This article will be perfect for you if you’re new to options. It will act as a beginner guide to options, and I will make it as easy to understand as possible without filling you full of useless jargon. I’ll explain what options are, and then we’ll talk about the 5 things you need to know about them. These include:
- Strike prices.
- Expiration dates.
- The difference between calls and puts.
- Buying versus selling options.
- Understanding premium and theta decay.
And then I will give you 4 basic options trading strategies.
If you’re more experienced with options, but find them a little bit confusing and need a refresher, this will be time very well spent. We are going through many practical examples.
When people explain options, they make it far more complicated than it needs to be. With options, it’s very easy to get analysis paralysis.
This is why I’m only going to focus on what I would consider being the essential knowledge. At no point will I bore you with the things like the Black and Scholes model, or the buy nominal model. That’s not my style and never has been. I like to keep things as simple as possible.
There’s a quote by Einstein that encapsulates this:
“Everything should be made as simple as possible, but not simpler.”
If you’re brand new to options trading there are a lot of rabbit holes that you can go down. To trade the strategies that I trade The Wheel or The PowerX Strategy, you need to understand a few of the basics. Then you’ll have all the knowledge and confidence that you need to start trading them.
So we are going to discuss the basics and focus on just what you need to know to form a rock-solid options foundation.
Before we continue, this article is a part of our Options 101 For Beginner Series. This is a series of FREE on-demand video courses where you will learn the building blocks of options trading, the core concepts, how to avoid crushing mistakes, and much, much more. You can check out this free course HERE.
A Beginner Guide To Options: What Is An Option?
We can start this beginner guide to options by talking about the most important thing. What is an option?
An option is a contract that gives you the right, but not the obligation, to buy or sell 100 shares of a stock or ETF at a specific price or by a certain date.
This all sounds horribly complicated, but I will make this so much easier for you.
Stocks vs Options
There is the main difference between stocks and options. A stock represents ownership of a company whereas an option is just a contract that you can use to buy or sell those shares.
There are many advantages to buying options instead of buying the stock outright. One option contract always represents the right to buy 100 shares.
Options Example: AAPL
This beginner guide to options will have a lot of examples. Let’s do a very specific example using Apple. AAPL is trading at $173.07 (at the time of this writing this beginner guide to options). We’ll keep it simple and say $173.
If you were to buy 100 shares of Apple, then this means that you have to fork out 100 times $173. This comes to $17,300 total. But let’s see what happens if you would buy one option to control it.
Let’s take a look at an options chain for Apple with the broker I use, Tradier. The current price (at the time of this writing this beginner guide to options) is $173.
We are looking for an expiration of around two weeks out from now. And we want to see how much does an option cost so that we can buy 100 shares of Apple.
We are looking at calls, and we scroll down until we see a strike price of 173. There currently isn’t a strike price of 173, but we can buy the 172.50 call, which gives us a right to buy Apple shares at $172.50. Currently, the last price traded here was $5.35.
If we buy one option that gives us the right to buy 100 shares of Apple for $172.50, this would be $535 (premium we pay).
You can already see There is a big difference. $17,300, or $535. Here’s what’s interesting. What if Apple would go down, to let’s say to $160?
If we had the stock, this means that we lose $173 – $160 which means we are losing $13 per share. $13 multiplied by 100 means that we are losing $1,300. That’s if we owned the stock outright.
What about the option? So if we had the option, we cannot lose more than the premium that we paid which is $535. This means the maximum that we can lose here is $535.
As you can see, it makes much more sense to trade the option, which is limiting the downside risk here. When you’re buying a call option, you can never lose more than this.
Now the stock, what happens if Apple goes to zero? It’s a very unlikely scenario, but it’s still a possibility. Remember Enron and WorldCom?
With owning the Apple stock, you could lose up to $17,300. But, if you are buying options, you can only lose the premium that you paid for this contract, $535 in this case.
5 Things You Need To Know About Options
Now that you have a basic idea of what an option is from this beginner guide to options, there are five things that you need to know about options. These are Universal.
Number one is strike prices. The strike price is the price at which the underlying asset, that you can buy the option contract, is exercised. In the previous example, the underlying asset was the Apple stock.
You’ll choose the strike price at the time of purchase when you are buying or selling the option. Which strike price and stock price determines if your strike is “in the money,” “at the money,” or “out of the money.”
I’m going to use Apple as an example again. So for Apple right now, it’s trading at $173.
