Are you looking to get into options trading but don’t know where to start? This article will be perfect for you! Not only will it act as a beginner’s guide to options trading, but I will personally help you understand it without all of the useless jargon.
I’ll explain exactly what options are by covering these 5-key topics:
- Strike Prices
- Expiration Dates
- The difference between calls and puts
- Buying versus selling options
- Understanding premium and theta decay
After we cover the basics, I’m going to give you 4 basic options trading strategies to start with as well.
And you know what, you might be saying I’m not a beginner. You might have some experience with options already. That’s perfectly fine! Use this as a refresher, especially when we cover some practical examples of options trading.
I’ve always found that when people try to explain options to new traders, they overcomplicate things. They give what I call: analysis paralysis.
So that’s why in this article, I’m only going to focus on what I consider to be essential information. I don’t need to include things like the Black and Scholes model because to be honest, it’s just going to bore you.
Let’s Keep it Simple!
If you know me, I like to keep things as simple as possible when it comes to trading.
I always look back at a quote from Einstein that encapsulates this:
“Everything should be made as simple as possible, but not simpler.”
So if you’re brand new to options trading, keep in mind that there are a lot of rabbit holes to go down. It is an expansive and never-ending category.
So let’s start with the basics and focus on what you need to know to form your rock-solid foundation!
By the way, 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’s Guide To Options: What Is An Option?
Let’s start this beginner’s guide to options by talking about the most important and fundamental thing: What is an option?
An option is a financial contract that gives you the right, but not the obligation, to buy or sell shares of a stock or ETF for a specific price by a certain date.
Options contracts are composed of blocks of 100 shares per contract. So for each contract you buy or sell, it is 100 shares of the asset that is changing hands.
This probably sounds complicated, but I will make this so much easier for you.
Stocks vs Options
The main difference between stocks and options is that a stock represents actual ownership of a company. Options are just contracts that can be used to buy or sell those shares.
There are so many advantages to trading options instead of outright stocks. Remember, one option contract always represents the right to buy or sell 100 shares of stock. This is the key to options trading!
Options Example: AAPL
I’m going to try and include as many examples as I can in this article, as I find they are the easiest way to learn about options trading.
Let’s look at a simple example using Apple (AAPL). Its price is a bit lower these days, but at the time of this trade, Apple was trading for about $173.
So first, if we were to buy 100 shares of AAPL stock at $173, it would cost about $17,300 total. Not too bad, but for some people, that’s a lot of capital to put into one company. Now, let’s take a look at options for AAPL.
Let’s hop over to my brokerage account on Tradier and look back at the options chain for Apple. So the current price is $173 per share. I usually look for an expiration date of about a week or two from the current date.
The options chain tells us how much an option will cost per contract, or looking at it another way, for controlling 100 shares of AAPL.
We are looking at call options when we talk about buying shares, so let’s scroll down to see the strike price of $173. Since there wasn’t a strike price for $173, we can use $172.50 to buy the call.
This means that when AAPL stock hits a price of $172.50, it gives us the right, but not the obligation to buy 100 AAPL shares. The last price traded on the left reads $5.35.
If we just buy one call option, it gives us the right to buy 100 shares of AAPL for $172.50. This means the premium is 100 x $5.35 or $535.
That is a major difference between $17,300 and $535. So what happens if AAPL stock goes down, to let’s say about $160?
So if we owned 100 shares of AAPL, we would lose $173-$160 or $13 per share. Of course, multiplied by 100 shares means a loss of $1,300. This is if we owned the stock outright.
And what about the option? If we owned the option, we could never lose more than the premium we paid for that contract. In this case, it’s $535.
As you can see, in this situation it makes more sense to trade the option because of limited downside risk. When you’re buying a call option, you can never lose more than the amount of the premium.
What happens if Apple goes to zero? Okay, this is very unlikely to happen but let’s just say hypothetically that it does. When you own the stock, you’ll lose everything. All $17,300 that you invested.
But if you are buying AAPL options, you can only lose the premium that you paid for the contract.
