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What is Options Trading?
When most people think of investment, they think of buying stocks on the stock market, and many are probably completely unaware of terms like options trading. Buying stocks and holding on to them with a view to making long term gains is after all, one of the more common investment strategies. It’s also a perfectly sensible to way invest, providing you have some idea about which stocks you should be buying or use a broker that can offer you advice and guidance on such matters.
This approach is known as a buy and hold strategy and can help you increase your wealth in the long run, but it doesnвЂ™t provide much, if anything, in the way of short term gains. These days, many investors are choosing to use a more active investment style in order to try and make more immediate returns.
Thanks to the range of online brokers that enable investors to make transactions on the stock exchanges with just a few clicks of their mouse, it’s relatively straightforward for investors to be more active if they wish to. There are many people that trade online on either a part time or a full time basis; buying and selling regularly to try and take advantage of shorter term price fluctuations and often holding on to their purchases for just a few weeks or days, or even just a couple of hours.
There are plenty of financial instruments that can be actively traded. Options, in particular have proved to be very popular among traders and options trading is becoming more and more common. On this page we have provided some useful information on what is involved in options trading and how it works.
What Does Options Trading Involve?
In very simple terms options trading involves buying and selling options contracts on the public exchanges and, broadly speaking, it’s very similar to stock trading. Whereas stock traders aim to make profits through buying stocks and selling them at a higher price, options traders can make profits through buying options contracts and selling them at a higher price. Also, in the same way that stock traders can take a short position on stock that they believe will go down in value, options traders can do the same with options contracts.
In practice however, this form of trading is far more versatile than stock trading. For one thing, the fact that options contracts can be based on wide variety of underlying securities means that there is plenty of scope when it comes to deciding how and where to invest. Traders can use options to speculate on the price movement of individual stocks, indices, foreign currencies, and commodities among other things and this obviously presents far more opportunities for potential profits.
The real versatility, though, is in the various options types that can be traded and the range of different orders that can be placed.
When trading stocks you basically have two main ways of making money, through taking either a long position or a short position on a specific stock. If you expected a particular stock to go up in value, then you would take a long position by buying that stock with a view to selling it later at a higher price. If you expected a particular stock to go down in value, then you would take a short position by short selling that stock with a hope to buying it back later at a lower price.
In options trading, there’s more choice in the way trades can be executed and many more ways to make money.
It should be made clear that options trading is a much more complicated subject than stock trading and the whole concept of what is involved can seem very daunting to beginners. There is certainly a lot you should learn before you actually get started and invest your money. With that being said, however, most of the fundamentals aren’t actually that difficult to comprehend. Once you have grasped the basics, it becomes much easier to understand exactly what options trading is all about.
Below we explain in more detail all the various processes involved.
Buying an options contract is in practice no different to buying stock. You are basically taking a long position on that option, expecting it to go up in value. You can buy options contracts by simply choosing exactly what you wish to buy and how many, and then placing a buy to open order with a broker. This order was named as such because you are opening a position through buying options.
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If your options do go up in value, then you can either sell them or exercise your option depending on what suits you best. We provide more information on selling and exercising options later.
One of the big advantages of options contracts is that you can buy them in situations when you expect the underlying asset to go up in value and also in situations when you expect the underlying asset to go down.
If you were expecting an underlying asset to go up in value, then you would buy call options, which gives you the right to buy the underlying asset at a fixed price. If you were expecting an underlying asset to go down in value, then you would buy put options, which gives you the right to sell the underlying asset at a fixed price. This is just one example of the flexibility on these contracts; there are several more.
If you have previously opened a short position on options contracts by writing them, then you can also buy those contracts back to close that position. To close a position by buying contracts you would place a buy to close order with your broker.
Selling & Writing Options
There are basically two ways in which you can sell options contracts. First, if you have previously bought contracts and wish to realize your profits, or cut your losses, then you would sell them by placing a sell to close order. The order is named as such because you are closing your position by selling options contracts.
