Beginner’s Guide to Options Trading
If you are new to options Dr Eric help you with this series of articles. In this series he explain the basics for someone new to options and options trading. He shares his experiences so you can learn quicker and avoid some of the mistakes that he made when he first started out
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each section quick links to the place on the page.. quick recap
each section quick links to the place on the page.. quick recap
each section quick links to the place on the page.. quick recap
Beginner’s Guide to Options Trading – Overview
Good Kids Trading is a community of ordinary people who all share an interest in trading options. Some good kids (we like to refer to members as 'good kids') rely on trading as their primary source of income, others see it as a pleasurable part-time job, and some are simply trying to navigate their way through the process. Personally, I belong to the category of people who consider it a side-hustle. I have “graduated” from the trying to figure things out category but let’s face it, there is always so much to learn about trading I think I’ll always be figuring something out.
If you are new to options let me help you with this series of articles. In this series I endeavor to explain the basics for someone new to options and options trading. I'll also share my experiences so you can learn quicker and avoid some of the mistakes that I made when I first started out. For those of you who already are familiar with the basics, check out this article on risk management for the options trader.
What is a stock option?
Soon after I got a handle on the basics of trading shares of stocks, I explored my broker and came across options trading. I was honestly put off by it at the start. Obligation to buy or sell versus right to buy or sell seemed so confusing. On top of that, I recalled that most of the financial guru’s I came across said that options were risky and should be avoided. Maybe they are right for most folks who don’t want to take the time to learn. For me, this advice was a disservice because I was willing to learn. I just didn’t know where to start. I've since found that trading options made more profits with less risk compared to trading shares.
Before we go any further, there are options for ETF’s, futures, and even crypto. For the sake of simplicity, I will be referring to options on stocks in this series, but the concepts apply to all option markets.
A stock option is a contractual agreement between the buyer and the seller over 100 shares of stock. Just as with any transaction, for every buyer there is a corresponding seller. When you trade options, you are either buying from or selling to someone else. The only negotiable portion of the contract is the price or amount of premium transferred from the buyer to the seller. All of the other terms are “take it or leave it” in nature. There are 5 main terms to options contracts:
Stock or Underlying – Each contract covers exactly 100 shares of the stock.
Expiration Date – This identifies the date that the contract is valid through.
Strike – This is the agreed upon price of the stock that the option will execute on, if it is executed.
Premium – This represents the cost of the option. The buyer of the option pays the premium to the seller of the option. Keep in mind the posted premium represents the cost for only one share. Multiply this price by 100 or move the decimal two places to the right to calculate the true premium exchanged per contract.
Calls or Puts – More on this below!
The premium is the only negotiable term in an option contract. If you don’t like the stock, time, or strike, find one that you do like and trade that!
Breakdown of a Typical Options Page.
These pictures are from tastytrade which is a very easy to use trading platform that was created for options traders by options traders. All major broker’s option pages will look similar though.
Indicates the stock symbol
All dates are expiration dates for the options contract.
By default the left side shows call options and the right sight has the put options
Since this is an article on the basics, we won't get in the weeds with the other features on this page.
What are Call Options?
Call options give the buyer the right to buy 100 shares of stock from the call option seller at the strike price on or before the expiration date. The buyer can choose to execute the option at any point in time up to the close of market on the expiration date. The seller must comply with the decision of the buyer and has no say in the matter.
What are Put Options?
Put options give the buyer the right to sell 100 shares of stock to the put option seller at the strike price on or before the expiration date. The buyer can choose to execute the option at any point in time up to the close of market on the expiration date. The seller must comply with the decision of the buyer and has no say in the matter.
Call Options vs Put Options
The main difference between call and put options is that call options allow the buyer to BUY 100 shares of stock and put options allow the buyer to SELL 100 shares of stock. This article will not go into specific strategies. Other articles in other series absolutely will. Instead, this article will solidify the foundation and understanding of the basics which all option strategies build upon.
Buying vs Selling Options
In both call and put options there is a buyer and a seller. The buyer and the seller are just two people connected over the internet, through a broker, who happen to have exact opposite opinions on what will happen in the future. This is no different than trading shares of stock. The buyer of shares thinks the price will go up while the seller thinks the price will go down.
With options, it isn’t quite as simple as “buy if you think the price will go higher and sell if you think the price will go lower.” Right now, it is more important to focus on what the buyer and seller agreed to!
