more out of their options positions that just straight bets up and down. Although the names can be confusing, the underlying concept for each of the option trading strategies is quite simple. Here are a few of some of the most popular strategies.
Watch this options trading straddle video for a more in-depth look:
The straddle is one of the simplest option trading strategies, but also the most dynamic and flexible. The straddle strategy consists of two orders, a buy call and a buy put order, with both placed at the nearest strike price to the current trading price of the stock.
Traders would use this very powerful strategy when they know a big move in a stock’s price is coming, but do not know in which direction. Of all the basic option trading strategies, the straddle is best deployed before a major news event like an earnings report, which can greatly affect a stock’s price.
Watch this Options trading strangle tutorial for a more in-depth look:
Very much like the straddle, the strangle is also one of the simplest option trading strategies and highly profitable. The strangle is completed by purchasing a call and put, but with a different strike price, allowing the stock to move above or below the current price and generate a profit for the trader.
Because the strangle is one of the option trading strategies completed with options that are currently out of the money, it costs less to execute and has a higher percentage profit potential. However, the strangle does have a greater chance of a large percentage loss, since the investor will lose everything if the price does not move significantly.
The strap has more similarities to the straddle and strangle than other option trading strategies, but is generally utilized for a one direction movement. The strap, also known as the “triple option,” is completed by buying two calls and selling one put of equal strike and expiration. The strap is implemented when an investor anticipates a higher price, but also wants protection to downside risk.
The strap can be profitable both to the upside and the downside, but only when the stock rises above the calls strike price plus the premiums for each trade, or only when it falls below the put’s strike price plus the price of the premiums.
Hedging is one of the best option trading strategies to minimize tax costs and to even out profits and losses. Often, hedging is employed by hedge funds or mutual funds to either lock in profits or losses for tax advantage and to reduce volatility and risk.
To hedge, investors simply need to buy calls or puts near the price of their current holdings. For example, an investor holding shares of Yahoo stock worth $19 per share could buy puts with a strike price of $20 to protect himself or herself from any downside risk.
Of course, profits would also be limited, as a rise in the stock’s price would cause the value of the puts to decline. Partial hedges are also one of the more popular option trading strategies, wherein an investor would buy calls or puts to hedge some, but not all of their position.
These are only four of the most popular option trading strategies, and there are literally hundreds of other strategies, with more being concocted by option traders every day.
Make More Money with Covered Call Options
Investors have been using covered calls options for decades as a way to generate an additional return on the stock holdings they already own. By selling covered call options, investors are able to generate returns from the premium option traders pay to contract their shares. What is the gain? The profits could be as much as 10-15% annually, depending on the stock and the calls.
What are Covered Call Options?
Covered call options are option contracts sold against already existing holdings. For example, let’s assume you own 100 shares of Microsoft (MSFT). With those 100 shares, you have one lot, allowing you to sell up to one lot of covered calls against your stock.
Covered calls are essentially a contracted offer to sell your stock at a specific price in the future. Through a broker, you and another trader agree on a price at which you’d sell your shares, and the options buyer pays a premium, which goes to you, for the contract to buy your shares.
The beauty of covered calls is that you can generate excess returns on your portfolio by writing them against the stock that you own. For example, the same 100 shares of Microsoft (MSFT) could be packaged, and you could sell a covered call against the value of the stock. Presently, Microsoft (MSFT) trades for $30 per share, and investors are paying $.20 per option for covered call options with a strike price of $31 and an expiration date just one month away. You could sell a covered call options contract on your 100 shares and net an instant gain of $20 ($.20 per option, $20 for the minimum lot).
Why Investors Want Your Calls
Investors want to buy your covered call options for one reason: to make money. If they buy the option to purchase your stock at $31, paying $.20 for the option, they make money if the stock rises above $31.20 per share. Unfortunately, should it surpass $31.20, you’ll be forced to sell your stock for $31.00 per share, negating the benefit of the premium the investor paid. However, should the price stay below $31.20, you’ll get to keep both the premium and your shares.
Managing your Risk
Investors who want to generate extra income with covered call options while still keeping their shares should take a few simple steps.
First, sell covered call options only at a strike price you think unobtainable. Also, plan to sell covered calls as often throughout the year as possible to spread risk, as well as to reduce the amount of time the stock has to make a big move. If you always roll your covered call options on your own stock into the front-month, the stock will have just 20 trading days of activity, minimizing the risk of selling your shares at a loss. In addition, selling more frequently generates a greater income and gets you the best premium to risk ratios.
