Your Guide to Options Trading
In this article, we will explain options trading for beginners starting with some options trading basics, along with an options trading example and a few different options trading strategies. We will also discuss the pros and cons of options trading, and whether or not other products, such as traditional stock investing or using CFDs (Contracts for Difference), are more suited to traders in today's market.
What is Options Trading?
Options trading is a form of speculation on an underlying asset that gives the holder the right but not the obligation to buy or sell the underlying asset within a set timeframe at a set price. These assets could be a stock, a bond, a commodity, or any other type of tradable market. Because of this, they are known as 'derivative' products, as the price of an option is derived from the price of the underlying asset.
Options trading originated in ancient Greece, where individuals would speculate on the olive harvest. Nowadays you can learn options trading and use options trading strategies across most markets such as Forex, stocks, commodities, bonds, and stock market indices. For those who do participate in online options trading, one of the most popular methods is stock options trading.
In online options trading, if you purchase an options contract, it grants you the right, but not the obligation to buy or sell the underlying asset at a set price before or on a certain date in the future. In this way, it is very similar to other forms of speculation in terms of picking the direction you believe that the market will move. In general, all forms of trading and investing will involve analysing a financial instrument on whether it is likely to move up or down over a period of time.
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One of the biggest differences between trading options and other products is the fact that options contracts have expiration dates. This means the expected gain on the trade is not as clear from the time the trade is taken as not only does the trader need to pick the right direction, they also need to estimate how long the market will keep moving in their direction, as well as the expected volatility of the move.
The price of an option paid at the outset changes as volatility changes, interest rates change, volume and many other factors. For now though, let's learn a little more about how to trade options and the different types of options trading strategies available to traders before we dig in a little deeper.
How to Trade Options
When you begin to learn options trading, the first element to learn is the two types of options contracts available. They are called 'calls' and 'puts'. It's important to remember that there are always two sides to every option transaction - the buyer of the option contract, and the seller of the option contract (known as the writer). While you can use options on most financial markets, let's stick to stock options trading for now and later on we will answer the common question: 'Is options trading better than stocks?'
Options Trading Basics: What is a Call Option?
Buying a call option gives the buyer the right, but not the obligation, to purchase the shares of a company at a predetermined price (known as the strike price) by a predetermined date (known as the expiry). The seller of the call option (known as the writer) is the one with the obligation. This is because if the call buyer decides to take the option to buy the shares (known as exercising the option), the call writer is obligated to sell their shares to the buyer at the predetermined strike price.
Let's suppose that a trader bought a call option on Apple with a strike price of $180, which was due to expire after six weeks. This means that the trader buying the call option has the right to exercise that option (meaning, the right to buy the shares), by paying $180 per share. If the price of Apple's shares goes up to $200, then exercising the option is a good deal for the buyer - they are able to get the shares at a lower price than they would pay on the open market.
The writer of the call option would then have the obligation to deliver those shares for $180 per share, no matter what the actual underlying price of Apple is. If the price of Apple's shares falls to $150, on the other hand, the buyer has no obligation to exercise the options contract. In this case, the buyer would let the contract expire, and the writer would hold on to their shares.
Buying a call option example
With a call option, traders would usually create profit and loss charts, similar to the one below:
In the example above, it shows the profit or loss of a call option which has a strike price of 40 that is purchased for $1.50 per share. When buying a call option, the worst-case scenario is that the share price does not reach your strike price and you lose the cost of buying the call option. The blue horizontal line to the left of 40 represents this loss. When the profit/loss line in blue goes above the zero line this is where the trade is breakeven. In the example above, it is at 41.50 which is the strike price plus the call price paid (40 + 1.50 = 41.50).
For traditional stock investors or CFD traders using the MetaTrader 5 trading platform provided by Admiral Markets, the profit or loss levels would be dictated by take profit and stop loss levels put on by the trader at the time of taking the trade which is then automatically shown on the chart in the platform, as shown below:
A screenshot of the MetaTrader 5 trading platform provided by Admiral Markets demonstrating entry, stop loss and take profit levels on the platform.
