Options Trading For Beginners Ultimate Guide [2022]

Options trading can seem complex, risky, and more suited for sophisticated investors. The truth is that anyone can learn options trading if they take the necessary time to educate and apply themselves. Options are derivatives, and when used effectively, they can provide investors significant advantages over trading stocks, mutual funds, ETF’s, and other well-known asset classes.

Stock Options Explained

A stock option is a time-sensitive contract that gives an investor the right, but not the obligation, to buy or sell a security at a specified price (strike price) and date (expiration date). Options contracts are considered derivatives. This means that the options contract value is “derived” or linked to the underlying security or asset. When it comes to stock options, the underlying asset is the company’s stock.

Options can be a great investment vehicle to help investors and traders enhance their returns as well as hedge their risk. They do this by providing investors with leverage, alternative income, and acting as insurance against volatility. Depending on your investment strategy, goals, and scenario, there are countless options strategies that can help you.

A popular use of options contracts for investors is to use them as downside protection in case of a stock dropping in price. Other investors chose to use them as an alternative method to generate additional recurring income from their underlying stock position. And another uses case, popular with day traders, is to use options to speculate on the movement of a stock.

Components of a Stock Options Contract

A single options contract represents 100 shares of stock. If you purchase one option you essentially have control over 100 shares of the underlying stock.

The amount you have to pay in order to purchase an options contract is referred to as the “premium”. This amount fluctuates as the price of the stock moves and as the expiration date of the contract approaches.

A stock options contract consists of a few different parts. It’s important to understand how these work in relation to the price of the stock and the pricing of the options contract. Let’s take a look at each one.

The Strike Price

In stock options trading, the options strike price is the price at which a stock can be bought or sold. The strike price is a key factor of the value of the option and its value depends on the underlying stock. For call options, the strike price is where the stock can be bought by the holder of the option contract. For put options, the strike price is the price where the stock can be sold.

Options Premium

The options premium is the current price associated with an options contract. The options premium consists of extrinsic value, intrinsic value, and time value. The premium is quoted as a dollar amount per share and a single options contract represents 100 shares. The premium of an options contract is greater given the more time to expiration.

Expiration Date

The expiration date for stock options is the date on which an options contract expires. It is the last day that you can trade an options contract. Once an options contract passes through the expiration date the options contract is considered invalid. Stocks that are highly liquid tend to have weekly options expiration dates.

Current Bid Price

The current bid price in options is the price at which you can SELL your options contract.

Current Ask Price

The current ask price in options is the price at which you can BUY your options contract.

What Are Call Options?

A call option gives a BUYER the right, but not the obligation to BUY a stock at a specific price (strike price) within a specific time period (expiration date). When you buy a call option you are betting on the price of the stock going up.

It’s worth noting that when you buy a call option you will be paying a “premium” amount. Whenever you pay for a call option there will be a “net debit” associated with the trade. When you sell a call option you will receive a premium. This means that you will receive a “net credit” as a result of selling the call option.

Buying a Call = Betting on the Stock Price Going Up
Selling a Call = Betting on the Stock Price Going Down

Buying a call option is done when an investor is “bullish” on the price of a stock and believes it will go up by the end of the expiration. Alternatively, when a call option is sold investors are “bearish” on the price of a stock.

Call Option Example

One way to think of call options is like a down payment to purchase something in the future. The traditional example to make sense of call options is purchasing a new home. Below are the basic components associated with a new home purchase transaction:

Purchase price of the home
Down payment on the home – (some percentage of the home)
Purchase contract outlining the terms

If you’re a potential homeowner and notice a new housing development go up you might be interested in purchasing a home in the future. However, you only want to exercise that right after the development is fully built-in that area. A potential homebuyer would benefit from having the option to purchase the home, but not the obligation.

A developer can sell you the right to own a $500,000 house in the next two years if you put down a non-refundable deposit. This non-refundable deposit is considered the “premium” you pay in exchange for the right to own a house in the next two years, but not the obligation. With regards to options, this is the price of the contract. In this example, the deposit might be $25,000 that the buyer has to pay the developer.