In The Money Calls (ITM)
This means that all the strike prices below the stock’s price are ITM, in the money for call options.
At The Money Calls (ATM)
Now, the strike price that is closest to the current price of the stock is ATM, or at the money. Since Apple is trading at $173, the strike price of 172.50 would be at the money.
Out Of The Money Calls (OTM)
Everything that is above the current price is out of the money.
The Opposite When Trading Puts
When you are trading puts, it’s exactly the other way around.
With the call, you get the right to buy this stock, and with the put, you actually have the right to sell this stock. So everything that is above the current price is in the money.
The at the money strike price doesn’t change. But everything that is trading below the current price is OTM, out of the money.
Strike Prices When Buying vs Selling
When you are a BUYER of options, you want to buy options that are in the money or at the money.
Same for put options, in the money or at the money. But, when you are SELLING options, then you want to sell options that are out of the money, OTM.
All options have an expiration date. On the expiration date, these options expire. All options have monthly expirations. Then there are some options with weekly expirations. It depends on your trading platform.
If we look at the tastyworks platform, you see that the weekly options have a W. Everything that does not show a W is a monthly option.
The expiration date is always specified as a Friday unless it’s a major holiday like Christmas 2020, which fell on a Friday. In this case, the expiration date was before the holiday.
Once an option expires, you no longer have the right to buy or sell the underlying stock at the specific strike price. Therefore, it’s very important that you choose the right expiration date.
How To Choose The Right Expiration Date
One goal of this beginner guide to options, is explaining what the right expiration date is. So let me give you a very broad outline here as a rule of thumb.
If you are an option BUYER you usually want to have a longer expiration date, because you want to give the stock more time to move in a direction. I personally like to use 30 days or more towards expiration.
Now, as an option seller, you want a shorter expiration date. For me, I usually want to have 14 days or less. We will talk more about this later in this article because it has something to do with time decay which is important.
Calls And Puts
The third things you need to know about options are calls and puts. I talked a little bit about this, but there are call options and put options.
Whether you’re trading The Wheel Strategy, The PowerX Strategy, or any other strategy you need to know when to use what instrument. Let’s take a look at both option types in more detail.
When you own a call option you have the right to buy a stock at the strike price before the expiration.
If the option has a strike price of 100, and the stock goes to a price of $110, you get to buy the stock at $100 per share instead of $110.
We’ll use AAPL as an example once again, and let’s say that you buy a call option at 175.
So this means that you can buy Apple for $175 on or before the expiration date, whichever we choose. Remember, you have the right to do this, but not the obligation.
If Apple is trading at $173 and you have the right to buy Apple at 175, this wouldn’t make sense at all. It’s better to buy Apple, if you would buy 100 shares, for $173. This is where intrinsic value comes into play.
If you can buy AAPL at $173 and the strike price is 175, the so-called intrinsic value of this option is zero. Absolutely nothing, because this call option right now is at the money or even out of the money.
It wouldn’t make sense to exercise this call option and buy the shares for $175. It is cheaper to buy just the stock outright at $173.
This call option would only be worth something if the stock moved above $175. But as long as the stock price of the stock remains $175, the call option is worthless.
Let’s take a look at another example with a different strike price. If Apple is trading right now at $173, and we buy a call option with a 175 strike price.
Let’s take a look at exactly how much it would cost if we go out to an expiration of April 14th. (All prices are from January 17th, the time of this writing). This gives us three months out.
How much does this currently cost? We have already determined it’s not worth anything right now. But if we are looking at this, then we see that right now, the last traded price is $8.68. This is where the expectations come in.
So this $8.68, all of this is the time value because right now the intrinsic value of the option is worth nothing. On the other hand, what if we go back here to the chart and look at an option that actually has some value, let’s just say we are looking at the 165.
The 165 call is in the money (ITM). Let’s see how much this would be worth, looking at the 165 strike price with the same expiration expiring on April 14.
Looking at the options chain, we see the 165 is way more expensive, $14.35 cents. This means it does have some intrinsic value.
How much? Right now we could buy Apple for $165, and Apple is currently trading at $173. If we buy Apple at 165 and sell it right away, we would make $8 a share.
This is the intrinsic value of this stock. This means that the remaining stuff is the time value. So $14.35 minus the $8, this gives us $6.35 in time value.