Option Trading Brokers Won’t Tell You
Option trading brokers may be your best friend in processing your orders, but it’s not always entirely smooth behind the scenes. Here is a brief list your option trading brokers are unlikely to tell you.
1. Broker-Assisted Isn’t Better
Outside the few products that brokers won’t sell via your online account, there isn’t much use in making a “broker-assisted” trade. Typically, broker-assisted trades cost two to three times the average cost of making a trade through your options trading broker, but only provide a few advantages.
Of course, the biggest advantage for new traders is the chance to get some advice on a trade, but is it really worth the cost? Not always. Although stockbrokers do bring some experience to the table, the particular broker you speak to may know little, if anything, about the actual stock or option in question.
Most brokers employed by discount operations are generally just there to approve purchases of irregular products, such as OTC stocks and other equities that are sometimes disabled to clients.
2. Yes, You Do Qualify for this Promotion
Promotional products abound, and it’s likely that while you’re paying your option trading brokers $9.99 per trade, someone else is paying just $6.99. The best way to find out if you’re paying too much is to give your broker a call, explain the situation about their latest promotion, and see what they can do for you. Sometimes all it takes is a call to one of the many option trading brokers to get the best commissions or a better margin rate.
3. You’re Still Paying for Charts, But Your Friend Isn’t
Investors with accounts open at option trading brokers could still be paying for benefits and tools other investors are getting for free. When you open an account, you’re entering into a contractual agreement to open an account and pay for the tools the broker offers to you.
As such, investors who opened accounts years ago may be paying for tools they no longer use. These same tools could now be offered for free. In many cases, real time quoting previously came with a monthly price tag, but competition has driven option trading brokers to give it away for free.
4. Please Trade Less – We Make More When You Do
Commission schedules can get hairy, especially considering the sheer number of products investors can trade through a standard brokerage account. With that said, your option trading brokers may be actually charging you more for less due to their pricing structure.
For instance, traders who make 90 trades or more in a quarter may get reduced commissions. However, those who make 89 are still paying just as much, but they may actually save money by making a small trade and closing it immediately to cross the 90 trade threshold.
While your option trading broker may not divulge what occurs behind the scenes, you are now savvy enough to ensure that your account is truly working in your favor.
Choosing Option Trading Brokers for Day Traders
Day traders are a different breed from the rest of the option trading world, and they require more from their option trading broker than any other type of trader. While swing traders may overlook advanced charting and quotes, day traders need the freshest prices and the best charting software.
Specialty Option Trading Brokers
Day traders are better served by specialty option trading brokers than firms that offer multiple products. Generally speaking, brokers that specialize in one part of an industry, in this case options, dedicate more energy to developing their software and their products to serve a niche investor.
In addition, specialty brokers are more accustomed to working with advanced traders like day traders in their everyday business than traditional and casual brokerage firms, which do more retirement planning than active trading. An excellent example of a specialty broker is OptionHouse or OptionsXpress, which are solely in the business of providing the ability to trade options.
More important than any other factor for day traders is time. Day traders routinely define solid entry and exit positions, as well as require fast execution and limited slippage when placing an order.
Many brokers that would make the cut for casual investors fail to limit slippage and provide less than instant execution, a problem that can erase the bulk of day trader’s profits. Thus, a day trader looking for a solid choice in the field of option trading brokers is best to try each platform and firm before signing up to test executions.
Executions can vary depending on your location, as well as the quality of each trader’s internet access, so when seconds matter, being closer to the broker can save valuable time and money on each trade.
Using a Niche Platform
Second only to the price of commissions, the platform used to execute trades is the most important piece of the puzzle for day traders. Option trading brokers that specialize in options usually offer free real-time quotes organized in a way that appeals to day traders. Since day traders move in and out of positions easily, it is important to dedicate enough screen real-estate to an options screener and have easy to access orders to make a move on the market as quickly as possible.
Fees and Account Access
Since day traders are usually traders by profession, their frequent earnings must be easy and inexpensive to access. This is where many option trading brokers diverge from the needs of day traders, charging upwards of $25 to wire money in or out of an account. Option trading brokers like OptionsXpress, which caters to serious traders, charges a withdrawal fee of just $15, well under the industry average.
Being a successful day trader hinges in seconds and scalped points, and choosing the right option trading brokerage can make a tremendous difference in your profits.
How to Select the Best Options Broker
Before you can even begin to start selecting trading opportunities and making an investment, you’ll be faced with perhaps one of the most important decisions of your investing career: choosing the best options broker to fit your individual needs.
