Options trading offers a different, exciting and higher risk way to day trade. Get practicing with options using these 5 options trading strategies for beginners.
Everybody likes to have options in their life – options lead to choices and often the more options you have, the better your chance of making a good choice!
What is options trading?
Options are a derivative contract that gives buyers rights but not the responsibility to buy or sell a security at a chosen price at some point in the future.
Derivatives are financial contracts, between two or more parties, where the value is derived from an underlying asset, group of assets, or benchmark.
Option buyers are charged an amount called a premium by option sellers. An option premium is the current market price of an option contract. The premium is therefore the income received by the seller of an option contract and the cost to an option buyer.
Options can either be call or put contracts. With a call option, the buyer of the contract purchases the right to buy the underlying asset in the future at the strike price. With a put option, the buyer gains the ability to sell the underlying asset in the future at the predetermined price.
Benefits of day trading options strategies
There are many benefits of trading options, but the two reasons that many choose to begin experimenting with them are:
- Requires a lower initial capital compared to purchasing shares directly
- Magnifies the potential returns
For example, let us say a trader wants to invest $5,000 in PayPal, trading at around $165 per share. With this amount, they can purchase 30 shares for $4,950.
If instead, this was a call option with a strike price of $165 that expires a month from now costing $5.50 per share (5.50 x 30 = 165), this can buy nine options for a cost of $4,950. As the option contract controls 100 shares, the trader is effectively making a deal on 900 shares.
Furthermore, there is also a limited downside for option buyers. When you buy a put or call option, you don’t have to take on the trade. If your assumptions on the direction are wrong your losses are limited to whatever you paid for the contract (the premium) and trading fees.
There is also more flexibility for the trader, rather than simply having to cut a trade at a loss as it went in the opposite direction to what they thought. With Options Trading a potential investor could decide to embark on one of the following.
· Buy the shares to add to their respective portfolio
· Buy the shares and then sell a portion or all of them
· Sell the Profitable Options contract to another investor
· Potentially make back some of the money spent on an unprofitable option by selling the contract to another investor before it expires
· Buy or sell the stock at the strike price at any given time before the option con-tract expires.
Risks when trading options
However, just like most things in life options trading also has its risks in addition to its benefits.
Firstly, options expose sellers (not buyers) to unlimited losses. When an investor writes a put, he or she is obligated to sell shares at a specified price within the contract’s time frame, even if the price goes against them with there being no limit on how high a stock price can rise.
Secondly, Options traders are looking to capitalize on short term price movement requiring them to not only pick the right time to buy but also when to sell before the option expires.
Best options trading strategies for beginners
1 Long Calls
A long call is simply buying a call option. You would purchase a call option if you believe that the stock is going to rise.
For example, let's say a stock is trading at $40. If you believe that the stock will go up, you could consider purchasing a $45 call. With the premium being $2.
You would lose the full $2 in premium if the stock closes upon expiration below $45 but the maxi-mum gain is potentially unlimited.
The breakeven is the strike price and the premium. In this example, if the stock closed at $47, you would gain $2 on the trade itself (buying at $45 and selling at $47). This would neutralise the $2 in premium amount.
2 Long Puts
The long put is a strategy in options trading where the investor buys an option to profit from the belief that the price of the underlying asset will go below the strike price before the expiration date.
For Example, a trader believes Roche is going to decline in a couple of months. A long-put option contract can be acquired, set to expire in three months, with a strike price of $100 per share, and a premium of $3 per share.
Eventually, the shares fall and are selling for $50. You buy the shares at $50 each, exercise your op-tion, and sell them for $100 each, making $47 per share in the process.
If however, the shares rise to $150, the trader only loses the premium they paid of $3 per share.
3. Short Puts
A short put is when an investor sells the right to sell short the option’s underlying asset for a speci-fied price.
For example, let's say that a trader writes a short put option and receives a $2 premium for each share. The trader (option writer) issues a $15 put strike price.
As long as the price remains above $15 per share, the buyer of the put option will have no reason to exercise the option and the trader (seller) can net the full $40 profit from the premium.
If however, the underlying asset price drops to $10. The investor would then give the option buyer the ability to sell the stock at the $15 a share level. The seller is entering the market by adopting a market position that has a $5 loss for every share.
The loss is partly nullified by the $2 premium per share that he received for the sale of the option, meaning the net loss would be $3 per share or $60 total.
4. Covered Calls
A covered call is done by holding a long trade in stock and also selling call options on the same stock for the same size as the long trade.
The purpose of doing so is to make some money from stock ownership while the stock is flat or to limit downside risk if the stock starts going down.
For example, let's assume an investor buys XYZ stock for $50 per share believing it will rise to $60 within one year. They are willing to sell a call option at $55 within six months, potentially giving up further long term profits if the shares keep rising to take a shorter-term profit with the premium.
If the underlying price reaches $55 level within 6 months. The investor gets to keep the $4 in pre-mium plus the $55 from the share sale, for the grand total of $59, or an 18% return over six months.
However, if for example the stock falls to $40, they face a $10 loss on the original position but can keep the $4 premium from the sale of the call option, lowering the total loss from $10 to $6 per share.
5. Married Put
A married put is an options trading strategy that involves an investor buying a put option for a stock that they own.
This would normally be done if the investor wants to keep the long position but believes the stock will drop over the short-term (before the put option expiry), offering some downside protection.
For example, a stock is trading at $50 per share.
An investor may choose to purchase some shares with a $45 put option at a $2 premium.
If the stock’s price falls to $42 per share, the loss is limited to $5 per share ($50-$45) plus the pre-mium of $2 per share. That’s because the put option can be exercised at $45, meaning losses be-low 45 are matched by the profit from the option.
On the other hand, if the stock’s price rises to $80. The investor can allow the put option to expire worthless since there is nothing to gain by exercising it. The investor could sell the shares initially purchased for $50 for a $30 profit, minus the $2 premium paid for the put option.