Disclaimer: Charts for financial instruments in this article are for illustrative purposes and do not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, Exchange Traded Funds (ETFs), Shares). Past performance is not necessarily an indication of future performance.
Did you know that you can download the MetaTrader 5 trading platform provided by Admiral Markets completely FREE? Not only can you view live and historical prices of thousands of different financial instruments but you can also trade directly from the chart and access advanced trading tools and indicators. Get started today by clicking on the banner below:
Selling a call option example
In the profit and loss chart of selling a call option, it shows a strike price of 40 which can be purchased for $1.50 per share. When shorting a call option, you are now the seller of the contract. This means that if the underlying shares of the stock reaches the strike price of the call, the seller has the obligation to fulfil it which means a short call has unlimited risk potential as the stock price could keep rising indefinitely. The profit potential is limited to the premium received when selling the call. This type of strategy is certainly not for beginners.
Now let's have a look at the other type of option which is called a 'put' option.
Options Trading Basics: What is a Put Option?
Buying a put option provides the buyer the right, but not the obligation, to sell the underlying stock at a predetermined strike price, by a predetermined expiry date. In this instance, the trader is betting on a fall within the stock price and is essentially shorting (or short selling) the market. Let's take a look at a stock options trading example:
Let's say that Tesla is trading at $360 per share (which is also the strike price), and the price of a put option at this strike price is $6 per contract, which expires in three months time. As one option contract equals 100 shares, the cost of 1 put is $600 (100 shares x 1 put x $6) - this is also known as the option premium. The trader's breakeven price is the strike price minus the price of the put. In this instance, the sum would be $354 ($360 - $6).
If at the expiration date of the contract, the underlying stock price of Tesla is trading between $354 and $360, the option will have some value, but will not show a profit. If the share price remained above the strike price of $360, the option would then become worthless, and the trader would lose the price paid for the put (which was $600). If the share price traded below $354 and lower, the trader would begin to be in profit.
How to Trade Options: 5 Options Trading Strategies
There are a variety of different types of options trading strategies used by traders. The mechanics of each strategy will differ depending on the style of trader. Some traders will be day trading options while others will be stock options trading using swing trading techniques to hold on to trades for a longer period of time.
At the very basic level though, learning how to trade options will require knowing the different types of strategies available using options contracts. Let's have a look at a few:
1. Buy a call option
This is the simplest type of options trading strategy available and is used when a trader believes the underlying instrument's price is likely to increase in value. If the underlying instrument's price rises and pushes up the option's premium price then the trader could potentially profit by selling the option before expiry. With a call option, you cannot lose more than the premium you pay to open it.
2. Buying a put option
This is another simple type of option strategy that is used when a trader believes the underlying instrument's price is likely to fall in value. If the price does fall and pushes up the option premium then the trader can profit by selling the option before expiry. With a put option, you cannot lose more than the premium you pay to open the position.
3. Sell a call (short call)
If you already own stock in a company you can sell an option on it. This is called a covered call. If you sell, or write, a call option and do not own the underlying instrument it is known as a naked call which is high risk as you could end up having to cover the full cost, as highlighted in the examples in the previous section.
Trading option spreads is more popular as it allows a trader to limit their risk. In this type of strategy, a trader would simultaneously buy and sell options. For example, a bull call spread is where a trader would buy a call at a specific strike price while also selling the same number of calls at a higher strike price on the same instrument with the same expiry.
While this strategy limits the upside to the profit made from the difference between the two strike prices it reduces the net premium spent. Traders can also use a bear put spread which works in the opposite manner.
Straddles are used if a trader believes a market will increase in volatility but are not sure on which direction the market could move. In this type of options trading strategy, the trader would buy or sell a call and put at the same time on the same market with the same strike price.
Have you noticed the similarity in all of these strategies?
In every one of these scenarios the trader still needs to perform some form of technical analysis or fundamental analysis to understand which direction the market could go, or whether or not the market is about to increase in volatility. So, on top of learning all the complex mechanics of options trading, they still need to learn how to trade the market as well to find actionable trading ideas.