You would usually use that order if the options you owned had gone up in value and you wanted to take your profits at that point, or if the options you owned had fallen in value and you wanted to exit your position before incurring any other losses.
The other way you can sell options is by opening a short position and short selling them. This is also known as writing options, because the process actually involves you writing new contracts to be sold in the market. When you do this you are taking on the obligation in the contract i.e. if the holder chooses to exercise their option then you would have to sell them the underlying security at the strike price (if a call option) or buy the underlying security from them at the strike price (if a put option).
Writing options is done by using the sell to open order, and you would receive a payment at the time of placing such an order. This is generally riskier than trading through buying and then selling, but there are profits to be made if you know what you are doing. You would usually place such an order if you believed the relevant underlying security would not move in such a way that the holder would be able to exercise their option for a profit.
For example, if you believed that a particular stock was going to either remain static or fall in value, then you could choose to write and sell call options based on that stock. You would be liable to potential losses if the stock did go up in value, but if it failed to do so by the time the options expired you would keep the payment you received for writing them.
Options traders tend to make their profits through the buying, selling, and writing of options rather than ever actually exercising them. However, depending on the strategies you are using and the reasons you have bought certain contracts, there may be occasions when you choose to exercise your options to buy or sell the underlying security.
The simple fact that you can potentially make money out of exercising as well as buying and selling them further serves to illustrate just how much flexibility and versatility this form of trading offers.
What really makes trading options such an interesting way to invest is the ability to create options spreads. You can certainly make money trading by buying options and then selling them if you make a profit, but it’s the spreads that are the seriously powerful tools in trading. A spread is quite simply when you enter a position on two or more options contracts based on the same underlying security; for example, buying options on a specific stock and also writing contracts on the same stock.
There are many different types of spreads that you can create, and they can be used for many different reasons. Most commonly, they are used to either limit the risk involved with taking a position or reducing the financial outlay required with taking a position. Most options trading strategies involve the use of spreads. Some strategies can be very complicated, but there are also a number of fairly basic strategies that are easy to understand.
You can read more about all the different types of spreads here.
Benefits of Trading Options
There are actually a number of benefits this form of trading offers, plus the versatility that we have referred to above. It’s continuing to grow in popularity, not just with professional traders but also with more casual traders as well. To find out just what it is that makes it so appealing, please read the next page in this section вЂ“ Why Trade Options?
10 Options Strategies To Know
Traders often jump into trading options with little understanding of options strategies. There are many strategies available that limit risk and maximize return. With a little effort, traders can learn how to take advantage of the flexibility and power options offer. With this in mind, we’ve put together this primer, which should shorten the learning curve and point you in the right direction.
4 Options Strategies To Know
1. Covered Call
With calls, one strategy is simply to buy a naked call option. You can also structure a basic covered call or buy-write. This is a very popular strategy because it generates income and reduces some risk of being long stock alone. The trade-off is that you must be willing to sell your shares at a set price: the short strike price. To execute the strategy, you purchase the underlying stock as you normally would, and simultaneously write (or sell) a call option on those same shares.
In this example we are using a call option on a stock, which represents 100 shares of stock per call option. For every 100 shares of stock you buy, you simultaneously sell 1 call option against it. It is referred to as a covered call because in the event that a stock rockets higher in price, your short call is covered by the long stock position. Investors might use this strategy when they have a short-term position in the stock and a neutral opinion on its direction. They might be looking to generate income (through the sale of the call premium), or protect against a potential decline in the underlying stock’s value.
In the P&L graph above, notice how as the stock price increases, the negative P&L from the call is offset by the long shares position. Because you receive premium from selling the call, as the stock moves through the strike price to the upside, the premium you received allows you to effectively sell your stock at a higher level than the strike price (strike + premium received). The covered call’s P&L graph looks a lot like a short naked put’s P&L graph.