Let’s assume that in the next year and a half, the development in that area has been fully built and you decide that you want to exercise your right to purchase the home. As a result, you end up purchasing the home at the agreed-upon price of $500,000.

However, within that year and a half of the houses being built, the market value of that home has increased to $700,000. Since your down payment is locked in a predetermined purchase price, you only pay $500,000 for the house while the market value is $700,000.

Alternatively, if you chose not to exercise your right to purchase the home after the two years are up, you end up losing your deposit of $25,000. The developer will end up keeping your $25,000 deposit for giving you the option to purchase the home.

What are Put Options?

A put option gives a BUYER the right, but not the obligation to SELL a stock at a specific price within a specific time period. When you buy a put option you are betting on the price of the stock going down.

Put options are essentially the opposite of call options.

Buying a Put = Betting on the Stock Price Going Down
Selling a Put = Betting on the Stock Price Going Up
Buying a put option is done when you are “bearish” on the price of the stock and you believe it will go down by the end of the expiration date. Alternatively, when a put option is sold investors are “bullish” on the price of the stock.

Put Option Example

A good way to think about put options is like insurance. Insurance is typically purchased to protect against unexpected or catastrophic loss. If you own a house, you have to have home insurance to protect your home from unexpected damage.

When you purchase a home insurance policy you have to pay a “premium” in exchange for the protection that the insurance policy provides. The insurance policy will outline the replacement value or face value of the house in the event the house experiences damage.

The same scenario applies when trading put options on stocks. Imagine you own 100 shares of AAPL stock, but rumor on the street is that they underperformed during the 4th quarter and their earnings release is expected to be below analyst expectations.

In light of this, you want to protect your AAPL position so you decide to purchase a put option. Apple is currently trading at $165 per share and its earnings are to be released at the end of the month. You purchase a put option which gives you the right to sell AAPL stock at $165 by the end of this month. In exchange for this put option, you pay $3.50 in premium.

At the end of the month, Apple releases their earnings and they significantly underperformed during the 4th quarter. As a result, the price of Apple stock drops by $10 in price to $155 per share. As a result of buying the put option as protection against a price decline, you have made $10 per share.

Purchasing the put option does however carry a cost, which in this case would be the $3.50 premium paid for the put option. If the price of Apple stock didn’t end up dropping the max loss on your trade is only limited to the premium paid for the put option.

Why Are Stock Options Used?

There are two primary uses for stock options: hedging and speculation.

HEDGING

The history of options trading dates back to Ancient Greece. The primary function of options contracts back then was to use them as a way to hedge risk. They were also used to speculate, but they were originally designed to hedge risk in specific products and markets.

Hedging with options contracts allows options buyers to hedge their risk in exchange for paying a premium. Just like you can purchase home insurance, you can purchase options contracts to hedge against the risk of a downturn in the market.

Let’s assume that you want to purchase shares in semiconductor stocks, but you want to “hedge” against a downturn in semiconductor stocks. Hedging will allow you to limit your downside risk while still allowing you to retain your upside profit potential in exchange for paying a premium. By purchasing put options, you protect your downside risk while being able to experience upside gain.

SPECULATION

The other primary reason why stock options are used is to speculate. Speculating is simply betting on the future price of a stock with options contracts. Someone who is bullish on the price of a stock can purchase underlying shares or purchase call options. A speculator who is bearish on the price of a stock can purchase put options. Speculating with options contracts is very attractive for traders because options provide them with leverage. They can speculate with a small amount and if they are right their payoff can be much larger than buying shares in the stock.

Different Types Of Options

What Is An Options Chain

LONG TERM VS. SHORT TERM OPTIONS

When it comes to trading options you can trade short-term options or longer-term options known as LEAPS.

LEAP OPTIONS

LEAPS stands for long-term equity anticipation securities and are options contracts that have an expiration date that is longer than one year, and up to three years in expiration. They are identical to other options, apart from their longer-term expiration. If you want to trade LEAP options, you will have to open an account with a broker that supports them.

