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Options Trading Lessons: A Beginner’s Guide

Options Trading Lessons – Options trading is a form of financial trading that involves buying and selling contracts that give the right, but not the obligation, to buy or sell an underlying asset at a specified price and time. Options trading can be used for various purposes, such as hedging, speculation, income generation, or portfolio diversification.

However, options trading also involves significant risks and complexities and requires a lot of knowledge and skills to master. In this blog post, we will cover some of the basic options trading lessons that every beginner should know, such as:

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  • What are options and how do they work?
  • What are the types and characteristics of options?
  • What are the factors that affect options prices?
  • What are the common options trading strategies and how to use them?
  • What are the benefits and drawbacks of options trading?
  • What are the best resources and tools for learning and practicing options trading?

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What are options and how do they work?

Options are contracts that give the buyer (the option holder) the right, but not the obligation, to buy or sell an underlying asset (such as a stock, an index, a commodity, or a currency) at a predetermined price (the strike price) and time (the expiration date). The seller (the option writer) of the option receives a fee (the premium) from the buyer for granting this right. The buyer can exercise the option at any time before or on the expiration date, depending on the type of the option. The seller is obligated to fulfill the contract if the buyer exercises the option.

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There are two main types of options: call options and put options. A call option gives the buyer the right to buy the underlying asset at the strike price, while a put option gives the buyer the right to sell the underlying asset at the strike price.

For example, if you buy a call option on Apple (AAPL) with a strike price of $150 and an expiration date of June 30, 2023, you have the right to buy 100 shares of AAPL at $150 per share on or before June 30, 2023. If you buy a put option on AAPL with the same strike price and expiration date, you have the right to sell 100 shares of AAPL at $150 per share on or before June 30, 2023.

Options trading is based on the concept of leverage, which means that you can control a large amount of the underlying asset with a small amount of money. For example, if AAPL is trading at $160 per share, you can buy a call option with a strike price of $150 and a premium of $10 per share, which means that you pay $1,000 ($10 x 100) to buy the option. If AAPL rises to $170 per share, you can exercise the option and buy 100 shares of AAPL at $150 per share, which means that you pay $15,000 ($150 x 100) to buy the shares.

Then, you can sell the shares at $170 per share, which means that you receive $17,000 ($170 x 100) from selling the shares. Your profit is $1,000 ($17,000 – $15,000 – $1,000), which is a 100% return on your investment ($1,000). However, if AAPL falls to $140 per share, you can let the option expire worthless and lose your entire investment ($1,000), which is a 100% loss on your investment ($1,000).

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What are the types and characteristics of options?

Options can be classified into different types and categories based on their characteristics, such as:

The style of the option

This refers to when the option can be exercised by the buyer. There are two main styles of options: American options and European options. American options can be exercised at any time before or on the expiration date, while European options can be exercised only on the expiration date. Most stock options are American options, while most index options are European options.

The moneyness of the option

This refers to the relationship between the strike price and the current market price of the underlying asset. There are three main states of moneyness: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM). An option is ITM if exercising it would result in a profit, ATM if exercising it would result in a break-even, and OTM if exercising it would result in a loss.

For example, if AAPL is trading at $160 per share, a call option with a strike price of $150 is ITM, a call option with a strike price of $160 is ATM, and a call option with a strike price of $170 is OTM. The opposite is true for put options.

The intrinsic value and the time value of the option

This refers to the components of the option premium. The intrinsic value is the amount by which the option is ITM, and the time value is the amount by which the option premium exceeds the intrinsic value. The intrinsic value represents the immediate profit that the option holder can make by exercising the option, while the time value represents the potential profit that the option holder can make by holding the option until expiration.

For example, if AAPL is trading at $160 per share, a call option with a strike price of $150 and a premium of $15 has an intrinsic value of $10 ($160 – $150) and a time value of $5 ($15 – $10). The intrinsic value of an option can never be negative, while the time value of an option can be zero or positive.

What are the factors that affect options prices?

