What Is Options Trading: A Beginner’s Guide

What Are Options?

Options are financial derivatives that depend on underlying securities' value like stocks. They are financial instruments that many traders use to take advantage of the fluctuation in the markets. An option is an essential contract between two parties that gives the holder or buyer the right to buy or sell any underlying asset like stocks at a specific cost by a particular schedule or date.

However, it only gives them the right — not the obligation — to do so. When the specified date arrives, you're not obligated to buy or sell the underlying asset. As its name implies, you're given the option to let the contract expire. But, if you're buying options, you'll have to pay or lose the "premium" that you used to access the market when you let the contract expire.

For example, you expect the price of RBOB gasoline to increase from $3 to $5 per gallon in the following weeks. You then decide to buy a call option that allows you to buy the commodity at $4 at any date within the next month. The cost of purchasing that option is called the premium.

If the price of RBOB gasoline increases to more than $4 before the option you bought expires, you can buy the commodity at a discounted price. But if it doesn't go over that price, you're not obligated to continue the purchase and can let your option expire. However, you'll lose the premium you spent to get that option.

Types of Options

There are two types of options: call and put options. These options simply indicate your prediction about the movement of the market. With that in mind, here are more detailed explanations of the two kinds.

Call Options

These options give the buyer the right to buy the underlying asset at its strike price indicated in the contract on or before the specified date. Traders and investors buy these options when they expect the underlying asset's price to increase and sell them if the price decreases. When buying a call option, the higher the value, the better.

In real situations, it's like setting up an order. If you think the price will go higher, you can buy a call option that somewhat works like placing a buy order.

Put Options

Put options, on the other hand, give buyers the right to sell an underlying asset at the strike price specified on the contract within the amount of time indicated in the contract. Investors and traders buy these when they expect the asset's price to decrease and sell them if the price is expected to increase. The more the value decreases when you buy a put option, the better.

Again, in real situations, it's like setting up an order. If you think that the price will drop, you will buy a put option which somewhat works like placing a sell order.

Advantages and Disadvantages of Trading Options

For a better outlook, here are the benefits and risks involved with options trading:

CFDs vs Options

CFDs, or contracts for difference, are financial instruments traded between traders and brokers to settle the price difference in an underlying asset or market. With a CFD, you agree to exchange the difference in the asset prices both when you open your trade position and when you close it. Buying or selling a CFD depends on if you think the price will move up or down.

For example, if you expect the $350 price of FB stock to increase in a few days, you can buy a CFD for that stock. Then, when you close your position and the price increases to above $350, the contract provider has to pay you the difference in the prices between the date you opened your position and when you closed it. However, if the price drops below $350, you'll be the one to pay the difference instead.

What Are the Differences?

Although options and CFDs are both financial derivatives, trading them is a different matter. To understand more clearly, here are how they're different from one another based on various factors:

Pricing Transparency

The price of a CFD only depends on the movements of the underlying market. If the price in the market increases, the CFD price also increases. But with options, the premium doesn't solely depend on the price movement. The time decay, i.e., the time to the expiration date, and the underlying volatility also affect the price.

Expirations

Unlike an option, a spot CFD has no expiration date. An option contract becomes more worthless as it nears the expiration date because of time decay.

Risks

There are more risks with a CFD, especially when the market moves against you. When buying options, on the other hand, if the market moves against your trade, you can just let your option expire and lose only your premium.

Flexibility

Options are more flexible for advanced trading strategies. You can use both call and put options for various strategies and offer you some other trading opportunities. CFDs aren't flexible like that; they're rigid and focused only on the price increase.

Profitability

Although both are profitable, the higher price increases offer the possibility of higher maximum profit for CFDs. Meanwhile, the profit potential from options is in fixed proportions and can only offer monetary results when the price increases more than the premium.

Options vs Binary Options

Binary options are also like real options. However, their main difference is that there are only two distinct outcomes with binary options: either 0 or 1, or, put another way, win or lose. This means that you can only win or lose when you trade, and the results you get are fixed.

Think of this as an example. You want to trade Adidas stocks for $70 per share. Your broker for the binary options offers you a strike price at $72, and the market is only active for a whole day after the binary options trade was placed. You're offered a 90% win rate, and you stake $300.

When you buy a call option for this trade, you're expecting the price to increase by more than $81. And if this is correct, you'll earn 90% of your stake. So, for $300, you win $270. However, if your prediction is wrong, and the price doesn't go over $81 until the expiration, you lose your entire stake of $300.

