Wanna be an options trader?
Options traders are often seen as financial wizards, dealing with complex math and theoretical finance.
Terms like puts, calls, strike price, open volume, theta, and vega might sound complicated, exciting, and a bit scary.
True, options traders can create super complex positions with huge potential payoffs in specific situations (like predicting a security's price movement direction, distance, and timing all at once). But at the end of the day, options trading follows the same basic rules as any other type of trading.
In this easy-to-understand guide, we'll cover the essentials of options trading. From there, it's up to you to dive deeper!
Getting to Know Option Chains
Options trading begins with the option chain. Any security can have an option chain if there's a market for its options and an exchange that supports trading them. An option chain is a list of calls and puts for a security, sorted by expiry date and strike price.
Here's a quick breakdown:
- A call is an option to buy a security at a specified price on a certain future date.
- A put is an option to sell a security at a specified price on a certain future date.
The listed price (or premium) is what the last contract for that strike price and expiry date was traded for. Most option chains also show the current bid/ask spread for each contract. The expiry date is when the contract expires, and the strike price is the specified price at which the contract can be exercised.
For example, a call option on AAPL for September 17th at a $45 strike price allows the option contract owner to buy a certain number of AAPL stock units (usually 100 units per contract) at $45 each on September 17th.
An option chain is simply a list of contracts that traders can use to quickly find the exact contracts they're looking for. Most traders start by checking the expiry dates and then searching for the strike prices they're interested in.
Buyers vs. Sellers
For every options contract, there's a buyer and a seller. Options exchanges just act as middlemen between buyers and sellers, so there's always another trader as the counterparty to any options contract.
The seller (or "writer") of a contract is responsible for meeting the contract's terms on its expiry date. The buyer (or owner) of the contract has the right (but not the obligation) to exercise the contract's terms on the expiry date. The contract's owner can change as it's bought and sold before expiry, but the writer remains responsible no matter who owns the contract when it's exercised.
The writer collects the premium for writing the contract and profits when the cost of meeting their obligation is less than the premium collected. The owner pays for the right to exercise the contract and profits when the return from exercising the contract is greater than the premium they paid for it.
More Important Facts and Terms
Options trading has many important details, and it's crucial to understand them before you start trading. Here are some key details and terms:
- American and European Style Options: American style options can be exercised anytime before or on the expiry date, while European style options can only be exercised on the expiry date.
- Open Interest and Volume: Open interest is the total number of open contracts for that date and strike price. Volume is the number of those contracts traded that day.
- In and Out of the Money: These terms are used to describe how close an option's strike price is to the security's current price. Most open interest on a security will be in the money, and out of the money options will be relatively cheap or expensive compared to in-the-money options.
- Options Exchanges: These exchanges act as middlemen between writers and owners, allowing the buying and selling of existing contracts. The exchange takes a small fee from each trade, which is used as insurance against writers who fail to meet their obligations. Option writers need to register with the exchange and qualify to write options, but most exchanges allow anyone to trade options once they're written.
Exploring the Options Trading Universe
This brief guide might seem overwhelming, but it's just the beginning of options trading. With this info, you can confidently start your journey as a beginner options trader.
As you invest time and effort, your knowledge and experience in options trading will grow. Eventually, you'll find that everything makes sense and is intuitive. Before you know it, you'll be making sophisticated trades without even realizing how far you've come.