Essential Options Trading Tips for Beginners
Explore essential tips for beginners in this quick guide to options trading. From key terms to basic strategies.
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Options Basics
Options are contracts that grant buyers the right, but not the obligation, to buy or sell a security at a predetermined price in the future.
Buyers pay a premium for this privilege. If market conditions are unfavorable, option holders can let the option expire without exercising it, limiting potential losses to the premium paid. Options are categorized as "call" or "put" contracts, allowing buyers to purchase or sell the underlying asset at a specified price.
Beginner investors can employ various strategies using calls or puts to manage risk, including directional bets and hedging techniques.
Buying Calls (Long Calls)
Trading options offers advantages for those who want to make a directional bet in the market.
It allows traders to buy call options, which require less capital than purchasing the underlying asset, and limits losses to the premium paid if the price goes down. This strategy is suitable for traders who are confident about a specific stock, ETF, or index fund and want to manage risk.
Additionally, options provide leverage, enabling traders to amplify potential gains by using smaller amounts of capital compared to trading the underlying asset directly. For example, instead of investing $10,000 to buy 100 shares of a $100 stock, traders can spend $2,000 on a call contract with a strike price 10% higher than the current market price.
Buying Puts (Long Puts)
Put options provide the holder with the right to sell the underlying asset at a predetermined price before the contract expires.
This strategy is favored by traders who hold a bearish view on a specific stock, ETF, or index but want to limit their risk compared to short-selling.
It also allows traders to utilize leverage to capitalize on declining prices. Unlike call options that benefit from price increases, put options increase in value as the underlying asset's price decreases.
While short-selling also profits from price declines, the risk is unlimited as prices can theoretically rise infinitely. In contrast, if the underlying asset's price exceeds the strike price of a put option, the option simply expires without value.
Covered Calls
A covered call strategy involves selling a call option on an existing long position in the underlying asset.
This approach is different from simply buying a call or put option. Traders who use covered calls expect little or no change in the underlying asset's price and want to collect the option premium as income. They are willing to limit the upside potential of their position in exchange for some downside protection.
Risk/Reward
A long straddle strategy involves purchasing both a call option and a put option simultaneously.
While the cost of a long straddle is higher than buying either a call or put option alone, the maximum potential loss is limited to the amount paid for the straddle. On the other hand, the potential reward is theoretically unlimited on the upside. However, the downside is capped at the strike price.
For example, if you own a $20 straddle and the stock price drops to zero, the maximum profit you can make is $20.