Options Trading Lessons

Options prices are determined by the interaction of supply and demand in the options market, as well as by various factors that influence the expectations and preferences of the buyers and sellers of options. Some of the main factors that affect options prices are:

The price and volatility of the underlying asset

The price and volatility of the underlying asset are the most important factors that affect options prices. Generally, the higher the price and volatility of the underlying asset, the higher the options prices, and vice versa. This is because the higher the price and volatility of the underlying asset, the higher the probability and magnitude of the option being ITM, and the higher the value of the option.

The strike price and the expiration date of the option

The strike price and the expiration date of the option are also important factors that affect option prices. Generally, the lower the strike price of a call option or the higher the strike price of a put option, the higher the options prices, and vice versa.

This is because the lower the strike price of a call option or the higher the strike price of a put option, the higher the intrinsic value of the option. Similarly, the longer the expiration date of the option, the higher the option prices, and vice versa. This is because the longer the expiration date of the option, the higher the time value of the option.

The interest rate and the dividend yield of the underlying asset

The interest rate and the dividend yield of the underlying asset are also factors that affect options prices but to a lesser extent than the previous factors. Generally, the higher the interest rate or the lower the dividend yield of the underlying asset, the higher the call options prices and the lower the put options prices, and vice versa.

This is because the higher the interest rate or the lower the dividend yield of the underlying asset, the higher the opportunity cost of holding the underlying asset instead of the option, and the higher the value of the option.

What are the common options trading strategies and how to use them?

Options trading strategies are combinations of buying and selling options with different characteristics to achieve a specific risk-reward profile. There are many options trading strategies, but some of the most common ones are:

Covered call

This is a strategy where you own the underlying asset and sell a call option on it. This strategy allows you to generate income from the option premium and benefit from a moderate rise in the price of the underlying asset. However, this strategy also limits your upside potential and exposes you to downside risk.

For example, if you own 100 shares of AAPL at $160 per share and sell a call option with a strike price of $170 and a premium of $5, you receive $500 ($5 x 100) from selling the option. If AAPL rises to $180 per share, you have to sell your shares at $170 per share, which means that you miss out on the extra $10 per share profit.

Your total profit is $1,000 ($10 x 100 + $5 x 100). If AAPL falls to $150 per share, you lose $10 per share on your shares, which is partially offset by the $5 per share premium. Your total loss is $500 ($10 x 100 – $5 x 100).

Protective put

This is a strategy where you own the underlying asset and buy a put option on it. This strategy allows you to protect your downside risk and benefit from a moderate rise in the price of the underlying asset. However, this strategy also reduces your net profit and requires you to pay the option premium.

For example, if you own 100 shares of AAPL at $160 per share and buy a put option with a strike price of $150 and a premium of $5, you pay $500 ($5 x 100) to buy the option.

If AAPL rises to $170 per share, you can sell your shares at $170 per share, which means that you make $10 per share profit. However, your net profit is reduced by the $5 per share premium. Your total profit is $500 ($10 x 100 – $5 x 100).

What are the benefits and drawbacks of options trading?

  • Options trading can provide leverage, which means that you can control a large amount of the underlying asset with a small amount of money. This can magnify your potential returns, as well as your potential losses.
  • Options trading can offer flexibility, which means that you can customize your risk-reward profile and tailor your strategies to different market conditions and scenarios. You can also use options to hedge your existing positions or create synthetic positions.
  • Options trading can enhance your income, which means that you can generate extra cash flow from selling options or collecting premiums. You can also use options to lower your cost basis or improve your entry and exit points.

In conclusion, Options trading is a form of financial trading that involves buying and selling contracts that give the right, but not the obligation, to buy or sell an underlying asset at a specified price and time. Options trading can be used for various purposes, such as hedging, speculation, income generation, or portfolio diversification. However, options trading also involves significant risks and complexities and requires a lot of knowledge and skills to master.

Options Trading Lessons – Frequently Asked Questions

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