Options trading is a bit complex compared to stock trading. In buying stock, you can decide on the unit of shares to buy, then the broker will fill the order. They will set it at your preferred limit price or the current market price.
However, when you are trading options, you need to understand advanced strategies. You also need to know the process involved in opening a trading account because it is different from the general investment account. You may want to read this article to find out the difference between options and stock trading.
How to Start Trading Options
You can follow these simple steps to start options trading:
1. Find Out What You Need to Open an Account
Options is a new world on its own and you must be ready for it. There will be new jargons to learn like puts, strike prices, calls, and so on. So, you have to approach the trading platform like you already know what you are doing.
An options account requires huge capital. As a result, the broker cannot hand over a trading license to you without asking certain questions. They will screen you to know your trading experience and to see if you understand the risk involved as well as your financial preparedness.
Before you open an account, you will provide the following:
- Investment objectives
- Trading experience
- Personal financial data
- The options type you choose to trade
Depending on the information you provide, the broker will assign you a trading level. You also need to screen the broker because they are important to your trade. Ensure that the broker offers research, support, tools, and guidance to you, as a new investor. You may want to check out https://www.optionstrading.org/glossary/ to find option trading terminologies and their definitions.
2. Decide the Direction of the Stock
This will determine the type of contract to pursue. If you predict that the stock price will appreciate, you can purchase a call. But if you predict that it will depreciate, you can purchase a put.
A call is an options contract that allows you to purchase stocks at predetermined prices (strike prices) within a time frame. A put, on the other hand, allows you to sell your shares before the expiration of a contract.
3. Predict the Low or High Movement of the Stock Prices
Your option is valuable if stock prices close the period of expiration “in the money”. This implies that they can either go below or above the strike prices. For a put, it goes below the strikes while for calls, it goes above the strikes. You will be happy to buy options with strike prices that reflect your predictions on the stock value.
For instance, if you predict that a company’s share price will rise from $100 to $120 around a certain date, you can purchase a call. The strike price will be lower than $120 in case it falls short, you won’t lose much. But if the stock appreciates above $120, the option is “in the money”.
In the same vein, if you predict that a share price will fall to $70, you can purchase a put. The strike price will be above $70 so that you can still make a profit at $70. If the value of the stock depreciates below your strike price, the option is “in the money”.
While this may appear simple, you cannot just choose a strike price. There are option chains or quotes that contain different strike prices. These quotes have standard increments between each strike price such as $10, $15, $20. They are also dependent on the stock prices.
Furthermore, the price of an option, known as the premium, is made up of 2 components: time value and intrinsic value. The difference between a strike and a share price, if the price of the stock is higher than the strike is called the intrinsic value. On the other hand, the time value refers to what is left after deriving the intrinsic value.
It factors in the volatility of the stock, interest rates, and the expiration time, among others. For instance, suppose you get a call of $100 and the stock is $110. Let us assume that the premium costs $15.
To get the intrinsic value, we will subtract the call from the stock price ($110 – $100) to get a value of $10. Therefore, the time value will be $5, which is what is left from the premium. You can check out an options trader named Jeff Clark if you want an experienced investor to guide you through the stock market.
4. Decide on the Duration of the Stock
We already mentioned that option contracts have expiry dates, which is the last time you can take action on the contracts. Just as you can’t choose any strike price, you also cannot choose any date. You can only choose from the dates offered at the time you put up the option chain.
An expiration date can vary from years, months to days. Weekly and daily options are the riskiest; they are best handled by seasoned traders. If you are investing for a long time, go for yearly and monthly expiration dates.
A long expiry date gives the stock enough opportunity to move, so your investment prediction can play out. You may want to go to this website to read about how to make a successful prediction with options.
Conclusion
Options trading may be complex, but an experienced investor can help to make it simple. We shared 4 steps to follow when you want to start trading. They are simplified so beginners can grasp the concept of options.