2. Married Put
In a married put strategy, an investor purchases an asset (in this example, shares of stock), and simultaneously purchases put options for an equivalent number of shares. The holder of a put option has the right to sell stock at the strike price. Each contract is worth 100 shares. The reason an investor would use this strategy is simply to protect their downside risk when holding a stock. This strategy functions just like an insurance policy, and establishes a price floor should the stock’s price fall sharply.
An example of a married put would be if an investor buys 100 shares of stock and buys one put option simultaneously. This strategy is appealing because an investor is protected to the downside should a negative event occur. At the same time, the investor would participate in all of the upside if the stock gains in value. The only downside to this strategy occurs if the stock does not fall, in which case the investor loses the premium paid for the put option.
In the P&L graph above, the dashed line is the long stock position. With the long put and long stock positions combined, you can see that as the stock price falls the losses are limited. Yet, the stock participates in upside above the premium spent on the put. The married put’s P&L graph looks similar to a long call’s P&L graph.
What’s a Married Put?
3. Bull Call Spread
In a bull call spread strategy, an investor will simultaneously buy calls at a specific strike price and sell the same number of calls at a higher strike price. Both call options will have the same expiration and underlying asset. This type of vertical spread strategy is often used when an investor is bullish on the underlying and expects a moderate rise in the price of the asset. The investor limits his/her upside on the trade, but reduces the net premium spent compared to buying a naked call option outright.
In the P&L graph above, you can see that this is a bullish strategy, so the trader needs the stock to increase in price in order to make a profit on the trade. The trade-off when putting on a bull call spread is that your upside is limited, while your premium spent is reduced. If outright calls are expensive, one way to offset the higher premium is by selling higher strike calls against them. This is how a bull call spread is constructed.
How To Manage A Bull Call Spread
4. Bear Put Spread
The bear put spread strategy is another form of vertical spread. In this strategy, the investor will simultaneously purchase put options at a specific strike price and sell the same number of puts at a lower strike price. Both options would be for the same underlying asset and have the same expiration date. This strategy is used when the trader is bearish and expects the underlying asset’s price to decline. It offers both limited losses and limited gains.
In the P&L graph above, you can see that this is a bearish strategy, so you need the stock to fall in order to profit. The trade-off when employing a bear put spread is that your upside is limited, but your premium spent is reduced. If outright puts are expensive, one way to offset the high premium is by selling lower strike puts against them. This is how a bear put spread is constructed.
5. Protective Collar
A protective collar strategy is performed by purchasing an out-of-the-money put option and simultaneously writing an out-of-the-money call option for the same underlying asset and expiration. This strategy is often used by investors after a long position in a stock has experienced substantial gains. This options combination allows investors to have downside protection (long puts to lock in profits), while having the trade-off of potentially being obligated to sell shares at a higher price (selling higher = more profit than at current stock levels).
A simple example would be if an investor is long 100 shares of IBM at $50 and IBM has risen to $100 as of January 1 st . The investor could construct a protective collar by selling one IBM March 15 th 105 call and simultaneously buying one IBM March 95 put. The trader is protected below $95 until March 15 th , with the trade-off of potentially having the obligation to sell his/her shares at $105.
In the P&L graph above, you can see that the protective collar is a mix of a covered call and a long put. This is a neutral trade set-up, meaning that you are protected in the event of falling stock, but with the trade-off of having the potential obligation to sell your long stock at the short call strike. Again, though, the investor should be happy to do so, as they have already experienced gains in the underlying shares.
What is a Protective Collar?
6. Long Straddle
A long straddle options strategy is when an investor simultaneously purchases a call and put option on the same underlying asset, with the same strike price and expiration date. An investor will often use this strategy when he or she believes the price of the underlying asset will move significantly out of a range, but is unsure of which direction the move will take. This strategy allows the investor to have the opportunity for theoretically unlimited gains, while the maximum loss is limited only to the cost of both options contracts combined.
In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a large move in one direction or the other. The investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.
What’s a Long Straddle?
