Investing with options— an advanced trader will tell you— is all about customization. Rewards can be high — but so can the risk— and your choices are plenty. But getting started isn’t easy, and there is potential for costly mistakes. Here’s a brief overview of option trading that cuts through the jargon and gets right to the core of this versatile way to invest.
Option trading is for the DIY investor.
Typically, option traders are self-directed investors, meaning they don’t work directly with a financial advisor to help manage their options trading portfolio. As a do-it-yourself (DIY) investor, you are in full control of your trading decisions and transactions. But that doesn’t mean you’re alone.
There are plenty of communities that bring traders together to discuss things like current market outlook and option trading strategies.
Most beginners start with stock options.
Options based on equities, more commonly known as “stock options,” typically are a natural lead for traders new to options. Stock options are listed on exchanges like the NYSE in the form of a quote. It is important to understand the details of a stock option quote before you make a move— like the cost and expiration date.
To help you get started, here’s the anatomy of a stock option quote.
As you can see in the example above, the stock option quote provides detailed information in compact form. Once you know what each segment represents, you can understand important details of the option contract— including the type, cost, and expiration date— at a glance.
There are different types of options.
Options are contracts that give the owner the right to buy or sell an asset at a fixed price for a specific period of time. That period could be as short as a day or as long as a couple of years, depending on the type of option contract. Fortunately, there are only two types of standard option contracts: a call and a put.
A call option contract gives the owner the right to purchase 100 shares of a specified security at a specified price within a specified time frame.
A put option contract gives the owner the right to sell 100 shares of a specified security at a specified price within a specified time frame.
It’s important to note, for both types of option contracts— a call or put— the owner is not obligated to exercise his or her right to buy or sell.
Options trade on different underlying securities.
Options can be used in many ways – to speculate or to reduce risk— and trade on several different kinds of underlying securities. The most common underlying securities are equities, indexes, or ETFs (Exchange Traded Funds).
There are quite a few differences between options based on indexes versus those based on equities and ETFs. It’s important to know the differences before you start trading.
Option trading is all about calculated risk.
If statistics and probability are in your wheelhouse, chances are volatility and trading options will be, too. As an individual trader, you really only need to concern yourself with two forms of volatility: historical volatility and implied volatility.
Historical volatility represents the past and how much the stock price fluctuated on a day-to-day basis over a one-year period.
Implied volatility is based on what the marketplace is “implying” the volatility of the stock will be in the future, over the life of the option contract.
Implied volatility is one of the most important concepts for option traders to understand because it can help you determine the likelihood of a stock reaching a specific price by a certain time. It can also help show how volatile the market might be in the future.
Option traders speak their own lingo.
When trading options, you can buy a call or sell a put. You can be long or short—and neither has anything to do with your height. Consequently, you can also be in-the, at-the, or out-the-money. Those are just a few of many commonly used words you’ll hear in a room full of option traders.
Simply put, it pays to get your terminology straight. That’s why we decided to create an option trading glossary to help you keep track of it all.
Option traders borrow from the Greeks.
We’re not talking about Aphrodite and Zeus. Options traders use the Greek Alphabet to reference how option prices are expected to change in the market, which is critical to success when trading options. The most common ones referenced are Delta, Gamma, and Theta.
Although these handy Greek references can help explain the various factors driving movement in option pricing and can collectively indicate how the marketplace expects an option’s price to change, the values are theoretical in nature. In other words, there is never a 100% guarantee that these forecasts will be correct.
Option trading starts with your financial goals.
Just like many successful investors, options traders have a clear understanding of their financial goals and desired position in the market. The way you approach and think about money, in general, will have a direct impact on how you trade options. The best thing you can do before you fund your account and start trading is to clearly define your investing goals.