Options Trading Basics for Beginners

The following is a guest blog post:

This article covers some basic stuff related to options traders. What are your choices when you are long or short an option? You have three choices: sell it (if you are long) or cover it if short, exercise it if long, or allow it to expire worthless. And that’s true whether you own a call or a put. Each choice has its pros and cons. Each choice might lead to different profit outcome.

 

The Basics

  • Options give you the right to buy or sell an underlying security at specific price
  • Call Option gives you the right to buy the underlying asset.
  • Put Option gives you the right to sell the underlying asset.
  • If you buy an option, you have the right to exercise the option.
  • If you sell a Call Option, you are obligated to deliver the underlying asset at the strike price at which the Call Option was sold.
  • If you sell a Put Option, you have to buy the underlying if exercised.
  • Options are good for a specified period of time after which they expire. This specified period is called “Expiration”.
  • You can choose any price at which you would like to buy or sell underlying instrument. These prices are called Strike Price.

 

If you are long an option, you can sell it

  • If you own a call option and you believe that the underlying is going to decline, you would choose to sell it.
  • If you own a put option and you believe that the underlying is going to rise, you would choose to sell it.
  • You pay a debit when buying options and you get a credit by selling it.
  • If you collect more than you paid, you have a profit.
  • If you collect less than you paid, you have a loss.
  • You bought this option by entering a buy order with your broker. This time you enter a sell order to close (eliminate) your position.

 

If you are short an option, you can buy it back

  • If you are short a call option and you believe that the underlying is going to rise, you would choose to buy it back.
  • If you are short a put option and you believe that the underlying is going to decline, you would choose to buy it back.
  • You get a credit when selling options and you pay a debit by buying it back.
  • If you pay more than you collected, you have a loss.
  • If you pay less than you collected, you have a profit.
  • You sold this option by entering a sell order with your broker. This time you enter a buy order to close (eliminate) your position.

 

If you are long an option, you can exercise it

  • Notify your broker that you want to do what the contract allows.
  • If you own a call option, you may buy 100 shares of the underlying stock. You pay the strike price per share.
  • If you own a put option, you may sell 100 shares of the underlying stock. You collect the strike price per share.
  • If you own any options, don’t even consider exercising.  You may not have the margin call problem, but did you buy options to make a profit if the stock moved higher?  Or did you buy call options so that you could own stock at a later date?
  • If you really want to own stock, when buying options you must plan in advance, or you will be throwing money into the trash. For most individual investors – at least inexperienced investors – buying options is not the best way to attain ownership of the shares.
  • If the stock prices moves higher by enough to offset the premium you paid to own the option, you have a profit.  But, regardless of whether your investment has paid off, it seldom pays for anyone to buy options with the intention of owning shares at a later date.  Sure there are exceptions, but in general: Don’t exercise options.  Sell those options when you no longer want to own them.

 

If you are short an option, you can let it to be assigned

  • If you are short an option that expires In-The-Money, you will be assigned.
  • Assignment takes place when the written option is exercised by the options holder.
  • If a call option is assigned, the options writer will have to sell the obligated quantity of the underlying security at the strike price.
  • If a put option is assigned, the options writer will have to buy the obligated quantity of the underlying security at the strike price.
  • Options are usually exercised when they get closer to to expiration.
  • If assigned, you will be long 100 shares of stock for each put you are short.
  • If assigned, you will be short 100 shares of stock for each call you are short.

Note: Only the option owner may exercise; only someone with a current short position can be assigned.

 

You can allow it to expire worthless

  • If you are long an option, this is not your ideal solution because it means you lost every penny that you paid to buy the option.
  • If you are short an option, this is an outcome you are hoping for because in this case, you just keep the credit you got when you sold it.
  • When you hold an option, hoping for a favorable movement in the price of the underlying stock, many times that move never occurs and your option is out of the money.
  • When an option is out of the money when expiration arrives, it has no value and is worthless. Because it expires, your right to buy the underlying stock expires.
  • You may try to sell your option before it expires, but if there is little time before expiration, or if the option is out of the money by a significant amount, you may discover that no one is willing to buy the option. If that happens, you still own the option and will have to allow it to expire and become worthless.

 

Basic terms:

Out-of-The-Money (OTM):

a) A call option whose strike price is higher than the underlying price

b) A put option whose strike price is lower than the underlying price

In-The-Money (ITM):

a) A call option whose strike price is lower than the underlying price

b) A put option whose strike price is above the underlying price

An-The-Money (ATM):

a) A call or put options whose strike price is near the underlying price

 

Kim Klaiman is a full time Options Trader and founder of steadyoptions.com – options education and trade ideas, earnings trades and non-directional options strategies.

Read more from Kim on his Options Trading Blog and Options Trading Forum

Twitter: @SteadyOptions_

6 thoughts on “Options Trading Basics for Beginners

    • Hi TDL,

      Like you, I am considering options as well. I just haven’t jumped into it yet. I still want to feel more comfortable before trying any options trading method. There’s little doubt that options can provide some great income each month if done correctly. Thank you for stopping by and commenting.

  1. Outstanding post! Been trading options for a couple of years. Have a good handle on most of these topics. Would love to learn more about strangles, butterflies and iron condors along with examples in laymen terms.

    • Hi Dirk,

      In recent months I have noticed that many dividend investors have jumped into the options world. Most are not using any ‘exotic’ strategies like strangles or butterflies, rather simply selling covered calls to generate premium income. I have yet to jump into the options world but selling covered calls or selling cash secured puts seem like two methods I would feel comfortable doing. Thank you for commenting.

    • Hi KR,

      Thanks for sharing that information. I know there are many binary options brokers that are loosely regulated domiciled outside the U.S.

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