5 Things You Need To Know About Options
Now that you have a basic idea of what an option is, here are the five things you need to know about trading them. These are universal and apply to buying or selling options.
Strike prices are the first thing you need to understand. The strike price is the price at which the underlying asset can be exercised. In our previous example, the strike price for AAPL was $172.50.
You have to choose the strike price at the time of purchase whether you are buying or selling an option. The price of the underlying stock will determine if your strike price is ‘in the money,’ ‘at the money,’ or ‘out of the money.’
Let’s look at the example of AAPL again with a price of $173.
In The Money Calls (ITM)
When a call option is ‘in the money,’ it means that the strike prices are below the stock’s current trading price.
Since these options have an actual inherent value, the premiums are much higher than those that are ‘out of the money.’ Since the strike price is below the current price of the stock, they can be exercised at any time as long as the stock price doesn’t fall below the strike price.
At The Money Calls (ATM)
With ‘at the money’ call options, the strike price is the closest to the stock price right now. In our example, when AAPL was at $173, we bought the $172.50 call option, which is ‘at the money.’
Out Of The Money Calls (OTM)
Anything above the current stock price is considered ‘out of the money.’ The premiums on ‘out of the money’ option contracts are much lower as they have a lower probability of finishing ‘in the money’ to exercise the contract. Most short-term ‘out of the money’ option contracts expire worthless.
The Opposite When Trading Puts
When you are trading put options, it’s the exact opposite as it is for call options.
With a call option, you have the right to buy the shares, but with a put you have the right to sell the shares. So for puts, everything above the current price is ‘in the money’ and everything below the current price is ‘out of the money.’
‘At the money’ prices are the same for puts and calls for obvious reasons. Buying a put contract is generally seen as being bearish on a stock because you benefit from the price of the stock falling.
Strike Prices When Buying vs Selling
When you BUY options, you want to generally buy options that are either ‘in the money’ or ‘at the money.’
But when you SELL options, you want to sell options that are ‘out of the money.’ If you sell ‘in the money’ options, the buyer can exercise them at any time, which is usually not to your benefit as a seller.
All options contracts have an expiration date. At this date, the option will expire so action will need to be taken. Depending on your trading platform, you might have weekly contract expirations, but typically all brokerages offer monthly expirations.
If we take a quick look at the tastyworks platform, you can see that weekly option contracts have a W beside them. Any other contracts can be assumed to be monthly expirations.
Expiration dates are always on a Friday unless it falls on a major holiday like Christmas or July 4th. In this case, options would expire on the trading session before the holiday, so usually the Thursday.
Once the option expires, you no longer have the right to buy or sell the shares of the underlying stock. This is why it is crucial to choose the right expiration date when buying or selling options contracts.
How To Choose The Right Expiration Date
This is one goal of mine when teaching trades about options: Explaining how to choose the right expiration date. Here’s a very broad outline that I use as a rule of thumb.
As an option BUYER, I like to choose a longer expiration date because it gives more time for a stock to move in that direction. I like to use at least 30 days when I buy options.
But as an option SELLER, I like shorter expiration dates. In my case, I use an expiration date of 14 days or less.
This is a rule I follow and I’ll go into more detail later in the article because it has to do with things like time decay.
Calls And Puts
The third thing I want to cover is the fundamental difference between calls and puts. I already talked about this earlier, but let’s go into a bit more detail.
Whether you’re trading The Wheel Strategy, The PowerX Strategy, or any other strategy you need to know when to use what instrument.
When you own a call option, it gives you the right to buy a stock at the strike price before the expiration date.
So let’s say a call option has a strike price of $100, and the underlying stock price goes up to $110. This means you get to buy the stock at $100 instead of $110.
Back to our AAPL example now.
Let’s say you bought a call option with a strike price of $175, which means you can buy 100 shares of AAPL stock if the price hits $175 before or at expiration.
But if AAPL is trading at $173 like in our example, having the right to buy the stock at $175 doesn’t make much sense.
This is where intrinsic value comes into play. If you can buy shares of AAPL stocks at $173, and the strike price is $175, then the intrinsic value is zero. Right now, this is an ‘out of the money’ call option.