What Are the Differences?

Since binary options also have the same general characteristics as real options, here are their differences based on these factors. 

Expirations

Binary options have clear yet very short and fast expirations compared to real options. Binary options can last up to only one minute, while real options have expirations that last for days, weeks or even a year.

Losses

With real options, you can incur up to 100% losses. While with binary options, you can get 15% of your money back and only lose up to 85%.

However, although binary options look more appealing, remember that their profitability is limited, and they're available only for a short period. In this regard, real options would still be better in the long run.

Profitability

As we've mentioned, your potential gains with binary options are fixed. Depending on how much the broker offered, you can get up to a 75% possible 'win' or more. But with real options, there's no limit, as long as the price moves in your favour.

Brokers

While many brokers of binary options are unregulated, real options brokers are regulated. That means they're registered and belong to a legitimate investor protection programme. This is a significant difference because, with regulated brokers, you can avoid fraud and the risk of losing your money due to bankruptcy.

With a real options tradingaccount, you're protected by the government and regulations that allow you to your money back if the broker closes down.

Trading Opportunities

Binary options trading exists, but it doesn't work the way trading should do. With binary options, you can buy but not sell to others. So, when you buy a binary option, you can only hold it and wait for the outcome.

Real options, on the other hand, can be traded to others before they expire. If there are signs of significant risks and losses, you can sell the options to retrieve some of the remaining amounts.

Underlying Assets

Real options contracts give you the right to trade the indicated underlying asset. For example, if you have an FB Call and Put Options, you can buy and sell FB stocks at their strike price at any time during their duration or before they expire. This shows that real options trading deals with the actual underlying assets in a real market.

Meanwhile, with binary options, you can't buy or sell any real underlying asset. Binary options are only available in digital forms without any real underlying assets. They're unlisted instruments, unlike real options. You're betting based on your hunch about the price movement to determine if you win or lose.

A Beginner's Guide on How to Trade Options

If you're now determined to trade options, here are the steps you need to follow to do so successfully.

Step 1 - Learn About Options

This is an essential step you shouldn't overlook and the reason why this whole guide was made. You have to understand how options work and what options strategies there are. It's also important to learn and understand the specifics of an option contract so you can know what you're getting into.

Additionally, there is specific terminology used by many traders when dealing with options. Here are some of them:

• Premium - We've mentioned this a couple of times. A premium is the amount or fee you need to pay as a holder to the option's writer.
• In the money - This is like an indicator used in a call or put option. When the price is more than the strike price in a call option, or it's less than the strike price in a put option, it's said to be "in the money," which means that if you exercise your right, you can trade at a better price compared to the market's price.
• Writers and holders - The writer is the seller of the option, while the holder is the buyer.
• Strike price - This is the price at which you can buy or sell the underlying asset on the option's expiry.
• Out of the money - This is the exact opposite of "in the money." In other words, you will incur losses when you exercise your right when the price is less than the strike in a call option or more than the strike in a put option. 

Aside from these, there are also some Greek symbols used to indicate risks in trading options. Once you clearly understand how they work, you can evaluate the risks that come along with the parameters that affect the price of the option. Here are the Greeks:

• Delta - This indicates the sensitivity of the price or how it will be affected by the underlying asset's price movement.
• Gamma - This is related to delta and means how much the delta moves for every price movement of the underlying asset.
• Theta - This shows the relationship of the price with time decay. A high theta indicates that the expiration of the option is near and how fast the time value decreases.
• Vega - This shows how sensitive the price is to the volatility of the underlying market and how much the price will change with every change in volatility.
• Rho - This will indicate the relationship between interest rate changes and the option's price movement. If the price increases due to a change in rates, rho is positive. Otherwise, it's negative.

Step 2 - Choose a Good Options Broker

There are many online options brokers out there, but remember to choose only a well-regulated one that's also a good platform. Also, be sure that it offers options for the assets you're interested in.

Step 3 - Open an Options TradingAccount

Although it may sound simple, opening your own account to trade options is actually a challenging step. Challenging in a way that you need to convince your broker that you're a good potential investor and pass a sort of a screening phase.

Brokers usually screen their potential investors to check their trading experience, how well they understand the risks involved and how prepared they are financially. Since you're opening an account, you need to provide the following:

• Personal financial data - This information may include details about the worth of your liquid investments, your annual income, employment information and even your total net worth.
• Trading experience - This covers your knowledge about trading and investing, your experience with options, the usual size of your trades and how many trades you make each year.
• Types of options - This pertains to what types of options you want or plan to trade and whether they're covered or naked.

