Basic options trading

A Guide Of Option Trading Strategies For Beginners.

Options are conditional derivative contracts that allow buyers of the contracts a. k.a the option holders, to buy or sell a security at a chosen price. Option buyers are charged an amount called a "premium" by the sellers for such a right. Should market prices be unfavorable for option holders, they will let the option expire worthless and thus ensuring that the losses are not higher than the premium. In contrast, option sellers, a. k.a option writers assume greater risk than the option buyers, which is why they demand this premium.

Options are divided into "call" and "put" options. A call option is where the buyer of the contract purchases the right to buy the underlying asset in the future at a predetermined price, called exercise price or strike price. A put option is where the buyer acquires the right to sell the underlying asset in the future at the predetermined price.

Why trade options rather than a direct asset?

There are some advantages to trading options. The Chicago Board of Option Exchange (CBOE) is the largest such exchange in the world, offering options on a wide variety of single stocks and indices. Traders can construct option strategies ranging from simple ones usually with a single option, to very complex ones that involve multiple simultaneous option positions.

[Options allow for both simple and more complex trading strategies that can lead to some impressive returns. This article will give you a rundown of some basic strategies, but to learn practice in detail check out Investopedia Academy's Options Course, which will teach you the knowledge and skills the most successful options trader use when playing the odds.]

The following are basic option strategies for beginners.

This is the preferred position of traders who are:

Bullish on a particular stock or index and do not want to risk their capital in case of downside movement. Wanting to take leveraged profit on bearish market.

Options are leveraged instruments – they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if the underlying asset traded itself. Standard options on a single stock is equivalent in size to 100 equity shares. By trading options, investors can take advantage of leveraging options. Suppose a trader wants to invest around $5000 in Apple (AAPL), trading around $127 per share. With this amount he/she can purchase 39 shares for $4953. Suppose then that the price of the stock increases about 10% to $140 over the next two months. Ignoring any brokerage, commission or transaction fees, the trader’s portfolio will rise to $5448, leaving the trader a net dollar return of $448 or about 10% on the capital invested.

Given the trader's available investment budget he/she can buy 9 options for $4,997.65. The a contract size is 100 Apple shares, so the trader is effectively making a deal of 900 Apple shares. As per the above scenario, if the price increases to $140 at expiration on 15 May 2015, the trader’s payoff from the option position will be as follows:

Net profit from the position will be 11,700 – 4,997.65= 6,795 or a 135% return on capital invested, a much larger return compared to trading the underlying asset directly.

Risk of the strategy: The trader's potential loss from a long call is limited to the premium paid. Potential profit is unlimited, meaning the payoff will increase as much as the underlying asset price increases.

This is the preferred position of traders who are:

Bearish on an underlying return but do not want to take the risk of adverse movement in a short sell strategy. Wishing to take advantage of leveraged position.

If a trader is bearish on the market, he can short sell an asset like Microsoft (MSFT) for example. However, buying a put option on the shares can be an alternative strategy. A put option will allow the trader to benefit from the position if the price of the stock falls. If on the other hand the price does increase, the trader can then let the option expire worthless losing only the premium.

Risk of the strategy: Potential loss is limited to the premium paid for the option (cost of the option multiplied the contract size). Since payoff function of the long put is defined as max(exercise price - stock price - 0) the maximum profit from the position is capped, since the stock price cannot drop below zero (See the graph).

This is the preferred position of traders who:

Expect no change or a slight increase in the underlying price. Want to limit upside potential in exchange of limited downside protection.

The covered call strategy involves a short position in a call option and a long position in the underlying asset. The long position ensures that the short call writer will deliver the underlying price should the long trader exercise the option. With an out of the money call option, a trader collects a small amount of premium, also allowing limited upside potential. Collected premium covers the potential downside losses to some extent. Overall, the strategy synthetically replicates the short put option, as illustrated in the graph below.

Suppose on 20 March 2015, a trader uses $39,000 to buy 1000 shares of BP (BP) at $39 per share and simultaneously writes a $45 call option at the cost of $0.35, expiring on 10 June. Net proceeds from this strategy is an outflow of $38.650 (0.35*1,000 – 39*1,000) and thus total investment expenditure is reduced by the premium of $350 collected from the short call option position. The strategy in this example implies that the trader does not expect the price to move above $45 or significantly below $39 over the next three months. Losses in the stock portfolio up to $350 (in case the price decreases to $38.65) will be offset by the premium received from the option position, thus, a limited downside protection will be provided.

Risk of the strategy: If the share price increases more than $45 at expiration, the short call option will be exercised and the trader will have to deliver the stock portfolio, losing it entirely. If the the share price drops significantly below $39 e. g. $30, the option will expire worthless, but the stock portfolio will also lose significant value significantly a small compensation equal to the premium amount.

This position would be preferred by traders who own the underlying asset and want downside protection.