So right now, since the strike price is higher than the current price of AAPL, it is essentially worthless.
Here’s another example with a different strike price for AAPL. So if Apple is trading at $173, and we buy the ‘out of the money’ call option with a $175 strike price, let’s use an expiration date of three months out. I bought the contract on January 17th with an expiration date of April 14th.
Take a look at how much this option contract currently costs: $8.68. So while the option contract is not worth anything right now, if we are thinking of three months out, this is where expectations come in.
So what’s the value of this contract? The premium is $8.68 and all of this is the time value of the contract. Right now, it has no value if you were to exercise it. But in three months? It could be worth a lot more if AAPL stock is trading well above $175 come April.
Okay so what if we look at an ‘in the money’ strike price now, say $165. We know this option has an intrinsic value right now because it is ‘in the money.’ So let’s look at the options chain to see how much this contract is worth with an expiration date of April 14th.
We can immediately see that the premium for the ‘in the money’ $165 contract is way more expensive. This is factoring in the intrinsic value of the contract.
Right now, we can buy AAPL shares for $165 each, when Apple is currently trading at $173. If we buy the stock at $165 and sell them right away, we would make a profit of $8.00 per share.
This is the intrinsic value of the contract. So if this value is $8.00, then we can surmise that the premium of $14.35 minus the potential profit of $8.00 per share brings us to $6.35 in time value.
When we look at the AAPL call with the $175 strike price, it has a higher time value than the $165 contract, but a much lower intrinsic value. This is something we will use to our advantage when trading options.
But it’s really that simple. We need to first understand the intrinsic value and time value for each option. Every option contract has these two things.
If the strike price is higher than the current price of the stock, it’s ‘out of the money’ and therefore, does not have any intrinsic value. If it’s lower, it is ‘in the money’ and has more intrinsic value, but less time value.
We’ll cover time value in more detail a bit later, but I wanted to cover it here first as a basic principle of options.
The same can mostly be applied to put options as well. We already know that AAPL is trading at $173 for our example. So let’s look at a couple of different put options, one that is ‘in the money’ with a $180 strike price and one that is ‘out of the money’ at $165.
Remember, this gives you the right to sell AAPL stock. So with a strike price of $180, if you were able to right now to sell AAPL shares, then you could buy it right back for $173 which would give us $7 of intrinsic value.
So if we are looking at the two put options, the first with a strike price of $180 and the second with a strike price of $165. Both of these have an expiration date of April 14th.
The intrinsic value for $180 is $7.00 because of the calculation we made earlier.
But for the $165 strike price, the intrinsic value is zero since we can’t sell the stock for $165 and buy it back at $173. That doesn’t make any sense at all!
The last traded price for the $180 put contract is $13.55. If we minus the intrinsic value of $7.00, we get the time value of $6.55.
Now for the $165 put contract, we see the last traded price is $6.40. The intrinsic value is zero, and therefore the time value is $6.40.
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
Okay, so we’ve got most of our basics for options trading. Next up is the difference between buying and selling options!
This is important because when you first get into trading options, the natural instinct is often to buy call options. For new traders, we always expect the price to rise. It’s difficult to be a bearish new trader.
When buying options, you have the RIGHT to buy them. When you sell an option you have the OBLIGATION to sell them. Does that make sense? Here’s a simple graphic that shows the main difference between buying and selling options.
When you buy a call option you have the RIGHT to BUY the stock at the specific strike price. That’s why when you buy options, YOU PAY a premium. So that’s why when you pay a premium, it’s called a debit.
When you buy a put option, you have the RIGHT to SELL the stock at the strike price. Here’s another graphic that illustrates selling options.
When you SELL call options, you don’t have the right to sell the stock you have the OBLIGATION to SELL at a specific price.
When selling put options, you have the OBLIGATION to BUY the underlying shares at a specific price.
You receive a premium when you sell options, which is why it is called a credit.
Let’s take a look at an example.
Buying and Selling Call Options
So let’s say you are going to buy a call option with a strike price of $180. Of course, this means that you will only make money if the stock price goes above $180.
