How to Trade Options?

Updated on January 4, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

How To Trade Options Definition

How to trade options refer to the ways in which investors can take a trade to make maximum profits. There is a series of steps and strategies that one must follow to take fruitful trades. Trading options in the stock market is a crucial affair as it involves a considerable amount of risk.

How-to-Trade-Options

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Thus, one must learn how to trade options to ensure they avoid losses and make profits in whatever trade they take., For investors, it is important to understand the markets and techniques before entering into a trade as it will help in optimum utilization of the situation, trader’s capital, and futuristic view of markets in order to generate maximum profits and/or to minimize losses to the trader.

Key Takeaways

  • Before trading options, it’s essential to understand how options work, including their types, pricing, and potential risks and rewards.
  • Determine your objectives and select a trading strategy that aligns with your goals, whether buying call or put options, selling covered calls, or using complex strategies like spreads or straddles.
  • Conduct thorough research on the underlying asset, market conditions, and any factors impacting the option’s value. Use technical and fundamental analysis to identify potential entry and exit points.
  • Set clear risk management guidelines, including determining your maximum loss and implementing stop-loss orders. Consider position sizing, diversification, and risk-reducing techniques such as hedging or protective options.

How To Trade Options Explained

How To trade options is one of the most important things to explore before any investor/trader begins trading. Trading into options is an important market component, and hence, this product should be studied well before making investments. With a proper understanding of market movements, one can make decent positive cash flows from the markets.

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For people to take trades, it is vital to learn about the market scenarios, analyze the trends, and then decide where to invest. The most important aspects of trading options include:

Understanding Markets

The first and foremost requirement is to have a market view. Options are of 2 types – a call and a put. In trading a call, the investor should have a bullish view of the market, and vice-versa for a put. However, the view should be based on an analysis of the market and political events. Markets are moved by sentiments; hence having the right view is very important for earning profits.

The Right Product

Investors must look for the right product based on the type of market that exists at that point in time. The market can be bullish or bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more and based on the same, they can choose their trading options. Let us look at some of the alternatives that traders might get.

The Right Investment

Exercising a long call or put options have unlimited profits and limited losses in the respective pro-market while exercising a short call or put options would have limited profits but unlimited losses in another scenario. Hence, choosing the right investment is very important for the required cash flow.

Once the right market, right product, and right investment are identified, traders can take a trade, which is most likely to yield good returns. However, nothing is guaranteed in options trading. The fluctuations, sometimes, may turn one’s dream deal into a nightmare or a casual trade into one’s dream trade.

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Ways to Trade Options

Once the investors understand the market, identify the right product, and assess the market trends, they learn about how to go about trading options. Listed below are a few ways or platforms through which traders can take trade:

Through Standardized Platforms

There are registered market vendors providing trading platforms to its customers who offer standard option products and, in exchange, charge a fixed commission. These are open to all investors, upon completion of basic authenticity requirements by the service provider.

Brokers

Trading into options can be executed through the registered broker (individuals or broker firms), who complete the client requirements in the market with other parties, and in exchange charge commissions. The commission varies with the standard platform-based commission. In such transactions, brokers may provide the advisory function to their clients to help them make investing decisions. The client may even opt for exotic and/or customized products by paying a little higher commissions.

Self Investments

Bigger firms hold their own trading booksTrading BooksTrading book is the type of book maintained by the bank, financial institution or a stockbroker banks for recording the transactions of the clients who have given them an opportunity to act as the broker or middle person for dealing in securities. read more as well, apart from providing a platform for trading such options to their clients. Such firms earn from their own risk holding activity into the markets.

Since options are traded on exchange globally, they are regulated with standard provisions. There is hardly any scope of adulteration with outside the market arbitrage. Hence, investors can be secured from their investments.

Formula

The below table signifies In-the-moneyIn-the-moneyThe term "in the money" refers to an option that, if exercised, will result in a profit. It varies depending on whether the option is a call or a put. A call option is "in the money" when the strike price of the underlying asset is less than the market price. A put option is "in the money" when the strike price of the underlying asset is more than the market price.read more (ITM), At-the-money (ATM) or Out-of-the-money (OTM) cash flows on options:

ProductITMATMOTM
CallSpot > StrikeSpot = StrikeSpot <Strike
PutSpot < StrikeSpot = StrikeSpot > Strike

The above cash flows should be net of option premium.