The strategy involves a long position in the underlying asset and as well as a long put option position.

An alternative strategy would be selling the underlying asset, but the trader may not want to liquidate the portfolio. Perhaps because he/she expects high capital gain over the long term and therefore seeks protection on the short run.

If the underlying price increases at maturity, the option expires worthless and the trader loses the premium but still has the benefit of the increased underlying price which he is holding. On the other hand, if the underlying price decreases, the trader’s portfolio position loses value but this loss is largely covered up by the gain from the put option position that is exercised under the given circumstances. Hence, the protective put position can effectively be thought of as an insurance strategy. The trader can set exercise price below the current price to reduce premium payment at the expense of decreasing downside protection. This can be thought of as deductible insurance.

Suppose for example that an investor buys 1000 shares of Coca-Cola (KO) at a price of $40 and wants to protect the investment from adverse price movements over the next three months. The following put options are available:

15 June 2015 options.

The table implies that the cost of the protection increases with the level thereof. For example, if the trader wants to protect the investment portfolio against any drop in price, he can buy 10 put options at a strike price of $40. In other words, he can buy an at the money option which is very costly. The trader will end up paying $4,250 for this option. However, if the trader is willing to tolerate some level of downside risk, he can choose less costly out of the money options such as a $35 put. In this case, the cost of the option position will be much lower, only $2,250.

Risk of the strategy: If the price of the underlying drops, the potential loss of the overall strategy is limited by the difference between the initial stock price and strike price plus premium paid for the option. In the example above, at the strike price of $35, the loss is limited to $7.25 ($40-$35+$2.25). Meanwhile, the potential loss of the strategy involving at the money options will be limited to the option premium.

Options offer alternative strategies for investors to profit from trading underlying securities. There's a variety strategies involving different combinations of options, underlying assets and other derivatives. Basic strategies for beginners are buying call, buying put, selling covered call and buying protective put, while other strategies involving options would require more sophisticated knowledge and skills in derivatives. There are advantages to trading options rather than underlying assets, such as downside protection and leveraged return, but there are also disadvantages like the requirement for upfront premium payment.

Options Basics.

Here are a few things you absolutely need to understand before this Playbook will make as much sense to you as we hope it will. Some of you probably already know these terms and concepts, or at least think you do. But how will you really know you know them unless you read this section? Therein lies the paradox.

Of course, if you’re a seasoned veteran or MVP, by all means skip right ahead to the option strategies. And for you rookies, well, read on. We’ll try to keep it interesting.

Throughout the site we talk about the “stock” that options are based on. That’s a bit of an oversimplification. Actually, options can be traded on several kinds of underlying securities. Some of the most common ones are stocks, indexes, or ETFs (Exchange Traded Funds). So feel free to substitute these terms to match your preferred style of trading.

Options are contracts giving the owner the right to buy or sell an asset at a fixed price (called the “strike price”) for a specific period of time . That period of time could be as short as a day or as long as a couple of years, depending on the option. The seller of the option contract has the obligation to take the opposite side of the trade if and when the owner exercises the right to buy or sell the asset.

Here’s an example of a standard quote on an option.

Call Options.

When you buy a call, it gives you the right (but not the obligation) to buy a specific stock at a specific price per share within a specific time frame. A good way to remember this is: you have the right to “call” the stock away from somebody.

If you sell a call, you have the obligation to sell the stock at a specific price per share within a specific time frame — that’s only if the call buyer decides to invoke their right to buy the stock at that price.

Put Options.

When you buy a put, it gives you the right (but not the obligation) to sell a specific stock at a specific price per share within a specific time frame. A good way to remember this is: you have the right to “put” stock to somebody.

If you sell a put, you have the obligation to buy the stock at a specific price per share within a specific time frame — that’s only if the put buyer decides to invoke their right to sell the stock at that price.

Using Calls and Puts in More Complex Strategies.

Much of the time, individual calls and puts are not used as a standalone strategy. They can be combined with stock positions and/or other calls and puts based on the same stock.

When this is the case, the strategies are called “complex”. This term does not imply they are hard to understand. It just means these strategies are built from multiple options, and may at times also include a stock position.

You’ll find out about the various uses of calls and puts when we examine specific option strategies.

Learn trading tips & strategies.

from Ally Invest’s experts.

Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.

Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. You alone are responsible for evaluating the merits and risks associated with the use of Ally Invest’s systems, services or products. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

Securities offered through Ally Invest Securities, LLC. MemberВ FINRAВ andВ SIPC. Ally Invest Securities, LLC is a wholly owned subsidiary of Ally Financial Inc.

Options Basics Tutorial.

Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, known as options, presents a world of opportunity to sophisticated investors who understand both the practical uses and inherent risks associated with this asset class.