7. Long Strangle
In a long strangle options strategy, the investor purchases an out-of-the-money call option and an out-of-the-money put option simultaneously on the same underlying asset and expiration date. An investor who uses this strategy believes the underlying asset’s price will experience a very large movement, but is unsure of which direction the move will take.
This could, for example, be a wager on an earnings release for a company or an FDA event for a health care stock. Losses are limited to the costs (or premium spent) for both options. Strangles will almost always be less expensive than straddles because the options purchased are out of the money.
In the P&L graph above, notice how there are two breakeven points. This strategy becomes profitable when the stock makes a very large move in one direction or the other. Again, the investor doesn’t care which direction the stock moves, only that it is a greater move than the total premium the investor paid for the structure.
8. Long Call Butterfly Spread
All of the strategies up to this point have required a combination of two different positions or contracts. In a long butterfly spread using call options, an investor will combine both a bull spread strategy and a bear spread strategy, and use three different strike prices. All options are for the same underlying asset and expiration date.
For example, a long butterfly spread can be constructed by purchasing one in-the-money call option at a lower strike price, while selling two at-the-money call options, and buying one out-of-the-money call option. A balanced butterfly spread will have the same wing widths. This example is called a “call fly” and results in a net debit. An investor would enter into a long butterfly call spread when they think the stock will not move much by expiration.
In the P&L graph above, notice how the maximum gain is made when the stock remains unchanged up until expiration (right at the ATM strike). The further away the stock moves from the ATM strikes, the greater the negative change in P&L. Maximum loss occurs when the stock settles at the lower strike or below, or if the stock settles at or above the higher strike call. This strategy has both limited upside and limited downside.
9. Iron Condor
An even more interesting strategy is the iron condor. In this strategy, the investor simultaneously holds a bull put spread and a bear call spread. The iron condor is constructed by selling one out-of-the-money put and buying one out-of-the-money put of a lower strike (bull put spread), and selling one out-of-the-money call and buying one out-of-the-money call of a higher strike (bear call spread). All options have the same expiration date and are on the same underlying asset. Typically, the put and call sides have the same spread width. This trading strategy earns a net premium on the structure and is designed to take advantage of a stock experiencing low volatility. Many traders like this trade for its perceived high probability of earning a small amount of premium.
In the P&L graph above, notice how the maximum gain is made when the stock remains in a relatively wide trading range, which would result in the investor earning the total net credit received when constructing the trade. The further away the stock moves through the short strikes (lower for the put, higher for the call), the greater the loss up to the maximum loss. Maximum loss is usually significantly higher than the maximum gain, which intuitively makes sense given that there is a higher probability of the structure finishing with a small gain.
10. Iron Butterfly
The final options strategy we will demonstrate is the iron butterfly. In this strategy, an investor will sell an at-the-money put and buy an out-of-the-money put, while also selling an at-the-money call and buying an out-of-the-money call. All options have the same expiration date and are on the same underlying asset. Although similar to a butterfly spread, this strategy differs because it uses both calls and puts, as opposed to one or the other.
This strategy essentially combines selling an at-the-money straddle and buying protective “wings.” You can also think of the construction as two spreads. It is common to have the same width for both spreads. The long out-of-the-money call protects against unlimited downside. The long out-of-the-money put protects against downside from the short put strike to zero. Profit and loss are both limited within a specific range, depending on the strike prices of the options used. Investors like this strategy for the income it generates and the higher probability of a small gain with a non-volatile stock.
In the P&L graph above, notice how the maximum gain is made when the stock remains at the at-the-money strikes of the call and put sold. The maximum gain is the total net premium received. Maximum loss occurs when the stock moves above the long call strike or below the long put strike. (For related reading, see “Best Online Stock Brokers for Options Trading 2020”)
What Are the Best Options to Trade?
Watch our video on how to find the best options to trade.
What Are the Best Options to Trade?
- Here are some of the best options strategies to trade:
- Naked options are best for reward but carry the highest risk.
- Selling options have a higher win rate than buying them.