Option buyers pay a price for time and uncertainty to purchase the right, or ability, to buy or sell 100 shares of stock depending on if it is a call or put option, respectively. From a profit potential standpoint, the buyer doesn’t know how much they stand to make. The buyer can only lose the amount of money they paid when they entered the trade. To put it another way, option buyers have a defined amount of risk and an undefined profit potential.
Option sellers are paid a premium from the option buyer. While the option buyer knows exactly how much they can lose when they enter a trade, the option seller knows exactly how much they can make. This is worth repeating. An option seller’s maximum profit potential is the premium they are paid at the beginning of the trade! Selling options by themselves comes with undefined risk. To offset this scary statement, the option seller benefits from time passing. Every day that passes brings the contract closer to expiration which means there is less time for the seller to be wrong. Similarly, when the price stays away, or even better, moves away from the strike price, this also benefits the option seller.
Which is better?
When I learned the differences between buying and selling options, I recall thinking that buying options was the clear winner. If things went wrong, I could only lose so much, and if things went the way I wanted, I could make a huge profit.
After a few years of learning and trading, I’ve found that I significantly prefer selling options. Options tend to be overpriced and selling overpriced options works better for me than buying overpriced options. In fact, selling options is the basis for many of GKT’s strategies.
There is a place for both buying and selling options in a trader’s portfolio which is why it is important to have a good grasp of both.
Putting it All Together
In this article we covered the basics of call and put options. We also discussed the key differences between buying and selling options. When we trade shares of stock, we have two ways to trade: buy shares or sell shares. With options trading, there are four ways to trade:
Buy Call Options – Check out GKT’s Beginner’s Guide to Buying Call Options
Sell Call Options – Check out GKT’s Beginner’s Guide to Selling Call Options
Buy Put Options – Check out GKT’s Beginner’s Guide to Buying Put Options
Sell Put Options – Check out GKT’s Beginner’s Guide to Selling Put Options
Behind each way to trade there are some nuances that must be understood and appreciated and an entire article is dedicated to each. For a little teaser, check out this chart that shows what you want the stock’s price to do for each possibility.
If you are intrigued by any of this, join our discord community! We make real trades daily and share both our successes and our failures. As a community we grow and learn from each other. Even if you are just starting out, there is a place for you at GKT
Beginner’s Guide to Options Trading – Buying Put Options
In this Beginner’s Guide to Options Trading series, I am covering basic option concepts in their most simple form. Check out the first article in the series which provides a general options overview. This article will go over the important concepts specifically behind buying put options.
Put Options Explained
The put option gives the buyer the right to sell 100 shares of stock at the strike price on or before the expiration date to the put option seller. The buyer can choose to execute this right at any point in time up to the close of the market on the expiration date. The seller of the put option is obligated to buy the shares if this happens. The put seller simply has no say in the matter.
Buying a Put Option Example
In this picture we are looking at the SPY options table expiring on Feb 17, 2023. For the purposes of this example, let’s buy the $395 strike put option for $7.29 a share. The current price of SPY is $395.88. Buying this put gives the right to sell 100 shares of SPY at $395 per share. We paid $729 for this right to sell shares of SPY before Feb 17, 2023.
How do Put Option Buyers Make Money?
Stated simply, put option buyers make money when the stock’s price goes down. Take time to think about this.
When you bought the $395 put, you bought the right to sell the stock at $395 to someone else. If the stock price goes up to $400, you’d much prefer to sell the stock at $400 rather than $395. On the other hand, if the stock goes down to $390, you’d be able to sell shares at $395! This is the “sell high” part of the old adage, “buy low and sell high.”
Why Would You Buy a Put Option?
There are several specific reasons why you might buy a put option but the fundamental belief is that the price of the stock will go down in the near future.
A bought put is a way to short stock without owning shares.
A bought put can hedge, or protect, 100 shares of stock that you already own from a price decrease.
A bought put can be combined with other options as one component of a more complex strategy
I mention these ideas here so that you are introduced to these concepts. Other articles will be dedicated to these and many other strategies. Since this is a basics article, we will go no deeper here.
Back to our Long SPY 395 Put Example
Imagine a scenario where SPY fell to $380 a share on Feb 17, 2023. How are you feeling about your put option that you bought? You should be happy for your winning trade! Using this as an example, we will discuss the three choices you have as an option buyer. Keep in mind that these three choices exist at any point between buying the option and the option’s expiration.
Exercise the option
Close the position
Exercising a Put Option
To exercise a put option, you start by notifying your stock broker and the rest will be carried out by them. Behind the scenes, the broker sells 100 shares of stock from your account to the person who sold you the option. The proceeds of the sale go directly into your account. If you happened to not have 100 shares of stock in your account, your broker would still sell the shares, but you’d be “short” 100 shares of stock.