All Hail the Internet
No technological innovation has been better to investors or traders than the internet. Today’s investors can research stock opportunities, look at charts dating back to the early 1900s, and buy and sell in a moment’s notice through the internet. Subsequently, it should come to no surprise that the best options brokers, from Scottrade to OptionsXpress, are all internet-based.
Before plunging into a broker and filling out the pages upon pages of paperwork now needed to open an options account, there a few things investors should consider.
2.Expected Market Activity
The Initial Investment
The amount you wish to invest will have a dramatic impact on the selection of brokers, as well as the features and options you have within your brokerage account. For instance, some brokers allow traders to trade options with a minimum deposit as low as $1000, while others not specialized in options require minimum account balances of $1000-2500. Some brokerages also offer special promotional rewards and better interest on account balances for traders with $25,000 or more.
Expected Market Activity
The amount of trades you plan to complete, as well as the amount of volume you will be trading, are very important to your choice of broker.
TradeKing, for example, charges $4.95 per trade plus $.65 per contract, whereas OptionsHouse, a specialty broker, charges $8.50 per trade plus $.15 per contract. A trade of only five lots would cost $8.20 through TradeKing and $9.25 through OptionsHouse.
However, as volume increases, OptionsHouse becomes considerably less expensive. A trade of 100 lots, for example, would cost just $23.50 through OptionsHouse, but a whopping $69.95 through TradeKing.
For the active trader trading large lots, OptionsHouse would be the best options broker. However, for small volume traders, TradeKing would be the best options broker.
Also important to selecting a broker is finding one with funding options that suit your needs. Whether you want to be able to ACH transfer money from your bank account to your broker or even access your account balance via a debit card, each broker has different opportunities to access your cash. In addition, each broker has different fees for withdrawals, often charging $2 for a check by snail mail or $10-20 to withdraw your cash via wire transfer.
This is where broker selection is incredibly important, and some traders may be better served to opt for a more premium discount broker. Scottrade may be the best options broker for a trader looking for face-to-face communication and withdraws or deposits on the spot at their offices.
Boiling it Down
When you boil down the process of selecting the best options broker, ultimately it is one that fits your individual needs. No, you won’t be able to meet every need perfectly, but with many different brokers to choose from, it is certain that you can at least find the best options broker for your individual needs.
Option Trading Tips for New Traders
The world of option trading can be both interesting and challenging, presenting risk-to-reward ratios that can either be highly lucrative or devastating. If you are new trader, consider these four option trading tips that will help you profit in the business of trading for yourself.
1. Invest in a Calendar
The best investment an options trader can make is in a calendar. Although simple, a calendar is often an overlooked tool of options traders, as each option has its own expiration date.
One of the best option trading tips is to be well acquainted with the expiration date, as it can have a dramatic impact on the premiums you pay to secure your position. Do you think it will take a month for a particular stock to rise, or should you account for two months? When does the company release its earnings results?
Ask yourself these questions, and then plan ahead. Buying calls expiring in March instead of April can increase your profits exponentially, as well as the outlay.
2. Know the Risks
One of the most important options trading tips is to know the risks of each particular option, strike price and expiration date. Options that expire within the month are generally more volatile and can rise and fall quickly, especially if the contract is thinly traded. In addition, be familiar with the individual stock’s earnings calendar, as it’s important to know when the option will be most volatile.
Profitable traders are not built from making a small quantity of big winning trades followed by several smaller loses. Instead, huge profits are made through consistency, and you can only be consistent if you know the risks and are consistent in your approach.
3. Invest in Knowledge
One of the best money saving option trading tips is to invest in yourself and what you know. There is a very good reason the most profitable option traders are those that have the most experience. They know the market, they know the best times to buy, and they know what to avoid. A small investment in your future as an option trader will pay dividends for years to come.
4. Keep it Simple
Some of the best option trading tips are the most simple. Why? Because new option traders tend to avoid following the option trading tips from seasoned traders, and they go on to repeat the same basic mistakes over and over again.
There is no better, nor simpler, options trading tip than to plan, strategize and learn from each and every mistake you make. You will make mistakes, and you will lose some trades. However, at the end of the day, you can’t change history.
If you were to pick just one of these options trading tips from this list to make yourself successful, make it #3. Invest in yourself and your portfolio will soon follow. Never pass up options trading tips from seasoned traders. They know the ropes, how to be profitable, and what mistakes should be avoided. There is a strong brotherhood amongst Wall Street traders, and you should use it to your advantage.
