Options Trading 101: The Complete Beginner's Handbook

Key Takeaway

• A standard option contract comprises blocks of 100 shares per contract, but you can have more if you want to trade higher volumes.
• With options trading, you’re purchasing the right to buy or sell shares of the underlying asset.

Once considered a practice reserved for financial professionals, options trading has become popular for individual investors in recent years. Options are a form of derivative financial instruments which can increase the potential for big profits – or big losses.

This article serves as a  basic options trading guide, providing the information you need to develop a solid understanding of the options market.

Options Trading 101: What is an Option?

Let’s start this beginner’s guide to getting started in options trading by talking about the most fundamental thing: What is an option?

An option is a derivative contract that gives you (the option holder) the right to buy or sell a security for a specified price by a certain date without the obligation to buy or sell the asset in question. For such a right, buyers have to pay sellers an amount called a premium.

The buyer chooses to buy the option or let it expire. If market prices are unfavorable for the option holder, they can let the option expire without purchasing it, keeping the losses lower than the premium. If, on the other hand, the market moves in a direction that makes the option more valuable, the buyer will make use of it.

 A standard option contract comprises blocks of 100 shares per contract, but you can have more if you want to trade higher volumes.

There are a few terms to understand within an option contract:

• Derivative: Options derive their value from another asset.
• Premium: The price to purchase an option. It is calculated based on the value and price of the underlying security.
• Expiration: The time and date the contract ends when the option contract cannot be bought or sold.
• Strike Price: The predetermined price of an option is bought or sold according to the contract.
• Expiration: Traders have until the option contracts date and time to exercise the option at its strike amount.
• Intrinsic and Extrinsic Value: Intrinsic value is the difference between the option’s strike price and the underlying security’s current price. Extrinsic value presents external factors that affect the premium.
• In-The-Money And Out-Of-The-Money: Based on the underlying asset’s price and the time left before the contract expires, an option is said to be in-the-money if it’s profitable or out-of-money if not profitable.

Interesting Fact: One of the advantages of trading options is that they are flexible. One can avoid them if it doesn’t provide profit and a better asset for the owner. 

How Does Options Trading Work?

Your options contract gives you a choice to buy shares in the future, which means that you have the potential for ownership as dictated by the terms of the contract. When thinking of options in trading, you have more flexibility in your investment because they can include stocks, bonds, ETFs, indexes, and commodities.

Prices fluctuate, so options allow you to speculate about if the amount of an asset will be lower or higher at a certain time in the future and by how much the price will rise and fall. You also get to speculate on the date the price changes will occur. Then, based on your analysis, you buy or sell your options to generate income or lower your risk of loss.

There are two basic types of trading options, depending on if you want to buy or sell:

• Call Options: Once the underlying security price has exceeded the break-even amounts, you can choose your option and earn the difference between the current premium and the premium you paid. You can alternatively buy the security at the agreed-upon strike price.
• Put Option: You can sell your options once the security amount has fallen below the break-even level. Alternatively, you sell the security when it hits the agreed-upon strike price.

If the price of the security moves in a direction that is not ideal for a call or put option, you can let the contract expire. So, your losses will be equal to the premium.

How to Start Options Trading?

Many trading platforms today offer options trading. You’ll need to open an options trading account and be approved. Approval is based on your financial preparedness and understanding of the risks. When approved, select orders you’d like to buy or sell. You’ll have to identify the type of asset, strike price, and expiration date. Then you can place orders for that option.

Options Trading 101: Summary

With options trading, you’re purchasing the right to buy or sell shares of the underlying asset. You don’t have ownership as you would if you directly bought the stocks, but there’s value in having the choice of trading options. To make a profit, you need to predict if the underlying asset’s price will rise or fall. This will require a significant amount of research and knowledge. Finding the right trading platform is also imperative.

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