- Debit spreads are directional trades but help offset some of the risk of naked ones.
- Credit spreads have less reward but best chance of having a winning trade.
- Iron condors are really good for range bound charts.
- Iron butterflies are good for tighter range bound markets.
- Straddles are great for big moves in either direction.
- Strangles are good for big moves in one direction.
- Calendar spreads makes time decay your friend.
Finding the best options to trade can be one of the most challenging aspects of options trading. There are so many stock to chose from. So how do you filter that down to the best setups? You only need a handful of options with best trading potential.
1. Right But Not Obligation
An option gives you the right but not the obligation to buy or sell a stock at a predetermined price. Options can make you money in any market. It’s easy to find options because you can trade options on pretty much anything.
When you’re looking for the best options to trade there are two important factors to consider. What is the implied volatility of the stock? And what direction do you think it’s going? When you look at implied volatility that gives you a hint about future volatility.
The more volatile the stock, the more it moves. The more it moves, the more money you make. The opposite is true also. If you don’t buy in the right direction, you can lose a lot also. What objective do you want to achieve with this trade? Are you bullish or bearish bias?
If you’re interested in learning more about the different ways you can play options, read our trading options for a living and our day trading options for income posts.
Options allow you the ability to trade in any market. You can trade when the market is up, down or trading sideways.
2. Moving Averages
When you’re looking for the best options to trade, a tool you can use are moving averages. Moving averages smooth out price action and filter out the noise of random price fluctuations. There are simple moving averages and exponential moving averages.
You can use these moving averages as support and resistance. They can tell you when to get in and out of a stock. The simple moving average is a great indicator if you’re going to swing trade options.
Simple moving averages identify trends. If you want to know when a long term trend is in effect or about to go into affect, SMAs confirm those moves.
Exponential moving averages are great when you’re day trading. The 9 and 20 EMAs will help you get a good entry and exit. VWAP is another great indicator you can use.
3. Calls and Puts
The moving averages help you determine the trend now you can determine if calls or puts are the best options to trade. If you’re bullish calls are what you’ll be trading. If you’re bearish then it’s puts.
When you’re bearish you can buy puts or sell puts. Selling a put is like shorting. You sell the put and cover at the cheaper price. Not every broker has shares you can short but they’ll have puts you can buy and sell.
So if you don’t have a platform like Interactive Brokers where you can short, you’re not stuck missing out on those moves. Put options are considered the easiest options to trade.
Are you looking to learn stock trading? Take our free stock training tutorials for more training.
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How Much Money Do You Need to Trade Options?
- How much money do you need to trade options? There isn’t a set amount but having $10,000 or more would be a really good start. $5,000 would also be okay. The more capital you have the more money you can make per trade though.
1. Large Cap Stocks vs Small Cap Stocks
Some of the best options to trade are the large stocks like Amazon, Google and Alibaba. Stocks like these tend to move quite a bit throughout the day.
One stock options contract controls 100 shares of stock. So you can trade the high priced stocks without putting up as much capital. While you can profit quite a bit with those moves, it can backfire on you also.
If you misjudge the trend of the day or get a bad entry, it can cost you. Especially with a stock that moves dollars a day. Options contracts also have expiration dates. If you get a bad entry but give yourself enough time, there’s a chance you can recover.
Small cap stocks may not have the same volatility as the more expensive stocks, but they’re great for swing trading. You can buy more and hold longer, allowing your profit target to materialize (receive our stock picks free for 14 days).
2. Watch Lists Show Best Options to Trade
Some times finding the best options to trade can be overwhelming. Playing the same stocks over and over can hamper you from taking advantage of other great plays.
The Bullish Bears send out a swing watch list with trade alerts every night to our paying members. Each one of those tickers has options plays.
Summary on Finding the Best Options to Trade
The best options to trade can be found no matter what type of trader you are. The flexibility of options to day trade, swing trade or long term trade can make any trader profitable.
Taking advantage of the tools and resources available to you will further your endeavors in the best way possible.
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