SHORT TERM OPTIONS

Short-term options are options contracts with shorter expirations. This includes anything from weekly expiration up to 1 year. Expirations over one year are considered longer-term options.

AMERICAN STYLE OPTIONS

American style options have nothing to do with where the options contracts are bought or sold. Instead, the term “American style options” refers to the terms of the options contract. With American-style options, options buyers and sellers have the right to exercise their options contracts any time before the expiration date.

For options traders who want flexibility in managing their options trades more effectively so they can buy them or sell them as they please, American-style options are the best choice.

EUROPEAN STYLE OPTIONS

European style options on the other hand don’t offer the same flexibility as American style options. If you have purchased a European-style options contract, you can’t exercise it before the expiration date. With European options contracts, you can only exercise them on the expiration date. As an options trader, this may significantly impact the way you manage your options positions.

OPTIONS ON FUTURES CONTRACTS

Apart from trading options on individual stocks and indexes, you can trade options on futures products. Options on futures in a similar fashion to stock options but are different in the fact that the underlying derivative is a futures contract. Most options contracts on futures tend to be European style, which means that you can’t exercise them early, you have to hold them until the expiration date.

OPTIONS CHAIN EXPLAINED

WHAT IS AN OPTIONS CHAIN?

An options chain is a list of the put and call options contracts that are available for trading on a particular stock. The options chain will display the puts, calls, expiration dates, strike prices, option premium, options volume, and options open interest.

Before you begin trading options, it’s highly recommended that you first learn how to read an options chain. An options chain will also display important statistical information related to the options contracts known as the “Greeks”.

Below is what a standard options chain looks like. On the left-hand side, you will notice the call options and on the right-hand side, you will notice the put options.

OPTIONS CHAIN EXAMPLE

READING A STOCK OPTIONS CHAIN

To understand how options pricing works, it’s important to have a solid understanding of the three core elements of an options premium. An options premium consists of intrinsic value, extrinsic value and time value.

1.) The bid and the ask column represent the current pricing of the stock options premium. The difference between the bid and ask price is the premium spread.

2.) Volume represents the amount of options contracts that have been traded for a particular strike price.

3.) The gamma, delta, vega, and theta are the four major options Greeks.

4.) The different dates shown represent the different options expiration dates upcoming for AMD.

5.) Open interest represents the total number of options contracts that have been traded but not yet liquidated by assignment or exercise.

6.) The strike column represents the different options strike prices available for trading.

All of the metrics shown on an options chain change every single day as the price of the stock fluctuates. It’s important to get comfortable with reading an options chain so you can understand the relationship between a stock’s price and its options market.

MONEYNESS OF AN OPTION

To get proficient with reading an options chain it’s important to understand three key expressions when it comes to options pricing.

These are in-the-money (ITM), out-of-the-money (OTM), and at-the-money (ATM).

“In-The-Money” (ITM) is an expression which means that the options contract has intrinsic value. A call options contract that is in-the-money means that the underlying stock can be purchase below its current market price. On the other hand, a put options contract that is in-the-money means that the underlying stock can be sold above its current market price.

“Out-of-the-Money” (OTM) is a term that is used to describe an option that has zero intrinsic value and only has extrinsic value. A call option that is OTM will have a strike price that is higher than the current market price of the stock. A put opion that is OTM will have a strike price that is lower than the current market price of the stock.

“At-The-Money” (ATM) means that an options strike price is equivalent to the current market price of the underlying stock. For example, if the current price of AMD stock ist $115 per share, ATM strike price ist at $115. Call options and put options can both be ATM at the same time.

ITM

IN-THE-MONEY

Has Intrinsic Value

ITM options have higher premiums

OTM

OUT-THE-MONEY

Has Zero Intrinsic Value

OTM options have lower premiums + only extrinsic value

ATM

AT-THE-MONEY

Strike Price = Stock Price

No Intrinsic Value, have extrinsic value and time value

UNDERSTANDING AN OPTIONS PREMIUM

To get proficient with reading an options chain it’s important to understand three key expressions when it comes to options pricing. An options premium consists of intrinsic value, extrinsic value and time value.

