Options trading has become an increasingly popular form of investing over the past decade. With the ability to potentially generate high returns while limiting risk, it’s no surprise that options appeal to both new and experienced traders alike. However, learning how to trade options effectively requires dedication and the right educational resources. Here we’ll explore the basics of options trading, strategies for beginners, and the best ways to learn in order to set yourself up for success.
What Are Options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (called the strike price) on or before a specified date (called the expiration date). There are two main types of options:
- Calls – Give the holder the right to buy the underlying asset
- Puts – Give the holder the right to sell the underlying asset
When you buy an options contract, you pay an upfront premium to the seller. This allows you to control 100 shares of the underlying stock without having to put up the full cost of purchasing the shares outright. Options are leveraged instruments, meaning you get exposure to large price moves with a relatively small investment.
Here are some key benefits and drawbacks of options trading:
Benefits
- Leverage – Control a large number of shares with a relatively small upfront investment.
- Risk management – Strategies like spreads help limit potential losses.
- Hedge portfolios – Hedge against stock positions or entire portfolios.
- Generate income – Collect premiums by writing/selling options contracts.
- Speculation – Profit from the price movement of the underlying.
Drawbacks
- Complexity – Options have advanced strategies/concepts that take time to learn.
- Expiration dates – All options contracts expire, so timing is important.
- Risk of loss – While risks can be managed, options sellers face unlimited loss potential.
- Access to capital – Cash or margin is needed to fund options positions.
Options Trading Strategies for Beginners
When first getting started in options trading, relying on basic strategies is key to avoiding common mistakes. Some of the most popular beginner strategies include:
Long Calls
Buying long call options allows you to profit from uptrends in the underlying stock without putting up the capital required for buying shares outright. When you buy a call, your loss is limited to the premium paid. However, you gain exposure to unlimited upside potential if the stock price increases. Long calls are a bullish options strategy used to speculate on rising prices.
Long Puts
Long puts work in the opposite direction of calls. Buying puts allows you to profit from downtrends in the underlying stock without shorting shares. The premium paid for the put option represents your maximum loss. But you gain leveraged exposure to downside moves in the stock price. Long puts are used as a bearish play when you expect declining prices.
Covered Calls
Also known as a buy-write strategy, this involves buying shares of the underlying stock and simultaneously selling call options on that same stock. The premium collected from the call sale generates income that lowers your cost basis on the shares. However, the call caps your upside if the shares rise above the strike price. Covered calls let you generate yield against a long stock position.
Cash Secured Puts
This strategy involves selling put options while setting aside enough cash to potentially buy the shares. If the stock price remains above the put’s strike at expiration, you keep the premium as profit. If the share price falls below the strike, you may get assigned on the shares at the lower entry price. Cash secured puts allow you to potentially buy stocks for less than today’s market price.
Best Methods for Learning Options Trading
With dedication and the right mix of learning resources, it’s possible to become highly proficient at trading options. Here are some of the best ways to learn:
Read Books & Take Courses
Books and online courses by respected options experts provide structured learning and theory that gives you a solid foundation. Some popular titles include:
- “Options as a Strategic Investment” by Lawrence G. McMillan
- “Option Volatility & Pricing” by Sheldon Natenberg
- Courses on platforms like Udemy and Skillshare.
Paper Trade and Backtest
Paper trading allows you to simulate live trading without risking real money. Test different strategies and get a feel for how options behave. Backtesting applies your strategy to historical data to see how it might have performed. Many brokerage platforms and tools like Thinkorswim offer paper trading and backtesting capabilities.
Join Online Forums
Participating in active online trading communities is a great way to learn from more experienced investors. Subreddits like r/options and r/thetagang have endless discussions on options strategies and market analysis. Just be cautious of following any tips blindly.
Start Small and Scale Up
When transitioning to trading real money, start small to minimize risk. Focus on a single strategy like covered calls and get comfortable with it before adding complexity. Slowly increase your position sizes and dollars at risk as your expertise improves. Compounding gains gradually leads to large returns over time.
Review Your Trades and Performance
Analyzing the results of your real money trades is vital for improving as a trader. Review your trading records and journal by asking yourself questions, such as:
- Did I follow my trading plan’s rules and guidelines?
- How did implied volatility impact my positions?
- Could I have better managed my exit strategy?
- Did I let emotions influence my decisions?
Continuously refining your process based on experience leads to growth and consistency.
Find a Mentor
Having an experienced options trader mentor you can supercharge your learning curve. A mentor can observe your trading and provide valuable customized feedback. Some brokers have mentorship programs that connect new traders with veterans. You can also turn to online communities to find a willing mentor.
Key Options Trading Skills to Master
Here are crucial skills every trader needs to develop for succeeding with options:
Understanding Implied Volatility
Implied volatility (IV) measures option premiums and represents how much the underlying stock price can move in the future. Higher IV means greater expected volatility and more expensive option premiums. Monitoring IV helps you determine whether options are overpriced or underpriced, enabling you to trade them at advantageous levels.