The power of options lies in their versatility, and their ability to interact with traditional assets such as individual stocks. They enable you to adapt or adjust your position according to many market situations that may arise. For example, options can be used as an effective hedge against a declining stock market to limit downside losses. Options can be put to use for speculative purposes or to be exceedingly conservative, as you want. Using options is therefore best described as part of a larger strategy of investing.

This functional versatility, however, does not come without its costs. Options are complex securities and can be extremely risky if used improperly. This is why, when trading options with a broker, you'll often come across a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Options belong to the larger group of securities known as derivatives. This word has come to be associated with excessive risk taking and having the ability crash economies. That perception, however, is broadly overblown. All “derivative” means is that its price is dependent on, or derived from the price of something else. Put this way, wine is a derivative of grapes; ketchup is a derivative of tomatoes. Options are derivatives of financial securities – their value depends on the price of some other asset. That is all derivative means, and there are many different types of securities that fall under the name derivatives, including futures, forwards, swaps (of which there are many types), and mortgage backed securities. In the 2008 crisis, it was mortgage backed securities and a particular type of swap that caused trouble. Options were largely blameless. (See also: 10 Options Strategies To Know .)

Properly knowing how options work, and how to use them appropriately can give you a real advantage in the market. If the speculative nature of options doesn't fit your style, no problem – you can use options without speculating. Even if you decide never to use options, however, it is important to understand how companies that you are investing in use them. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

This tutorial will introduce you to the fundamentals of options. Keep in mind that most options traders have many years of experience, so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with how the stock market works, you might want to check out the Stock Basics tutorial first.

Option Basics and Basic Trading Strategies.

Here I want to cover some of the option basics. In particular I want to focus on understanding the motivation behind buying or selling an option. From there, we'll look at some basic option strategies to better understand the building blocks to more advanced strategies.

If you are brand new to options, see 'what is an option contract?' before going into some of the option basics I'll discuss here.

One reason people are often intimidated by options is that they appear very complex. Yes, there are a lot more variables to them than simply trading a stock, but let's try to simplify some of the basic options concepts to get you started. Later, we'll add additional concepts as they are needed.

Most people think about options in terms of buying a call or buying a put. If I buy a call, I will generally make money when the underlying instrument (stock) goes up. If I buy a put, I will generally make money when the underlying instrument (stock) goes down.

Now, let me ask you this. if I am the buyer of an option, who is the seller?

The answer is. the options market maker.

Market Makers and the other side of the options trade.

In the options market, there is a market maker who MUST take the other side of your order if it is at his ask price (if he is selling) or bid price (if he is buying). Ok, this may seem to be going beyond option basics. but trust me, this is really important to understand.

The market maker doesn't just sell options, he may buy them as well to offset his risk, to lower position sizes and so forth. So, an option contract he sells me may in fact be a contract he bought from someone else.

Who is that person? They may be possibly another retail options trader or an institutional investor. In that case, the other trader is the one who has the opposing expectation.

I may buy a call option because I expect the stock to go up, but they sell the call option because they expect the stock to go down or at least stay below the strike price they sold.

Likewise, I may have bought a put option because I expect the stock to go down, but the other trader sold me the put option expecting the stock to stay above the sold strike price.

Obviously, someone will be right in that trade and someone will be wrong. The question is. who has the better odds?

Why buying options can be risky.

To help understand this point better, let me illustrate. Let's say I'm bullish on POT (Potash Corp) and would like to take advantage of an upward move. I might buy the $90 call for $5.80. For me to make any money on this trade, what must happen? POT must be at least $95.80 by expiration just for me to break even. If POT made a sharp move up in just a few weeks, I may make a nice return on this trade.

Now, let's look at the other side of the trade. Assume the seller of the $90 call is currently holding 100 shares of POT they bought at today's market price ($86) and sell me the $90 call for $5.80. What do they want to have happen? If the stock goes nowhere by expiration, they keep the $5.80 and their cost basis is now $80.20 ($86 - $5.80).

If the stock goes up to $89.95 by expiration, they still get to keep the $5.80 AND they could sell the stock for a combined profit of $9.75. That's an 11% ROI in just 4-6 weeks. Alternatively, they could simply sell another call for $90 or even $95 for the next month and take in some additional premium.

Let's review the two sides quickly then.

A. I buy a call option and I need it to move A LOT to make money.

B. I sell a call option and I win if the stock goes up a little, down a little or the stock just plain goes nowhere.

Which trade has more risk? I think buying options does. Does that mean I don't buy options?

No. it just means I buy them with the awareness that the odds favor the seller more than the buyer.

Basic options trading strategies.

Now that I've covered some of the option basics, let's review some basic options strategies that could be constructed from a call option or put option.

The key point of this section was to lay a foundation of option basics. Before you can understand and be successful with any of the advanced strategies, it is important to make sure you have the basic options concepts down.

Options Trading.

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