Options trading is a leveraged style of trading and different from buying or selling stocks. There are many strategies, but to keep things simple, we’ll focus on one-legged strategies as opposed to the more complex multi-legged strategies.
To trade options, you need approval from your brokerage to open a margin account. Once that is done, you need options approval. There are several levels of options approval. Each level coincides with your trading experience and capital in your brokerage account. The higher your level of approval, the greater the number of types of options strategies you can trade.
Options are based on a specific stock. If you’ve done research on the stock, that same research can be used to open a position in the associated option, since the option is derivative of the stock. In this way, instead of trading the stock, you can utilize leverage and trade the option.
Let’s look in more detail at a few one-legged options trading strategies.
Options are composed of two types: puts and calls. Puts are bought if you believe the stock is going to go down. In contrast, if you believe the stock price will rise, calls can be bought. The buying of an option to open a position creates a “long” bias.
When you purchase a call, you are betting that the stock price will increase above your strike. Using MSFT again, you believe the stock price will rise above $105 by August. You buy the Aug 105 call options for $1.30 per contract. If MSFT is above $105 on 8/17 when the option expires, your profit will be $130 per contract. Depending on how far above $105 the stock price is, your profit can be more.
Of course, the opposite is true. If MSFT is below $105 on 8/17, you’ll lose your full investment.
Here’s how it works: Let’s say MSFT (Microsoft) is trading at $98. You believe it is going to have bad earnings and that the stock price will drop below $90 within the next three months. You buy the Aug 90 put for $0.80 per contract. If the stock price falls below $90 by the third Friday of August (when options expire for the listed month), your profit will be $80. Depending on how far below $90 the stock price is, you can earn more than $80.
If the stock price remains above $90 at expiration, you’ll lose the full $80 per contract. In this way, you know exactly how much money you’re risking.
Each option contract represents 100 shares of the underlying stock (MSFT). That’s why an $0.80 contract represents $80 (100 x $0.80 = $80).
The “90” in “Aug 90” is called the strike price. “Aug” is called the strike month. You can trade options in weeklies or monthlies. In the above example, the option is a monthly, which means it will expire on the third Friday in August or 8/17/18. If the option were a monthly, it would expire on the Friday of the listed week.
Selling Puts and Calls
Selling a put or call means selling to open a position. That may sound odd, but it works similar to shorting a stock, in which shares are borrowed to open the position short. Selling to open creates a strategy called a naked put or naked call. These strategies require the highest option approval levels and aren’t for beginners.
To sell a put, on your order ticket, you select to sell the option rather than buy. Instead of hoping the stock price will decrease, you want it to remain above the strike. This is a neutral to bullish strategy.
Using MSFT again at $98, if you sell the Aug 95 option for $0.80, your profit will be $80 per contract if MSFT is above $95 at expiration. Unlike buying an option to open, profit and loss are both capped. You can’t earn more than $80. But you can lose more than $80. As the stock price falls further below the strike, you continue losing more. Losses aren’t infinite, however.
Premium is an important concept when selling puts or calls. When the above put position is opened, the $80 of premium is deposited into your account immediately. Whether you keep the full $80 or not depends on how you manage the trade. If MSFT is above $95 on 8/17, you’ll collect full premium ($80).
You can buy back the option before expiration. For example, say MSFT is at $100 on 8/1 and the option premium has dropped to just $0.15. If you buy it back, your profit will be $65 ($0.80 − $0.15 = $0.65).
While selling puts caps your profit and has finite losses, selling calls do not. Let’s say you write a call on MSFT for the Aug 105 for $1.30 premium. With MSFT at $98, your strategy is betting that MSFT will not go above $105 by 8/17. If MSFT is at $106 by 8/17, you lose the full the $130 initial investment plus a little more. In fact, depending on how far above $105 MSFT is at expiration, you’ll continue to lose more. The losses are unlimited.
If you are just starting with options, long single-legged positions are the simplest to learn and manage. You may find that you’re waiting until expiration or selling the option before expiration for a little profit. Once you get comfortable with these basic strategies, you can start venturing into more involved and complex options strategies.
TD Ameritrade has a platform called Thinkorswim which is one of the best when it comes to buying options on. Plus, it has some of the best training for options trading.
Robinhood also offers options trading, and they offer free trading. Their platform pricing is great, but it can be hard to trade on your phone. Many people use TD Ameritrade for research, then place their actual trades on Robinhood to save on commissions.
If your thinking about trading, make sure that you really understand it and don't invest more than you can afford to lose.