What does “short” stock mean?
Short stock means you are in “debt” shares of stock but plan on buying some in the future to pay off the debt. To illustrate this, forget stocks for a second. Jack and Alan are friends going out to lunch at a fast food restaurant. Jack orders his food and steps aside. Alan orders, but realizes that he left his credit card at home. He bought $10 worth of food but only has $5 in cash in his wallet. Alan says to Jack, “Hey Jack, can you spot me some money, I’m $5 short.” Jack, being a good friend, paid the balance for Alan. Alan is effectively short $5 to Jack who expects to be paid back at some point in the future.
Back to our Example
The current price is $380 and you own a put option that allows you to sell the stock at $395. Keep in mind you paid $7.29 at the beginning of the trade to buy this option. When you exercise the put, you are exercising the terms of the contract and sell the 100 shares to the option seller for $39,500. You would now be short 100 shares of SPY. If you were to buy 100 shares of SPY at the current price of $380 to cover the short, this would cost $38,000. This nets a profit of $1,500 ($39,500 from the sale - $38,000 from buying back the shares). Subtracting the initial debit paid of $729 leaves you with an overall profit of $771!
Sell to Close the Put Option
Closing a position is a simple way of saying “getting back to zero.” Another term people use is “flattening” the position. If you buy 100 shares of stock, you will have +100 shares in your account. To close the position, you need to get back to zero shares. To accomplish this, you just sell the 100 shares. If you’ve gone short 100 shares, your account will show -100 shares. To get back to zero, you must buy 100 shares. This same concept applies to options.
When an option moves in the desired direction, it becomes more and more valuable. The math behind this is well beyond the scope of this article, but we can look at this conceptually. If the price of SPY is $380, how much money would you pay to immediately be able to sell it to someone else for $395? Probably somewhere close to but less than $15. If you paid more than $15, you’d be guaranteed to lose money. Paying less than $15 means you’d make money on the transaction. The other factors that go into the equation, such as time and volatility, impact that ultimate price but this is all calculated by your broker.
In our example, if the price is $380 on the day of expiration, the $395 put option you bought will likely be worth somewhere close to $15! For easy math, let’s say it’s worth $14.79. Because you bought the option, you must sell it to close the position.
$14.79 of income from selling back the option – $7.29 debit when buying the option = $7.50 profit.
Recall that this is per share, so this results in a $750 total profit.
With options, the market’s close on the option's expiration date is the definitive end of the trade. If you choose to do nothing it comes down to the option being “in the money” or “out of the money” at expiration.
Example of a Put Option Expiring In the Money
We bought the $395 put in SPY. If on expiration, the price of SPY were $394.99 or less, then this put would be considered ITM, or in the money. When an option expires ITM, something will happen to your account. This “something” typically means that the option terms will be executed by your broker automatically. The broker does this because it is the most profitable outcome for you at that moment. By executing the contract, the broker would sell 100 shares of SPY at the strike price of $395 and would deposit the $39,500 in proceeds in your account. Since the price of SPY is less than $395, you could buy 100 shares of SPY for less than a total of $39,500. The difference is your profit.
Example of a Put Option Expiring Out of the Money
If we buy a put, the price is considered out of the money, or OTM, if the price is above the strike price. In this example, we bought the $395 put on SPY. If, on expiration, the price were $395.01 or higher, then this put is considered OTM. Options that expire OTM are essentially worthless. For a bought put, the broker would simply remove the option from your portfolio. It wouldn’t make sense for the broker to execute the contract since this would create a loss on top of the loss of the initial premium paid.
The fundamental idea behind buying a put option is that you believe the stock price will go down in the near future. Buying a put allows you to sell 100 shares of stock to someone at the strike price, for the cost of the premium you paid. If your bearish assumption is correct, the put option will gain value because you have the right to sell the shares at a price higher than you can buy them back for.
Check out these other articles in GKT’s Beginner’s Guide series if you want to learn more!
Beginner’s Guide to Selling Call Options
Beginner’s Guide to Buying Put Options - That's this article!
Beginner’s Guide to Selling Put Options
If any of this sounds interesting to you, hop into our discord! Whether you are ready to trade real money, paper trade, or just want to watch how others are trading, there is a place for you. Trading in a community of like minded people is far more fun, educational, and profitable! www.goodkidstrading.com/join