INTRINSIC VALUE:

The intrinsic value of an option is the current value of the options contract, or how much it’s worth. When an option is said to be “in-the-money” it means that there is a net gain for the option holder. For example, A $50 call option on a stock that is currently priced at $60 per share would be considered $10 in-the-money. If this holds at expiration the option holder would have $10 in intrinsic value.

ITM CALL OPTIONS: Intrinsic value = Current Stock Price- Strike Price of the Option

ITM PUT OPTIONS: Intrinsic value = Strike Price – Current Stock Price

An out-of-the-money option (OTM) will have zero intrinsic value. This is because an options holder would not exercise an options contract that would result in a net loss. As a result, an options holder would just let the option expire worthless since there is no payoff for them.

TIME VALUE

The second component of an option’s premium is the time value. It’s important to understand that an in-the-money option that is not yet expired has both time value and intrinsic value. The time value of an option represents the additional amount a buyer is willing to pay over the intrinsic value.

An in-the-money option loses time value the closer it gets to expiration. An option that is further away from its expiration date, will have a higher time value. This is because there is more “time” for the value of the option to increase or decrease until the expiration date. As the option gets closers and closer to the expiration date, it will lose more and more time value.

The time value of an options contract is calculated by taking the difference between the option’s premium and its intrinsic value.

Time Value = Current Options Premium – Intrinsic Value

Options Premium = Intrinsic Value + Time Value

As you remember from our options chain example, you will see the bid and the ask column. These represent the cost of our premium. As you just learned, that premium amount is made up of time value and intrinsic value.

For example, let’s assume that we have a $117 call option on AMD which has a premium amount of $4.85. AMD is currently trading at $119.50 per share, so in this case, our intrinsic value is $2.50 ($119.50 – $117). This means that our time value portion is worth $2.35 ($4.85 – $2.50).

When we add these two amounts up they come out to $4.85 which is our premium amount. Understanding how much of the total premium is intrinsic value and how much is time value will give you a better understanding of how options are priced.

EXTRINSIC VALUE

Lastly, we have the extrinsic value of an option. The extrinsic value of an option is the difference between the current price of an option (premium) and its intrinsic value. The extrinsic value of an option expands as volatility increases in the underlying security.

For example, if a call option has a strike price of $100, and the current stock price is trading at $105, that option has $5 of intrinsic value. The actual option premium may cost $5.75. The extra $0.75 represents the extrinsic value of the option.

Out-of-the-money call options and out-of-the-money put options premium amount consist only of extrinsic value.

Understanding how intrinsic value, time value, and extrinsic value impact the options premium is instrumental in learning how options are priced.

THE GREEKS

THE GREEKS EXPLAINED

The price of an options contract can be very complicated to understand. The Greeks are a set of statistical risk measures that help illustrate the pricing characteristics of particular options contracts. They give options traders a deeper understanding of the price sensitivity associated with options. The Greeks can shed light on some of the following factors associated with an options price:

1.) Changes in implied volatility

2.) Theta-decay sensitivity

3.) Rate of change in an options price

4.) The expected stock move by expiration

Making sense of the Greeks can take a bit of time for people new to options. However, the Greeks are incredibly useful in helping traders make sense of the pricing mechanism associated with options contracts.

The four major Greeks include delta, gamma, vega, and theta. Rho is considered one of the miner Greeks and is less used by options traders, but it is worthwhile to mention. –

DELTA

Delta measures the rate of change in an option’s price relative to a $1 change in the price of the underlying stock. The value of delta in an options chain can be positive or negative depending on the type of option you are looking to trade.

Delta is extremely important to understand because it can help you visualize the directional price volatility associated with a stock option. It is very useful in helping you understand how the price of an option’s premium will change as the price of the underlying stock begins to move.

Delta of Call Options

The delta of call options will always range from 0 to 1. This is because as the price of the underlying stock goes up in price, the call option also increases in price.

Delta of Put Options

The delta of put options will always range from -1 to 0. This is because as the underlying stock price goes up in price, the value or “premium” of the put option decreases.