The premium of the option is the cost to purchase that option (long or short, call or put), driven by the intrinsic value of the underlying and time to maturity of the option.

Hence,

Premium = Time Value + Intrinsic Value

As the option approaches maturity, the time value portion of the option starts reducing, and just before maturity, the premium comes near 0.

Examples

Let us consider the following examples to check how the how to trade options work:

Example #1

Call A is traded at $5. An investor with a bullish view goes long call A at the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more of $105. Calculate the profit/loss at the end of maturity if the Spot at maturity is $115. Also, comment if the call was ITM/ATM/OTM to the investor.

Solution:

  • Strike Price: $105
  • Call premium: $5
  • Spot Price: $115

Total cost paid by investor: $105 + $5 = $110

As Spot in the market is $115, the investor can purchase the underlying at $105 and sell the same at $115, making a profit of $10 on the underlying.

However, net profit = Profit – premium = $10 – $5 = $5.

How to Trade Options Example 1

This call is ITM to the investor.

Example  #2

Put B is being traded at $5. An investor with a bearish view goes long putLong PutLong put is a strategy used in options trading by the investors while purchasing a put option with a common belief that particular security's price shall go lower than its striking price before or at the arrival of the date of expiry.read more B at the strike price of $95. Calculate the profit/loss at the end of maturity if the Spot at maturity is $105. Also, comment if the put was ITM/ATM/OTM to the investor.

Solution:

Total cost to be paid by investor: $105 + $5 = $110

However, as Spot in the market is $105, the investor would make a loss if he purchases the underlying at $105 and sells the same at $95. In this scenario, since he is “long” the option, he has a choice to either exercise the same at maturity or not.

How to Trade Options Example 2

If he exercises the option, he will make a loss of $10 (plus the premium paid @$5 to make a total of $15 loss).

However, he would not exercise the option and be restricted to a loss of only the premium amount of $5 paid to purchase the option.

This call is OTM to the investor.

Benefits & Risks

It might be easy to learn how to trade options, getting used to the process and becoming an expert takes time. It is a gradual process, which is likely to make amateur traders come across a lot of challenges besides helping them reap good profits. Here is a list of benefits and risks that trading options bring to the table.

 Advantages

  • The benefit of limiting losses by going long on options.
  • The benefit of investing now for future expected profits. Sometimes the earnings are much more than expected earnings if the future expected event performs well beyond expectations.
  • Investment can be minimal, and risk can be taken on the much larger underlying value, which is not the case while investing in cash stocks.
  • It creates a huge leveraged network for investors in the entire market. Enhances the value of money.

Disadvantages

Frequently Asked Questions (FAQs)

What are the key factors when selecting an options trading strategy?

When selecting a strategy, consider your risk tolerance, investment objectives, time horizon, and market outlook. Different methods have varying risk-reward profiles and suit other market conditions, so choose one that aligns with your preferences and expectations.

What are the key factors when selecting an options trading strategy?

When selecting a strategy, consider your risk tolerance, investment objectives, time horizon, and market outlook. Different methods have varying risk-reward profiles and suit other market conditions, so choose one that aligns with your preferences and expectations.

How can I determine the value of an options contract?

Options pricing is influenced by several factors, including the underlying asset’s price, time to expiration, implied volatility, interest rates, and the option’s strike price. Option pricing models, such as the Black-Scholes model, can help estimate an option’s value based on these factors.

What are the risks associated with options trading?

Options trading involves risks, including the potential loss of the entire investment. Market volatility, time decay, and changes in the underlying asset’s price can all impact the value of options. Understanding and managing these risks through proper risk management techniques is crucial.

This has been a guide to How To Trade Options and its Definition. Here, we explain the concept with examples, formula, benefits, and risks of trading stocks. You can learn more about derivatives from the following articles –

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