August 16, 2021

Stock options 101: Tips for trading options

Tips for trading Options

Trading options have been around for a long time and most people trade them without realizing it. Options are a group of financial assets that day traders can add to their day trading portfolios alongside stocks, bonds, ETFs, and MTFs among other instruments. If you make time to understand stock options (what they are and how to trade them), you won’t have trouble navigating the markets like other traders who blindly jumped into trading. Interestingly, trading stock options offer many advantages than meet the eyes.

What are options?

To help you understand what stock options are, it’s always best to learn what options are. In the financial markets, traders can obtain the right to buy or sell an asset at a specific price on or before a stipulated date. Since options derive their value from an underlying asset, stock options refer to contracts that consist of stocks. And the same applies to other assets such as commodities, currencies, or bonds.

Whatever stock options you are able to obtain, you reserve the right to either buy or sell (call or put in stock trading lingua), sell it at the predetermined time before the contract expires and they (speaking about stock options) can be bought like virtually every other asset with a brokerage investment account.

Contrary to popular misconceptions, options are flexible and can be used to enhance your portfolio. How? Depending on what your goal for stock options trading is you can serve as an avenue of making added income or leverage. Here is an example to help drive our point home. Whenever the stock market is declining, stock options can be used to hedge against the dip to limit the amount of loss one would have incurred from the downside move. In simple terms, stick options are effective for limiting downside losses. You should always keep this information at heart because such insights are rare to come by stock option 101.

In addition to been used to hedge the market, stock options can also be used to generate income. And last but not least, stock options can be used to speculate market conditions they can be used to wager on the direction of a stock. Like every other financial asset including stocks and bonds, trading stock options has its risks and one must take note of them before kick-starting their day trading career. That way, you would have been equipped with the knowledge required to keep your loss low and build a robust and profitable stock portfolio.

What are options derivatives?

Taking our lessons on stock option 101 further; earlier we mentioned that options belong to a class of financial assets and it’s mostly influenced by the value or price of an underlying asset. That “larger group” of assets or securities is known as derivatives. As such, the derivative’s price is mostly influenced or dependent on the price of an underlying asset which explains why options are regarded as derivatives of financial securities.
Examples of derivatives include but are not limited to futures, mortgage-backed securities, puts, swaps, and forwards. You should make time to get the necessary education needed to trade stocks options to boost your chances of success as a stock options day trader. Thankfully, the day trading chat room offers exceptional stock options 101 training and mentorship programs to get you started on your trading journey on the right foot.

What are call and put options?

Recall that trading stock options give an investor the right and not the obligation to buy and sell specific stocks at a predetermined price (on or before a predetermined date) and the price of the stock influence the price of the derivative. If you are trading stocks, there are terminologies you should familiarize yourself with (from stock options 101) call option and put option.

What is a call option?

It’s almost impossible to discuss stocks options 101 without mentioning “call options”. In the stock market, “the call option” is used to refer to a situation where an investor buys a stock. On the other hand, a “put option” gives you the right (not obligation) to sell stock. Putting everything in perspective, options contracts grants you the right to either buy or sell an underlying asset at a predetermined price on or before a stipulated date. If the underlying asset is a stock, it is said to be a stock option contract.

Hopefully, you got the explanation. You can get think of a call option as a down payment for a purchase you intend to make in the future. A typical example is you walking around your neighborhood and you see an ongoing development project. Suppose you pick interest in buying the property, you can own a home in that area in the future but you will have to demonstrate your intentions by securing your interest in the property and this can be done by making a down payment.

The down payment gives you the right to secure your property in the future when the project is completed. That way, you would have bought a call option from the developer and secured your right. Suppose the home property will be sold for $400,000 after completion, your down payment can be in the region of $20,000. In options trading, this cost is referred to as premium (the price of an option contract.)

Assuming after a couple of years, say three years later the area is properly developed and approved, you can now exercise your right to buy the property at the agreed price of $400,000 because you have already purchased that contract.

It doesn’t matter if the market value of the house rises to $800,000 because of your down payment, all you have to pay is the predetermined price of $400,000. On the other hand, if the property doesn’t get approval and the agreed time to complete the payment elapse, you will lose the right to buy at the initially agreed price of $400,000. Now you will have to pay the current market price of $800,000 because the contract is expired. Mind you, the down payment you made to secure the right to buy the house is nonrefundable. As such, the developer keeps the $20k regardless of whether you exercise the right or not.

Put option

As you may already know, the put option is the opposite of “the call option”. Using our initial example of buying a property. When you purchase the house, the first thing that comes to mind is buying insurance. The insurance coverage will protect your interest in case of damage, say as a result of fire or natural disasters. However, you will have to pay a certain amount for the insurance company to cover your property premium.

Hold that thought and link it to our topic of discussion stock options 101. Assuming we are no longer using the house as an example and decide to replace the property with another asset, say stocks. You can also purchase “insurance” on your S&P 500. But this time, you are not purchasing insurance coverage rather; you are buying a put option.
If you are worried that the bears are about to take over the market due to an impending reversal in market trend and you don’t want to lose more than 10% of your long bullish position in the S&P500 index that is trading at say $2500, you can purchase a put option which gives you the right to sell the index at 2550 dollars at stipulated time in the future.

Assuming the price plummet by 20% ( which equals 500 points on the index), you would have won 250 points and still cap your loss at 10% regardless of whether the stock value drops to zero while you are still bullish. Suppose, the dip or reversal doesn’t happen within the anticipated period and the momentum continues upwards, the only loss incurred is the premium spent. That is how you protect your investments using options. Now you can add protection to the list of options available to stock traders. Recall that we mentioned how stock option day traders can use this asset to make recurring income and hedge the market.

Stocks Options 101: More terminologies for stock options day traders

In the stock options market, there are four things you can do with stock buys calls, sell calls, buy puts, and sell puts. Like other assets, buying stock options opens a long or bullish position. If you buy a call option, it gives you the “right” to enter long in the underlying asset, in this instance; the underlying asset is a stock.

Short-selling your stock opens a short or bearish position. As such, “selling a call” allows you to open a short position in an underlying asset. If you are buying options, you are regarded as a holder while sellers are called writers. The major difference is that call holder and put holders are not obligated to buy or sell their stocks. Buying or selling stock options is a right they may choose to exercise or sit out. As such, limiting potential loss to only the premium spent.

On the other hand, call writers and put writers, are obligated to buy or sell the stocks of the option expires since one has to make good on the promise made to either buy or sell. This exposes the stock options day trader to more risks in addition to the option premium.

There you have it, stock options 101. You can always learn more about stock options from courses. Our education offers more insight on stock options trading strategies and effective tools, type of stock options, and how to leverage option speculations and hedging on your stock options trading plan.