Step 4 - Practice Trading

Don't hastily jump into trading options. It's best if you practice first before spending your real money. Practice will help you gain experience on how the broker's platform works and understand the mechanics of trading options without the risk of losing funds.

Pick the Right Option to Trade

When practising, you'll have to choose which option you plan to trade, so choose the one you're actually planning to trade for real next time. This also applies to after you practice and when you're actually trading. Choose the right option based on your prediction of the underlying asset's price movement.

To help you determine which options to trade, here are some useful notes:

• If you expect the price to increase, you can buy a call option and sell a put option.
• If you think the price will remain the same, you can sell both call and put options.
• If you predict the price to decline or drop, you can sell a call option and buy a put option.

Step 5 - Devise An Options Strategy or Plan

It's now time to develop or pick up a strategy you'll use to trade options that can help you manage and lessen risks for better chances of success. There are actually different existing trading options strategies you can use to get different results.

Step 6 - Predict the Strike Price

You can't just randomly choose a strike price since it will affect your possibility of earning. When you buy an option, it only works if the price closes on the expiration date in the money, above for call options and below for puts. It's best if you buy an option that has a strike price that shows your prediction about the price during the duration of the options.

Say, for example, you think that the stock you're trading right now is going to increase from $500 to $550 in the near future. You can buy a call option that has a strike price of less than $550 so that it still works at $550. Then, if the stock's price really moves higher than the strike price, your option is in the money.

The same goes for when you expect that the share or stock price will drop to $450. You can buy a put option instead and have a strike price of more than $450. If the stock price falls below this strike price, your option is in the money again.

Step 7 - Determine the Time Frame

The contract's expiration date is another thing you can't simply randomly choose. There are two main options styles based on the time frame: American and European. If you're a holder of an American option, you can exercise your option at any date until the expiration date. However, if you're a holder of a European option, you can only do it on the exact date of expiry.

Additionally, an expiration can last from days to weeks to months and even to years. Shorter expirations, like daily or weekly, are usually risky. Longer expiration, on the other hand, allows the asset or stock to move more as well as your investment. But, remember that the longer the period, the more expensive your option will be.

Step 8 - Monitor Positions

Once you've fulfilled all the previous steps and have opened your position, make sure to monitor them. Watch the market movement intently and keep an eye on your options position.

Again, if the option is in the money, you can close it before the expiration date for better results. But if there's nothing to gain from it, you can simply leave the position to expire. This way, you will only lose the money you paid for opening the position.

The Best Strategies for Options Trading

Strategies are beneficial factors when trading options. That's why we compiled the most popular strategies used to trade options that can be used without any problems by beginners, too.

Purchasing a Call Option

One of the most straightforward strategies is where you buy a call option if you think the value of the underlying asset will increase. And if it does, and your premium increases, too, you can sell your option before it expires. You can also hold your option until its expiration date and when the asset's price is more than the strike price. This way, you can buy at the strike price and end up with a good output.

Spreads

This is a strategy where you buy and sell options at the same time. Trading a call spread means you buy one call option while selling another at a higher strike price. Your possible output from this is the difference between those two strike prices.

Buying a Put Option

This is another one of the simplest strategies that are based on your prediction on whether the price of the underlying asset declines. If you're correct and the premium rises, you can succeed by selling it or hold it until expiration, when you can take advantage of the situation if the price is below the strike price.

Straddles

This is when you buy or sell call and put positions at the same time, on the same market and at the same strike price. This is a good strategy, especially if you're expecting volatility in the market but are unsure how it will move. With straddles, you can see a decent result whichever direction the price moves.

Your break-even points or levels are the strike price added by or subtracted by the sum of the two premiums on both sides of the strike. And your major risk is still the price you paid to open the position.

Married Put

This is for protecting your own asset against a possible decline in the market movement. Hedging your investment means you can buy a put option on the asset, which is called the married put. If the price of the underlying asset drops, you can earn possible gains on the put and help you limit losses.

This strategy somewhat works like an insurance policy since a price floor, which is the strike price, is established once the price of the asset significantly drops.

Conclusion

Now you've gained adequate knowledge about options trading, but it's best if you practice first with a Libertex demo account before putting out your money immediately. This way, you can experience the market and options trading without spending real money and get to test various strategies to help you develop your own plan in trading.