One quick way to find actionable trading ideas is through the Technical Insight Lookup indicators which can be accessed for FREE in the MetaTrader Supreme Edition. Once you upgrade your platform you can access this indicator and other advanced trading tools completely free. Below is an example searching for Apple Inc where we can see all the different active technical analysis events and trading ideas for short-term, medium-term and long-term positions:
An example of the Technical Insight Lookup indicator, searing for Apple Inc, from the MetaTrader 5 Supreme Edition upgrade.
To upgrade your MetaTrader 5 trading platform to the Supreme Edition completely FREE and access the Technical Insight Lookup indicator, simply click on the banner below:
Learn to Trade Options
When learning to trade options it is important to understand all the influences on an option's price. Options are tradable securities, meaning that very few options actually expire and see shares transferred. This is because most traders are merely using them as a vehicle to speculate on the price movement of the underlying asset. However, not all options follow the magnitude of the price movement of their underlying assets. This is because the value of an option decreases over time, which leads to characteristics that are fundamentally different than just buying a stock.
This may sound strange but it is just one reason, among many, why beginner traders lose money in options trading. That's why, when using options trading strategies, it's important for traders to understand 'the Greeks' - Delta, Vega, Gamma and Theta. These are statistical values that measure the risks involved with trading an options contract:
- Delta: This value measures the option's price sensitivity to changes in the price of the underlying asset. Essentially, it is the number of points the option price is expected to move for each one-point change within the underlying asset. A one-point move in the underlying asset will not always equal a one-point move in your option value. The delta values range from 0 and 1 for call options, and 0 and -1 for put options.
- Vega: This value measures an option's sensitivity to changes in the volatility of the underlying asset. It represents the amount an option's price will change in response to a 1% change in the volatility of the underlying market.
- Gamma: This value measures the sensitivity of the delta value in response to price changes within the underlying instrument.
- Theta: This value measures the time decay of an option. The closer the option moves to the expiration date, the more worthless it can become. Theta measures the theoretical dollar value an option loses each day.
There are also some other factors to take into consideration that affect an option's price. Some of these include:
- The volatility of the underlying instrument. More volatile stocks can help an option's contract move towards the strike price. However, this increased volatility will affect the Greek's and the option's price and premium paid.
- The time to expiry. The level at which the underlying market is trading and the time left to expiry before the option's contract expires is critical in determining profit and loss and risk management. There are three important terms to know:
- In the money. This is when the underlying instrument's price is greater than the strike price for a call, or lower than the strike price for a put. It's called in the money because if the holder exercised their option they can trade at a better price than the underlying price.
- Out of the money. This is when the underlying instrument's price is lower than the strike price for a call, or greater than the strike price for a put. The option will incur a loss if it is out of the money at expiry.
- At the money. This is when the underlying instrument's price is equal to the strike price.
As you can see, there is a considerable amount to consider when trading an options contract. This is on top of the analysis required to locate a profitable trade, to analyse the direction, and to find possible areas to buy or sell, and where to exit.
The complexity of options trading is just one reason many traders have turned to other products to speculate on the financial markets, such as CFDs (Contracts for Difference), as well as just traditional stock investing. Let's see how they differ from options trading.
Is Options Trading Better Than Stocks?
Investing in real stocks is relatively simple. After you do your technical analysis, fundamental analysis and stock research you can simply buy shares in the company through an online broker. If the share price rises then you could potentially be in profit. If the share price falls then you would be losing money on the investment. The simplicity of this is what attracts many traders and investors to this type of passive investing.
Did you know that with Admiral Markets you can open an Invest.MT5 account and invest in more than 3,000+ stocks and Exchange Traded Funds (ETFs) from 15 of the largest stock exchanges in the world? With this type of account, investors can also:
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- Invest in stocks and ETFs from 15 of the largest stock exchanges in the world.
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Some would argue that options provide additional benefits than traditional stock investing such as the ability to buy put options to potentially profit from a falling market. However, some would say the using Contracts for Difference (CFDs), provides a simpler way to trade long and short. Let's have a look at the differences.
