Options Trading Strategies For Beginners
According to Oxford dictionary, “An option is a financial contract that gives an investor the right, but not the obligation, to either buy or sell an asset at a pre-determined price (known as the strike price) by a specified date (known as the expiration date).” Options are derivative tools, which means that their costs are derived from the cost of their underlying security, which could be practically anything: stocks, bonds, currencies, indexes, commodities, etc. In case the market conditions are disadvantageous for the options owners, they will allow the option they own expire without value, thus making sure that the deficit is not bigger than the so-called premium. Contrary to the options holders, options sellers (they are also called writers sometimes) presume a larger risk than the first, which is why they normally require this premium.
The theory divides options into “call” and “put” types. In case of a call option, the contract buyer also buys the right to purchase the financial assets at any time in the future at a discussed price, called exercise or strike price. With the second type, called put option, the buyer can sell the financial asset at any time in the future at the fixed price.
Trading options VS Direct Assets
First of all, let us discuss some benefits of trade options. CBOE, or the Chicago Board of Options Exchange is the biggest and most influential options exchange in the world. You can find various types of options on CBOE: Exchange-Traded Funds (ETFs), single stocks and indexes. It might be a good idea to think about your strategy when trading options. Traders normally choose from the most basic strategies, such as “BUY / SELL individual options”, to more complicated ones which include a number of concurrent option positions.
In this article, we would like to focus on some basic approaches for beginners.
Buying Calls – Long Call
This strategy can be a good choice for those who:
- Are confident in a specific financial asset, such as stock, Exchange-Traded Funds or index they are trading and would like to reduce the risk
- Are interesting in taking leverage to bargain cheap rising prices
That is why many professional traders call options leveraged tools, meaning that options give an opportunity to increase the profit by compromising smaller amounts of assets. Otherwise, a somewhat bigger amount would be needed if trading a particular asset. A traditional options agreement on stocks regulates 100 shares of the particular asset (security).
Let us imagine that a trader is planning to invest $5000 in Tesla, trading about $167 per one share. With this money, he can buy thirty shares for almost $5000. Assume that the price of the stock can rise to $180 over the upcoming month (which is a 10% increase). If you do not take into account any additional fees, such as brokerage, transaction commission or other fees, the trader’s profit will be around $500, or 10% on the money invested.
Now, let us assume that a call option on the stock with a starting price $167 that closes in around a month from today’s date costs $6.50 per one share and $650 per contract accordingly. As stated above, the trader’s investment budget is $5000 so he can purchase nine shares for a total cost of almost $5000. The option contract regulates 100 shares, the trader in efficiently agreeing to control 900 shares.
In case the price of the stock grows by 10% at expiration, the option will most likely expire in terms of money and cost $16.60 per share or about $15000 on 900 shares. The profit will reach 200% on the invested capital, which is much bigger than trading a certain asset directly.
Risk/Reward for this strategy:
The potential loss that a trader can encounter from a long call is restricted to the paid premium. At the same time, the potential income has no limits: the option profit will grow in line with the underlying asset. Theoretically, the profit can reach millions.
Buying Puts – Long Put Strategy
This strategy is the most advantageous for those traders who:
- Unlike the previous strategy, bearish on a specific ETF, index or stock, but still want to minimize the risk
- Wants to use leverage to get profit from a bear market/falling prices on stocks
As you may have understood, a “put” option type works opposite to a “call” option type option. The most important feature of a put type is that it becomes profitable when the price of the underlying asset decreases. While decreasing prices is not a problem for short-selling (it is still possible to get a profit), the risk with going short does not have any limits. The price can both increase or decrease. Be careful with put options and always keep a track of the underlying asset: if it grows past the option’s strike cost, it will easily expire worthlessly.