This time value of the 175 option is way higher than the time value of the option with the 165 strike price. This is the expectation. That’s something that we will use to our advantage when buying or selling options.
It’s that simple. You need to understand this intrinsic value and the time value, which is also called extrinsic value. You need to understand that each option has these two things.
So if the strike price is higher than the current price that the stock is trading at, it’s out of the money and therefore it doesn’t have any intrinsic value. That’s why it is important.
Now we will go over time value in more detail in just a little bit, but I want to cover it here first, as this is one of the basic principles of options trading.
The same is for the put option. We already know that Apple is trading at $173. So let’s say that we are looking at two put options, one that is in the money with the 180 strike price, and then one that is out of the money at 165.
Now again, this gives you the right to sell Apple. So if you were able to right now to sell Apple at $180, then you could buy it right back for $173 which would give us $7 of intrinsic value.
We are looking at two puts, the first with a strike price of 180, and the same expiration of April 14. The second has a 165 strike price also expiring on April 14th.
We will calculate the intrinsic value, which is some real value. The intrinsic value is always the strike price, 180, minus the current stock price. In this case, it would be $7.
The 165 put has an intrinsic value of zero. If we would be able right now to sell Apple for $165 and then buy it back at $173, this doesn’t make sense. So therefore it is zero.
Looking at a put of 180 we see that the last traded price here is $13.55. We already know that the 13.55 minus the intrinsic value gives us 6.55 as time value.
Looking at the 165 put, we see the last traded price was $6.40. The intrinsic value is zero and therefore the time value is $6.40 since it doesn’t have any intrinsic value.
To summarize calls and puts, a call option gives you the right to buy a stock at a certain price. A put option gives you the right to sell the stock at a certain price.
Buying vs Selling
For this next part of this beginner guide to options, let’s talk about buying options versus selling options.
When buying options, you have the RIGHT to buy them. When you sell an option, then you have the OBLIGATION to sell it. I prepared a simple graph that shows you the difference between buying options vs selling options.
When buying a call, you have the RIGHT to BUY the stock at a specific strike price. When buying options, you pay a premium.
So this is why it’s often called a debit when you’re paying a premium here. When buying a put, you have the RIGHT to SELL a security at the price.
If you are selling calls, you don’t have the right anymore to sell the security, you have the OBLIGATION to SELL the security at a specific price.
When selling puts, you have the OBLIGATION to BUY the underlying stock at a specific price. You receive a premium and that’s why it’s called a credit, you’re receiving a credit.
Buying and Selling Call Options
Let’s say that you are buying a call option with a 180 strike price. This means that you only make money when you’re buying it, and when it goes above $180. Your outlook as a call buyer is that the stock is going up.
But, if you are selling a call, this option will expire worthless as long as we stay below $180. This is why if you think that Apple will not go higher than $180, that’s when you would, for example, sell a call.
Buying and Selling Put Options
Let’s just say now we are buying a put with a strike price of $165. In this case, we want the price to go below $165. If we are selling a put, we expect the stock to stay above.
This is important because that’s how we make money trading options. It really depends on your outlook.
When you are an option seller you receive a premium as long as the price stays above or below your certain price. Depending on whether you sold a call or put, then you’re just keeping the premium.
Now let’s talk about premium with options, or the so-called theta decay.
What is this and why is this so important? There is this idea of theta which is how much an option decay.
You’ve already heard about time premium, right? We have heard about the time value, and the so-called theta is how much of the time value disappears in a day.
In order to illustrate this, I made an illustration here that shows you see exactly what I mean. So you see we have this time value, and we know that this time value over time moves slower. Here’s how it works.
Now, in the last 30 days, this is when it is really accelerating. So this is where, as an option buyer, you want to stay on the left side of the graph (before the last 30 days). You have more days to expiration, maybe 60, maybe 90 days, maybe you have more.
As an options seller, you want to be in 30 days or less. This is why I said I like to be at smaller than 14 days if I am a seller. And if I am a buyer, I want to be above 30 days
Theta over 14, 30, & 60 Days
Now, in this beginner guide to options, I want to show you why this is so important. In order to do this, I will show you an options chain to show you these different theta decay and time premium at 14, 30, and 60 days.
We are using Apple as an example, and we will look at an ATM option. So we are looking, let’s say, the 175 call.
And we will look at the time value 14 days out, the theta of 14 days out. Then we will look at the theta of 30 days out, and we’ll look at the theta of 60 days out.
