Options Trading for Beginners: How to Get Started - MagnifyMoney

Options Trading for Beginners: How to Get Started

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Whether a day trader or novice investor, you might feel the itch to learn how to trade options. At first glance, options offer promises of massive returns with a low investment. But if you don’t know what you’re doing, options trading can wreak havoc on your portfolio in the blink of an eye.

Trading options, for beginners, can feel overwhelming. That’s why MagnifyMoney’s here to help you understand the basics so you can trade with confidence.

What are options and how do they work?

An option is the right to buy or sell a security or other asset at an agreed-upon price at a future date. You pay a fee for this right, known as a premium. When the asset trades beyond the agreed-upon price, known as the strike price, you pocket the difference between the asset’s new price and the strike price.

If the stock doesn’t move in the direction you predicted within the contract’s predetermined time frame, you can let the option expire. In that case, you’ll lose — and the seller will earn — the fee paid for the option, but nothing more.

What is options trading?

Options trading is typically used to bet on stock price movements. But options aren’t just for stocks. You can also use options to bet on the price movements of currency, exchange-traded funds (ETFs) and major market indexes such as the S&P 500 and the Dow Jones Industrial Average, also known as the Dow.

Expert tip: Buying an option differs from buying a stock. With options, you’re buying the right to buy or sell on an asset, not buying or selling the asset itself.

The length of options contracts can vary. Most options typically expire each month, but as frequently as each week or as far out as a few years.

Your options contract will spell out all the specifics, including the type of security, strike price and expiration date. Each contract typically represents 100 shares of stock. So if you buy three contracts, for example, your options position tracks the performance of 300 shares of stock, without you needing to buy 300 shares outright.

Call options vs. put options

Options trading beginners need to know about the two basic types of options trades: call and put options.

Call options

A call option lets you buy an asset at a predetermined price by some future date. If the stock trades above that price by the contract expiration date, you keep the difference between the stock’s current price and the option’s strike price.

Your gain potential is boundless, and the maximum you could lose is the premium.

Put options

A put option, on the other hand, lets you sell the asset or stock at a predetermined price within a set period of time. You make money by collecting the premium the buyer pays for the put option contract.

Profit-wise, puts are limited. Your gain potential is capped at the strike price less the contract premium. However, your loss potential is also capped at the contract premium like a call option.

Type of optionMaximum gainMaximum loss
CallUnlimitedThe premium
PutStrike price minus premiumThe premium

Case study: Call options in action

Let’s say you feel confident that a publicly traded electric carmaker will outperform expectations. Instead of buying the car manufacturer’s stock, you can buy a call option with a strike price well above the manufacturer’s current share price.

Maybe the stock price today is $50 per share, and you buy a one-month call option to buy 100 shares at a $60 strike price. If the stock’s price climbs to $70 one month from now, you have the right to purchase 100 shares at $60. You would exercise your option, buy the 100 shares at $60, then immediately sell those 100 shares at $70. You’ll pocket the $1,000 difference, less the premium you paid.

Generally speaking, the further a stock’s strike price is from its current price, the lower the call option premium.

Case study: Put options in action

Let’s say you own 100 shares of stock in that electric carmaker, and it’s currently trading at $100 per share. You expect the stock to appreciate over the long term, but the short term looks to be a bumpy ride.

To limit your losses and lock in the stock’s current price, you could buy a six-month put option with a $100 strike price at a premium of, say, $5. If the stock’s price falls to $80 within those six months, you can exercise your option and sell your 100 shares at $100 per share.

Without the option, your 100 shares would have lost $2,000 in value ($10,000-$8,000). With the put option, however, you spent $500 (100 shares x $5 premium per share) to save $1,500 ($20 price difference x 100 shares = $2,000, less the $500 premium).

Options strategies

Beyond calls and puts, you can use other strategies when trading options.

Long call (buy)

You buy the right to purchase a stock at a future date because you believe the stock’s price will increase.

Covered call (sell)

You sell call options when you expect the stock price to remain flattish or go up only a bit. If you are correct and the buyer doesn’t execute the option, the option expires. You pocket the premium the buyer paid.

Long put (buy)

You buy the right to sell a stock at a set price by a specific date. You typically buy puts when you expect the asset’s price to go down below the strike price.