Delta Example

Let’s assume we were looking to buy a $150 June 30 call option on AMD that costs us $4.50 with a delta of +0.45. This means that if the price of AMD goes up to $155 the price of our options contract will go up to $6.75. A $5 gain in the price of the stock means that our options contract will increase by $2.25 ($0.45 X 5). This represents a 50% increase in our options position.

GAMMA

Gamma measures the rate of change of an option’s delta for a single $1 move in the underlying stock price. An easy way to think of gamma is like deltas’ older brother who babysits them. Gamma is used to understand the price movement of an option relative to how far “in-the-money” or “out-of-the-money” it is.

Below is a graph that will help you conceptualize gamma and its related values.

Gamma values range from -1 to 1.

The gamma of long positions is a positive value and a negative value for short positions. At-the-money options contracts will have the highest gamma because delta is most sensitive for at-the-money options.

A higher gamma value indicates that the delta could change significantly with a very small move in stock price. Or plainly put, a higher gamma means that the options price is very sensitive to small changes in the price of the underlying stock.

A lower gamma value indicates that the options delta will not change much with a change in the price of the stock. This means that the options price is not very sensitive to changes in the price of the underlying stock.

GAMMA EXAMPLE

Let’s assume a stock is trading at $10 per share and has a delta of +0.50 and a gamma of .10. For every 10% move in the price of the stock, the delta will shift by 10%.

This means that a $1 increase in the price of the stock will cause the delta to move up to +0.60. If the price of the stock were to drop by 10%, the delta will move down to 0.40.

VEGA

Vega measures how sensitive an option is to implied volatility. It represents the change in the options price for a 1% change in implied volatility. The implied volatility is used to price options and the value is reflected in the option’s premium.

If there is an anticipation that the price of the stock is going to rise, implied volatility will increase and the price of the option will also increase.

Vega measures how much the options premium will change if the implied volatility moves up or down by 1%. Vega values are positive from 0 to 1 for long options positions and negative from 0 to -1 for short options positions. Below is a graph that illustrates the mechanics of vega.

As you can see, the longer the time to expiration, the bigger impact that volatility has on price. As the option approaches expiration, the value of vega will fall. In addition to this, vega will increase as the stock price gets closer to the target strike price.

As you can see from our graph above, like gamma, vega is highest for at-the-money options. Subsequently, the further an option is out-of-the-money or in-the-money the lower the vega value will be.

HOW IS VEGA USED IN OPTIONS TRADING?

If your options strategy is centered around increases or decreases in implied volatility, vega can be a useful measure to help you gauge the sensitivity of an options price to implied volatility.

Since vega changes when there are large moves in the underlying (higher levels of implied volatility) it can help you establish a range of price sensitivity. Vega can help you better manage your portfolio if you know what you can expect when implied volatility levels begin to shift.

THETA

Theta is a measure of how much an option erodes in value every day. It’s a rate of decline in the value of the option due to time decay. The term “theta” is often referred to as “time decay” and it is representative of the nature of options contracts in that they are a function of time.

The value of theta is always expressed as a negative number and can be thought of as the amount you lose every day if you buy options. If you are an options seller, you stand to benefit from theta decay.

If you sell options you want them to expire worthless so you can keep all the premium. As an options seller, theta benefits you because the value of your option slowly goes down as the option approaches expiration.

THETA EXAMPLE

Let’s assume that you purchased a call option on AMD with a strike price of $140 for $8. The option expires in 14 days with a theta of -$0.50. This means that every day the buyer of the option holds the option, they will lose $0.50 if the stock price remains the same.

As the buyer of an option, you are facing directional risk as well as theta risk which is something you need to be aware of before you ever enter a trade.

RHO

Rho is considered the fifth Greek and tends to be used less by options traders. Rho measures an option’s sensitivity to changes in the risk-free rate of interest. It measures the impact on an options price for a 1% change in interest rates. The risk-free rate refers to the interest rate paid on US T-Bills.

If you’re trading options on products or stocks that are dependent on interest rates, Rho can be useful to gauge an option’s sensitivity.

Ask you can see the Greeks can be extremely useful in helping you to further understand the pricing mechanics associated with options.