Options Trading Software
Options trading software extends far beyond the basic trading platform to include risk analysis programs, option trading simulators, and technical analysis programs. Are you taking full advantage of options trading software?
As an example, you’ve sold short 100 shares of Microsoft stock at a price of $47 and bought a call contract with a strike price of $50 at a price of $.10 per option. What is the most you can lose from this trade? After calculating, you would find that the maximum you could lose is $310. You’ve sold 300 shares at $47 and are offering to buy shares at $50 at a cost of $.10 for the right to do so. Thus, if Microsoft falls, you’d earn on the short sale, but lose the $10 you paid for the options. If Microsoft rises to $55, you’d lose $800 on the short sale, but make $490 for a total loss of $310.
There has to be an easier way to calculate this than by hand, and there is with the help of risk analysis options trading software. The most basic options trading software operates on spreadsheets to calculate exactly how much an investor can make or lose with each trade, while the most complex software uses implied volatility and other indicators to give a mathematically perfect risk assessment.
Option Trading Simulators
Option trading simulators are generally more in-depth than risk analysis software and provide more mathematical operations to determine a trader’s expected earnings or losses. These types of options trading software even calculate the daily loss in price as the option nears expiration and loses its premium price. Most professional traders use these kinds of programs to ease their nerves by knowing every potential outcome of their investments.
Technical Analysis Software
Contained in almost every options trading platform, technical analysis software allows investors to easily and quickly run technical indicators over their options charts to look for opportunities. These are generally preloaded with technical analysis tools, including trend lines, relative strength index, MACD, and moving averages, but newer software even includes chart pattern tools to find Elliot waves and head and shoulder patterns.
Options trading software is here to stay. With the aid of software programs, today’s investors can screen more options picks, test their strategies and run risk analysis programs long before one person armed with a calculator could do the same. Of any investment an option trader could make in his or her future, options trading software should come second to a quality education, as it saves time and money – allowing traders to spend more time trading and less time calculating.
Which Software Do You Need?
There are certainly traders who trade without software, but most use at least some options trading software to help in everyday tasks. If you’re making mostly straight option bets, risk calculating software could be avoided, as could simulation software. However, if you’re long on money and short on time, it would be best to at least consider a very basic program to help do the thought-work for you.
How Options Trading Software Has Revolutionized Investing
Before the internet and computers were household commodities, options trading was incredibly limited to those with access to a traditional broker or Wall Street. Today, with the ever growing changes in options trading software, traders can buy, sell, chart and view historical archives of option prices all from home.
Following the popularity of technical analysis and chart patterns in trading strategies, brokers revised their own trading software to allow investors the opportunity to both research and chart their picks and buy and sell from one location.
Today’s option trading software has significantly improved even over the past five years, as broadband connections and internet access have spread through virtually every country on the map. Most options trading software now allows for users to save, edit and revise their own charts, as well as add extra components and technical analysis tools to make better trades.
Real Time Quotes
During the roaring stock market of the 1990s, day trading was briefly “America’s past time.” Thousands of books, educational software, trading strategies and even “as seen on TV” products popped up across the nation to teach traders how they could be an instant millionaire in the dotcom boom.
Even with this huge explosion in the amount of trading software, particularly option trading software, most traders were still paying a monthly fee for access to real time quotes. At the time, Level 3 Nasdaq quoting was the best thing since sliced bread. No longer did traders use charts that were 10 minutes out of date. However, access to such luxurious charting in options trading software cost upwards of $10 – $25 per month, and it wasn’t until the last few years that many brokers finally made access to real-time charting absolutely free.
Technical Analysis and Tools
Long before options trading software came preloaded with hundreds of technical analysis indicators, each calculation was computed by hand, without the aid of computer models. One simple and very popular indicator, the relative strength index, could take hours to compute, as the model’s algorithm changed with the addition of another bar.
Today, options trading software comes standard with tools that allow you to import indicators directly to the option or stock price, with calculations performed instantly. Even the amount of volume can be charted and analyzed technically.
Ask any trader with a technical analysis trading background about calculating indicators by hand. It’s long and hard work, and the results were out of date before the computation was even complete. Today’s option trading software practically makes the calculator obsolete.
It’s a Great Day to Be a Trader
There really is no better time to be entering the options trading circle. With so many high powered tools, incredible charting and fully featured options trading software, today’s investors are on easy street compared to the traders of the past.
The options trading business is driven entirely by competition and is arguably improving faster than any other industry. In the past three years, more software, better prices and increased competition in the brokerage business is bringing out the best tools for traders at the best price: free.