Short put (sell)

Also known as a naked or uncovered put, you sell a put when you think an asset’s price will remain above the strike price. You earn money by pocketing the buyer’s premium if they don’t exercise their option. If the asset’s price drops below the strike price and the buyer exercises their option, you stand to lose considerably. Tread lightly.

To learn more about these strategies, including when to try them, read our deeper dive into popular options trading strategies.

How to options trade in 6 steps

1. Open an account for trading options

Since trading options is riskier and more complicated than trading stocks, not everyone can give it a go. When you open a brokerage account, you’ll have to apply for brokerage permission to trade options. The firm may ask for information such as your annual income, trading experience, net worth and liquid net worth and investment objectives.

Brokerage firms that allow options trading include E*TRADE and Fidelity. Other popular options trading platforms include TradeStation, TD Ameritrade, Interactive Brokers and Charles Schwab. You can also review our best online brokers roundup for firms that let customers trade options and their per-contract fees.

2. Determine your trading objective

Before looking for specific trades, take a moment to identify your trading goals. You’ll choose a trading strategy based on your goals and available cash.

Three common objectives include: hedging your existing bets, speculating on future stock price movements and generating income.

3. Choose your assets to option

Unsure where to start? You could start with stocks on which you feel particularly bullish or bearish. Remember that the largest and most liquid stocks typically have the most buyers and sellers. Smaller stocks may have limited or no options activity.

As you’re choosing assets to option, don‘t forget to factor in the time frame. If you find an asset you expect to move but can’t pinpoint a time frame, consider writing a contract on an asset where you have a more defined timeframe.

4. Choose your option strike price

Your bearish and bullish feelings can help you decide where to set your strike price. The more time you allow an asset to reach the strike price, the higher premium you’ll likely pay.

When setting your strike price, you’ll typically choose a price in standardized increments, such as $2.50, $5 or $10.

5. Choose your option style

Options have three styles: American, European and Bermudan.

These designations have nothing to do with geography. Instead, they specify when you can exercise the option. You can exercise American options any day between the purchase and expiration dates. On the other hand, you can only exercise European-style options on the final date of their expiration period. A Bermudan option is an American option hybrid that specifies exact dates on which the option can be exercised.

American options are most common but expect to pay more in fees for their flexibility.

6. Place your options trade

If trading through an online brokerage, you can trade options during regular market hours. Simply go to your online order interface at your broker and follow the steps to write (buy) or sell an option.

7. Monitor your position

Remember that trading options isn’t a passive buy-and-hold strategy. You’ll need to track your investment to take action should the asset hit its strike price. Set alerts for your various positions so you don’t miss big news and events.

Also, remember that closing out an option position is considered an event subject to capital gains taxes.

Pros and cons of trading options

  • Allows you to speculate on asset prices without buying the asset
  • Can be used as a tool to hedge risk
  • Can generate income by collecting premium fees
  • Unlimited downside in certain situations, such as when selling an uncovered call option
  • Retail investors must compete with sophisticated professionals with deep resources and investing knowledge.
  • Expiration dates force investors to time the market to generate profits successfully.

Before you jump in, understand that trading options can produce bigger returns — and losses — than buying and selling stocks. Thus, new options traders should dip their toes into this water only if they clearly understand the ins, outs and risks of the myriad options available.

Frequently asked questions

An option is the right to buy or sell a stock or other asset at a set price at a future date. You’ll pay a premium to secure this right and set the price (called the strike price) and expiration date for the option. Investors make money with options when the asset reaches or exceeds the strike price. Your profit will be the difference between the asset’s new price and the strike price you set.

Unlike regular options, binary options don’t grant you the right to buy or sell as security at a pre-determined strike price. Instead, binary options are yes/no propositions where you essentially buy a bet on whether an asset will exceed or fall below a set price. Then, when a binary option expires, you receive either a predetermined cash payout (if you won your “bet”) or nothing at all (if you lost your “bet”).

To trade options on Robinhood, you’ll need to qualify as a Level 2 trader on the platform, which means new traders without much market experience may not qualify. If your account activity qualifies for options, you’ll see “options trading” in your account settings. After enabling options trading, you’ll be asked a series of questions to see if you further qualify.

The “Find a Financial Advisor” links contained in this article will direct you to webpages devoted to MagnifyMoney Advisor (“MMA”). After completing a brief questionnaire, you will be matched with certain financial advisers who participate in MMA’s referral program, which may or may not include the investment advisers discussed.