Looking at the 175 call that has about two weeks to expiration, you see that the theta is 10.92 cents per day, we’ll say 11 cents. This is how much the option is losing.
Let’s take a look at the exact same option here, just with a different expiration. We want to go months out, so February 18th, and we are looking at the 175. We see the theta is already less. It was 8.34 cents.
And now if you go even further out to March 18th, 60 days, and we look at the 175, it is only 6.23 cents.
What does this mean? Well, it actually means that you are losing less money per day if you have an option that has a longer expiration.
The Rule Of Thumb
When buying options you want to have at least 30 days until expiration. When you’re selling options you want to take advantage of this time decay that occurs here in the last 30 days.
That’s why you want to sell options at around 14 days. So now you get an idea of why that is the case. It’s important that you understand premium with options.
Now that you know the basics about it, how can you apply it? Because that is what you ultimately want to know as an options trader reading a beginner guide to options.
So we’ll talk about four basic option trading strategies. And again, you can make it more complicated if you want to, but I want to keep it easy and simple here.
4 Basic Options Strategies
So let’s actually talk about options trading strategies, that are perfect for this beginner guide to options. I will explain them and I will give you four different scenarios.
One: Buy Calls
The first options trading strategy that you can apply is that you can simply buy calls. Now when would you just buy calls?
You would buy calls when you expect the stock to go up, which is a bullish scenario.
Two: Sell Calls
On the other hand, you can sell calls. You would sell calls when you expect the stock to go sideways or drop if the stock goes down. Now we will bring it all together right now so that you know exactly when to apply it.
Three: Buy Puts
You can also buy puts. This is when you expect the stock to go down, and then you can sell puts.
Four: Sell Puts
You can also sell puts when you expect the stock to go sideways.
The Wheel Strategy & The PowerX Strategy
I will show you some very specific examples of trades that I did recently in this beginner guide to options. This is where now we talk about The Wheel Strategy and we will talk about the PowerX Strategy.
So these are two trading strategies that I personally use, and here is what you do.
With the PowerX Strategy, we expect the stock to move and make a move in that direction. So either going up or down. This is when we would buy calls or when we would buy puts, nothing else.
We’re not messing around with it. We keep it simple. If we expect the stock to go up we buy calls, if we expect the stock to go down we buy puts.
The Wheel Strategy Example
Now with The Wheel Strategy, it is different. So first of all, we sell puts because we expect the stock to stay above a certain price. Let me show you a very specific example of a trade that I just did last week.
This is trade that I currently have on with KSS. I sold 11 puts with an expiration of January 21st, and a strike price of 44.
Now, this is where we go back to what we just learned in this beginner guide to options. When we are selling puts we expect the stock to go sideways.
And as you will see here, this is until the expiration of January 21st. Just a few more days. So if the stock stays above $44, I just keep the premium.
This way the stock can go sideways, it can go up or it can go slightly down. Not a whole lot, but slightly down. Now, if it goes below $44, I’m getting assigned. I have to buy the stock at $44. That’s what we just talked about.
From putting this trade on I received $451 in premium. This is the so-called credit that we talked about. Now, this credit is mine to keep. I can keep it no matter what the stock does.
However, if it dips below, then I have to buy the stock as well and this is when we get assigned. And then when I do own the stock, this is when I’m selling calls. This way I would collect more premium and I would make sure that the stock stays below a certain price.
If I get assigned, I would probably sell calls at 50, because I expect the stock to stay below this.
As you can see, it is super important that you understand the basics of options. Now with this, you can always make more complicated trading strategies.
For example, you can trade spreads.
You might have heard about bull spreads. Bull spread means that you are buying a call and you are selling a call both at different strike prices.
There are also bear spreads, and these are generally called vertical spreads. This is where you would buy a put and sell a put.
You can get more and more complicated. This is where you can go with iron condors, butterflies, or you could do something like straddles. With straddles you buy a call and you buy a put.
Beginner Guide To Options: Summary
Every other options trading strategy that is out there focuses on these four basics. This is why it is important that you master these four building blocks first. Then you can move on to more complicated trading strategies.
If you talk about iron condors and butterflies, this is where you trade four options each with both of them. But all you’re doing is buying and selling calls or puts.
I know that this was a lot, but I hope that you found this helpful and now know the basics of options.
If you enjoyed this beginner guide to options and would like to learn more about the two strategies that I trade, I suggest picking up a copy of my books.
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