If you are new to options trading, it can be both exciting and nerve wracking. Options are a little more complex than traditional investments (such as stocks), and they can involve more risk. But once you understand how to trade options, they can help you implement your strategy, generate income, manage risk, and more.
So if you are approved to trade options, what’s the next step?
Learning the language of options
Before making your first options trade, it can help to be comfortable with some of the lingo and the unique characteristics of options. For example, you’ll want to understand:
- What options are. They are contracts that let you buy or sell an underlying asset (like a stock or ETF). For example, the buyer of an Apple call has the right, but not the obligation, to buy Apple’s stock. Each options contract typically controls 100 shares.
- The difference between calls and puts. The buyer of a call option has the right (but not the obligation) to buy an underlying asset before the contract expires, and the buyer of a put option has the right (but not the obligation) to sell an underlying asset before the contract expire.
- Buying vs. selling options. When you buy options, you use money at the outset of the trade. When you sell options, you generate money at the outset of the trade. There are some more complex strategies that involve both buying and selling options at the same time.
Understanding these foundational aspects of options can help you build a stronger options trading plan. You might even familiarize yourself with some frequently asked options questions. These include: What does it mean to exercise an option, what factors determine an options contract’s price, and what are options Greeks?
How to trade options in 5 steps
Ok, once you have a handle on some basic options terms, you can begin building a plan that makes sense for you. While there’s no exact process that you must follow, here’s a general 5-step plan that you could consider.
Step 1. Figure out how much risk you are willing to take
Deciding how much money you are comfortable putting at risk trading options can help you build a strategy that’s right for you. This might be a specific dollar amount or percentage of your investible funds. Remember that each options contract typically controls 100 shares (there are other, less popular types of options contracts, including nano and minis, that control a different number of shares), so be sure to consider this in your risk evaluation.
An aspect of this decision is how an options trade might impact the rest of your portfolio (e.g., are you taking on additional risk with an options trade or managing risk for some of your other investments). You’ll also want to decide which account you want to use for your options trade (e.g., individual account, IRA), as certain accounts may restrict some types of options strategies.
Step 2. Identify what you want to trade
Next, you need an outlook on a specific investment. There are a couple of key decisions to make here: What direction you think an investment may go (e.g., you think a specific stock will go up in value) and over what timeframe you think the investment could move in this direction (e.g., before the company’s next earnings announcement in a couple of months).
There are a variety of resources that can help you generate ideas, including market commentary, investing ideas, and screeners. You can make your own assessment of which direction an investment might go using company financial statements, charts, and other research tools. Many factors can impact how a stock performs. In particular, earnings reports and dividends are critical factors that can influence an underlying stock of an options contract.
Step 3. Pick a strategy
Once you know your outlook, you could then explore strategies. Important decisions for selecting your strategy include picking the expiration date and strike price. Unlike stocks, an options contract lasts a predetermined amount of time until its expiration date. The strike price is the price the underlying will transact upon exercise/assignment. For call options, the strike price is the price at which an underlying stock can be bought. For put options, the strike price is the price at which shares can be sold.
You can find options to trade in the options chain, where you can see all the calls and puts available for a specific stock, plus the expiration dates and strike prices.
What are some specific strategies that you can utilize? If you want to use options to implement a bullish outlook (i.e., you think an investment is likely to increase in price), you could buy call options or you could help limit your risk, but also your gain, with a more advanced strategy called a bull spread. If you want to implement a bearish outlook (i.e., you think an investment is likely to decrease in price), you could buy put options or you could help limit your risk, but also your gain, with a more advanced strategy called a bear spread.
There are a wide range of options strategies that you can explore to implement your strategy, including those that depend on volatility—such as straddles and strangles.
Step 4. Understand how volatility and probability influence options
It can sometimes be difficult to pick the right options contract for your strategy. Moreover, during the life of an options contract, circumstances can change, impacting the probability of success. Factors like changes in volatility can have a significant impact, so it can be helpful to set up and manage your trade with these factors in mind.
Helpful tools that you can use to help find the right contract for your objectives are the Options Trade Builder and Profit/Loss Calculator. These tools allow you to see what a trade might look like, and to visualize the risk and reward based on how time, volatility, and changes in the underlying asset’s price can affect an option's value.
Step 5. Have an exit plan
An important part of building your plan is having a system in place to monitor your options position as well as having an exit strategy. Because options contracts expire, this may require you to make some decisions along the way.
At times throughout the life of an options contract, you’ll want to ensure your initial outlook still aligns with the trade. You can decide whether to hold (take no action), roll (close out your current position to enter a new one with different characteristics), or close the trade.
These steps may help you go from being approved to trade options to actually placing your options trade. There are many different types of options strategies and nuances that can only be discovered with experience. But with time, you can learn what you need to optimize your options trading strategy.