Interpreting Greeks
The “Greeks” are metrics that indicate how an option’s premium will change based on various factors. They include:
- Delta – Rate of change compared to the underlying
- Gamma – Rate of delta change
- Theta – Time decay
- Vega – Sensitivity to IV
Understanding Greeks allows you to manage positions based on precise risk metrics instead of guesswork.
Evaluating Risk/Reward
Before placing any trade, the potential risk versus reward should be evaluated. This entails:
- Considering the maximum loss if the trade hits your stop
- Estimating the profit target if the trade works out
- Weighing whether the payout justifies the potential loss
Favorable risk-reward setups lead to sustainable profits over many trades. Unfavorable setups can produce large losses.
Managing Emotions
Controlling emotions like greed and fear separates the successful traders from average ones. Some tips include:
- Trade smaller position sizes to avoid stress
- Use stop-losses and take-profits to remove bias
- Avoid impulsive reactions; stick to the trading plan
- View losses objectively as part of trading business
Mastering emotions enables you to act rationally when making crucial trading decisions.
Timing Entries and Exits
Solid timing centers around waiting patiently for prime opportunities while avoiding chasing. Some key elements include:
- Allowing trades to come to you rather than forcing them
- Using technical indicators to identify momentum shifts
- Entering on pullbacks within clear uptrends or downtrends
- Booking profits once target objectives are reached
Even mediocre trading strategies can yield big returns through precise timing and execution.
Common Options Trading Mistakes
New options traders often make the same mistakes repeatedly. Being aware of these common pitfalls allows you to avoid them:
Trading Without a Plan
Failing to have a trading plan with concrete rules often leads to emotional decisions and overtrading. Your plan should define things like:
- What underlying securities you will trade
- Entry/exit criteria
- Position sizing methodology
- Risk management guidelines
Trading plans create discipline and give you principles to fall back on during challenging moments.
Overleveraging
Options inherently contain leverage. However, using too much leverage by oversizing positions can lead to extreme losses. Stick to position sizes that allow you to comfortably handle some volatility in the underlying security.
Holding to Expiration
Options expire worthless if they end up out of the money at expiration. Avoid hoping for miraculous rebounds and exit losing trades before expiration according to your stop loss rules.
Not Accounting for Dividends
Stock dividends impact options prices and should be accounted for. For call options, dividends are generally bearish. For put options, dividends are generally bullish. Make adjustments to neutralize the dividend’s effects.
Overtrading
Trading too frequently usually underperforms buy-and-hold due to transaction costs like commissions and bid-ask spreads. Be patient and wait for prime low-risk, high-reward trades. Overtrading often reflects greed or an attempt to make up losses quickly.
Going Against the Trend
Rookies often try to pick bottoms and tops prematurely. Wait for clear reversals confirmed by price action instead of randomly guessing. Trading with the dominant trend improves odds substantially.
Neglecting Tax Implications
Frequently trading options can create tax headaches through early assignment, exercise, and unqualified covered call disqualification. Understand basic tax treatment for options to avoid nasty surprises.
Options Trading Platforms
Using a powerful options trading platform can provide valuable tools for analysis, efficient order entry, and position management. Here are some top platforms to consider:
Thinkorswim
Offered by TD Ameritrade, Thinkorswim features advanced charting, scanning, spread trading, and paper money capabilities. The learning curve is steep but it’s ideal for active options traders.
TradeStation
TradeStation has a focus on options analysis and support for complex strategies. The platform features real-time scanning, risk modeling tools, and automated trading systems.
tastyworks
Created by the founders of Thinkorswim, tastyworks emphasizes simple options trading with videos, tutorials, and low commissions. Its mobile app makes basic options trades fast and easy.
E*TRADE Pro
E*TRADE Pro provides options trading along with stocks, ETFs, and futures. It has live streaming charts, technical studies, screeners, and options profit calculators.
OptionsPlay
OptionsPlay specializes in options flow tracking and unusual options activity. This data helps identify institutional trading signals day traders can leverage.
Key Takeaways for Learning Options Trading
Here are some key takeaways for learning to trade options effectively:
- Make use of books, courses, communities, and mentors when starting out.
- Paper trade and backtest before putting real capital at risk.
- Employ basic strategies like covered calls and cash secured puts initially.
- Start small with position sizing and increase over time.
- Review trades frequently and learn from both winners and losers.
- Develop skills like evaluating IV, Greeks, and risk/reward scenarios.
- Trade with the trend and focus on high probability setups.
- Avoid common mistakes like overleveraging and overtrading.
Mastering options trading requires dedication and experience. But for those willing to put in the time, options provide leveraged opportunities to potentially profit in bullish, bearish, neutral, or volatile markets. With education and discipline, options can become a valuable component in your overall investing strategy.
Conclusion
Options trading offers unique advantages but carries complexity. Utilizing a mix of theoretical education and hands-on practice can provide a solid foundation. Starting with basic strategies and small positions minimizes risk. Maintaining a trading journal and reviewing performance enables refinement of your options approach. While demanding significant time and effort, options ultimately give disciplined traders the chance to generate strong risk-adjusted returns across diverse market conditions.