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Brand New to Options? Learn the Basics Here

Option Trading is continuing to see a rise in popularity with traders-- and it's easy to see why.

You can take small amounts of capital and leverage it up for fast gains. You can also learn how to hedge your portfolio against drops in the market. Or maybe you could take the other side and become the "insurance salesman," collecting premium every month.

But with all of the opportunities, there is a fundamental lack of understanding as to how the options market works.

This guide about Option Trading Basics will get you the information you need to become a great options trader.

What is an Option, Anyways?

Options are a contract. That's it.

It's a contract between two parties to exchange something.

What are they exhanging? Risk.

Capital markets are risky by nature. Stocks go up, stocks go down-- sometimes they crash. Due to this risk, some investors want to remove some of that risk, and are willing to pay a risk premium for it.

The Risk Exchange in Options Trading

It's like car insurance. Driving is risky, and to protect yourself, you pay a risk premium to the insurance company so if anything really bad happens, you don't lose a ton of money.

Options are also a derivative. That means their price is derived from something. That "something" is simply the relationship with the underlying stock, and the risk premium people are willing to pay.

How the Price of an Option is Derived

Options are contracts that have an expiration date. If the buyer of the option does not use (exercise) that option before the date, then it will be rendered null and void.

Where Options Trade-- the Options Market

Since options are a contract, there will always be two sides to each trade. There will be an option buyer, and an option seller.

The buyer is looking to pay a premium to transfer risk. The seller is willing to accept that risk for a certain premium.

Because there are so many stocks and so many kinds of options, it makes sense to standardize the contracts.

For most options, the standard size of the contract is 100 shares.

Because the market is so big, it wouldn't make sense to have thousands of different people trying to call each other to match their needs. To solve this, we have a centralized options clearing organization to help match buyers and sellers. This organization is known as the Options Clearing Corporation (OCC).

All Standard Options are Cleared Through the OCC

There are differnet markets like the CBOE, Nasdaq, and the NYSE, but they are all participant exchanges within the OCC.

Why You Should Trade Options

When you trade stock, you can only bet on one thing:

Long or short. Up or down.

The only decision you make when trading stock

With options you have two extra components: risk, and time.

Because of these extra parts, you can make bets on the direction of the stock, how fast the stock will move, and how long will it take to get there.

Understanding how prices move over time will get you an edge in the options market.

In other words, many more options open up for you in your trading.

Want More? Get our Free Video Training Here.

Learn how to make money trading options, no matter where the market goes.


The Difference Between Stock and Options

A stock represents a share of a company. And because it's a fraction of a company, there is a fixed amount of stock-- this is known as the float.

With options, there is no fixed amount-- it is theoretically unlimited. The only time an option is created is when two parties come to an agreement on the risk pricing and they transact with one another. When this happens, open interest is created.

The open interest in an option refers to all contracts that are open and haven't been settled.

The Major Parts of a Stock Option

There are 4 main parts to a stock option.

Underlying: this is the stock or etf that the option is based upon. Because options are transactional in nature, there must be something to transact!

Strike: this is the value at which the transaction will take place.

Month: this is when the option will expire.-- that means the terms of the contract will expire on that expiration date. For standardized options the expiration date is on the third Saturday of that month.

Call or Put: This defines what "kind" of option it is, whether it's to buy or sell the underlying.

The Difference Between a Call Option and Put Option

There are two distinct kinds of options-- a call and a put.

A call option gives the buyer the right to purchase shares at a certain price, and it gives the seller the obligation to buy at a certain price.

A put option gives the seller the right to sell shares at a certain price, and it gives the seller the obligation to sell at a certain price.

The key difference lies in what the contract transaction looks like-- whether they want to buy or sell stock.

How You Can Trade Options

Due to high demand from retail investors, most all brokerages allow option trading in cash and margin accounts.

There are a few brokerages out there that still limit your ability to trade different kinds of option strategies. This is a bad idea because it removes your ability to manage risk through options adjustments. Either get full access to all strategies, or find a new broker.

What Happens if You Get Assigned

If you have a short option position on, there is a chance that you can get assigned. Keep in mind, that chance is very low.

If you are assigned, the transaction in the option will be carried out.

If you are short a put option, you will have shares put to you, and money will be debited out of your account. If you are already short the stock, then the short will be removed from your account.

If you are short a call position, you will have to come up with the shares to sell to the call buyer. If you already have the shares in your account then they will be removed and money will be credited to your account. If you don't have the shares you will be assigned a short stock position, and short margin will come into play.

How You Can Make Money Trading Options

There are two main ways traders make money with options.

The first way is directional trading. This is where traders will use the leverage and risk structure of options to make a bet on the movement in a stock price. There are advantages to options over stock because you can dictate exactly how much you are willing to risk on a bet.

The second way is volatility trading. This is where traders use the other two components-- risk and time-- to make bets on the market. If a trader is expecting less movement than what the market is pricing in, it's often called income trading.

These two kinds of money-makers are not exclusive. You can find ways to make bets on both direction and volatility, which gives you a distinct edge over other traders.

Can I daytrade with options?

Absolutely, but there are risks. Because you are using options on a short term basis, there are extra issues to deal with.

The first risk is liquidity risk. If you are going to daytrade options, you must make sure that the options you are trading are very liquid so you can enter and exit very easily.

The other risk is volatility risk. If you are trading in size, you become much more sensitive to movement in the implied volatility of the option. That means the profits you expected to make may vary much more than you think.

Also keep in mind that these are leveraged instruments, so if you are not successful at daytrading, the leverage can hurt your account.

Trading Options With Stock

Stock and option combinations are great opportuniteis for investors as they offer ways to get better prices on stocks they really want to own.

There are 4 main combinations of long stock positions.

The different risks of stock and option trading

The first is the cash-secured put. This is a trade where the investor is short a put with the intention of getting assigned. This is a great way to enter into a stock on a reduced basis.

The second is the buy-write, or covered call. This is a combination of long stock with a short call that is "covering" the stock. The premium received in the stock helps to reduce the cost basis of the position, and removes some of the overall risk in the position.

The third is a protected put. This is a combiation of long stock with a bought put. The investor pays a premium to remove downside risk underneath the strike price of the option. This is a good position if the investor wants to eliminate downside risk on a position but still wants upside exposure.

The fourth is a collar. This is long stock paired with a covered call and a protected put. This trade has limited risk from the protected put and limited reward from the covered call. This allows the investor to keep the stock position on but with much less volatility.

Want More? Get our Free Video Training Here.

Learn how to make money trading options, no matter where the market goes.