Why Options Traders Should Consider Trading CFDs
A CFD, just like an option, is also a derivative product that enables traders to speculate on the rise and fall of a market. When trading a CFD, it is essentially a contract between two parties, the buyer and the seller. It stipulates that the seller will pay the buyer the difference between the current value of a market, and the value when the contract ends.
In this instance, the seller is usually your broker. With a CFD, the trader simply pays the difference between the opening and closing price of the underlying market. Unlike options trading, where a one-point move within the underlying asset doesn't always equal a one-point move in the options contract, the CFD tracks the underlying much more closely. Here are some key differences between options trading and CFD trading:
Contract expiry dates - the market may keep moving in your favour after your option expires, therefore you cannot profit from the move
Generally no expiry dates
Not all shares and instruments are available to trade on with options
Traders can trade over 3,000+ markets
Option writers are exposed to unlimited losses
Traders can use stop losses and volatility protection orders to manage risk
Value of options declines over time and they are regarded as 'wasting assets' due to time decay
No time decay on a CFD contract - get the full profit or loss
Option traders must have a minimum of $25,000 in their trading accounts at all times when day trading options as an industry requirement.
Traders can open a CFD account with just $200
There are also some distinct features of trading CFDs such as:
- Leverage: Retail traders can trade positions with a maximum leverage up to 30:1 and professionally categorised traders up to 500:1. Leverage amounts vary on the instrument being traded and range from 2:1 up to the maximums. If you would like to learn more, make sure to check out Admiral Markets' Retail & Professional Terms.
- Trade in any direction: Go long or short on any market, and take opposing trades to hedge your exposure with certain accounts.
- Hold trades as long as you want: With CFDs, you can trade in and out of markets within seconds, or you can choose to hold positions for days, weeks, or months.
- Advanced risk management tools: Use stop-loss orders and take profit levels to minimise risk.
- Access global markets such as Forex CFDs, Stock CFDs, Index CFDs, Commodity CFDs, Bond CFDs, ETF CFDs and Cryptocurrency CFDs.
How to Start CFD Trading Today
Now you know a little more about the pros and cons of options trading and some of the distinct features of CFD trading and stock investing, what is the best way to get started? Here are just a few steps to begin with:
Step 1: Your Trading Platform
Picking the right trading platform is one of the first things to consider when trading. Finding the best options trading platform can be a bit tricky, as not all offer the variety of markets traders need in today's globalised marketplace. While having access to global markets is important, other factors such as stability, user-friendliness and accessibility are also important.
With CFD trading you can start trading on the most used and well-known trading platforms in the world such as MetaTrader 4, MetaTrader 5, MetaTrader Supreme Edition plugin (exclusive to Admiral Markets) and MetaTrader WebTrader.
Unlike very niche options trading platforms, the MetaTrader platforms are the go-to software for CFD trading worldwide. This means that there is much more support and more features available for individual traders.
Step 2: Your Trading Methodology
CFD trading is a simple form of speculation on the financial markets. However, with so many potential trades available across so many markets - where some even trade 24 hours a day - how can a trader identify the best reward to risk opportunities? By having a methodology that includes:
- Your routine: When will you look at the markets each day?
- Your style: What kind of trader are you? Day trader, scalper, swing trader or will you manage trades more like a longer-term investor?
- Your markets: Which markets will you focus on? Shares, Forex, commodities, indices?
- Your methodology: How will you make trading decisions to buy, to sell, or to exit a position at profit or loss?
Why start trading with Admiral Markets?
- Trade and invest with a well-established, reputable company that is authorised and regulated by the Financial Conduct Authority (FCA).
- Use the world's most popular trading platform MetaTrader for PC, Mac, Web, Android and iOS operating systems.
- Supercharge your trading platform by upgrading to the Supreme Edition completely FREE for actionable trading ideas on thousands of different markets.
- Open a Trade.MT4 or Trade.MT5 trading account to trade via CFDs (Contracts for Difference) which will allow you to go long and short on an instrument to potentially profit from both rising and falling markets.
Did you know that you can test out all the services, products and trading platforms offered by Admiral Markets by opening a FREE demo trading account? Not only test the services and products but you can also test your trading ideas and theories in a virtual environment until you are ready to go live.
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About Admiral Markets
Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.