But when you sell the call, this option will expire worthless as long as the price stays below $180.
So if you think the price of AAPL won’t go higher than $180 by the expiration date, then you should sell the call option!
Buying and Selling Put Options
Okay so what about put options? If we are buying a put option with the strike price of $165, we believe the price of AAPL will fall below $165 by the expiration date.
But if we are selling the put option, we expect the price of AAPL to stay above $165. Make sense?
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 make a lot of income from the premiums you receive.
This brings us to our next topic: premiums! Premiums are tied to theta decay and are a critical component of trading options. So what is theta and why does it lead to option decay?
We already talked about time premium and time value earlier in the article. The theta is how much of the time value disappears with each passing day as the contract approaches the expiration date.
Here’s a fun little drawing I made that shows exactly what this means. We have a time value that is slowly deteriorating over time. Here’s how that works.
In the last 30 days is when the decay really accelerates. As an option buyer, you want to stay on the left-hand side of the graph, or before the final 30 days before expiry.
Remember that as an options seller, you want to aim for 14 days or fewer to expiry. And when you are a buyer, you should be looking at 60-90 days or longer.
Theta over 14, 30, & 60 Days
So let’s take a look at why theta is so important when trading options.
We will look at the options chain for the different theta decay and trim premium for 14, 30, and 60 days.
Again, let’s use AAPL and the $173 stock price as our example. For the ‘at the money’ call option, we’ll take a look at the $175 strike price.
So let’s look at the time value 14 days out and 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.
So check out the $175 call option that has about two weeks to expiration. You can see that the theta is 10.92 cents or $0.1092 per day. So let’s call it $0.11 per day. This is how much value the option is losing each day.
If we look at that same option with a different expiration of about 30 days from now, we see the theta is $0.0834 cents per day. The theta is less because the time value is more.
Finally, if we go out 60 days to March 18th, we can see that the $175 strike price call option has a theta of $0.0623 per day.
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 you buy options contracts, you want to have at least 30 days until expiration. When you’re selling options, you want to take advantage of the time decay that occurs in the final 30 days. This is why you want to sell options closer to the expiration date.
Now that we have the basics down, how can we apply it to our trading?
I’m going to talk about four basic option trading strategies, and again, you can make things as complicated as you want. But remember for me, I like to keep things simple!
4 Basic Options Strategies
Here are the four basic strategies I am talking about. When I say basic, I mean they are basic. But that’s exactly what you need when you first start trading options!
- Buy Calls
The first strategy I’m going to talk about is as simple as it gets: buying calls.
When would you buy call options? You would buy call options when you expect the stock price to go up, which is certainly a bullish sentiment.
- Sell Calls
On the other hand, you can also sell call options. Selling call options is when you expect the stock to go down or at least trade sideways. While it isn’t explicitly bearish, it is making a bet that the stock price will not exceed the strike price of the contract.
- Buy Puts
Buying puts is certainly bearish because you are banking on the fact that the stock price will fall in the future.
- Sell Puts
Selling puts is similar to selling calls: you are expecting the price of the stock to stay within range or at least above the strike price.
The Wheel Strategy & The PowerX Strategy
Now we get to my two favorite options trading strategies: the Wheel Strategy and the PowerX Strategy. They are the two option trading strategies that I personally use on a daily basis.
The PowerX Strategy is a focused bet on a stock move in either direction. Depending on which way it moves, we buy calls or we buy puts.
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
The Wheel Strategy is a bit different. First, we start by selling put options 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.
Here is a trade I personally made with the stock KSS or Kohl’s Corporation. I sold 11 put options with an expiration of January 21st and a strike price of $44.
We just need the stock to stay above the $44 price level and I get to keep all of the premium.
The stock can go sideways, or it can go slightly up or down as well. But if it makes a big move lower and falls below $44 then I’m going to get assigned these shares. This means I’ll be forced to buy the stock at the $44 strike price.
For selling those put options, I received a premium of $451. This credit is mine to keep no matter how the stock does. If it drops below $44 and I get assigned, then I would have to own the stock.
At that point in the Wheel Strategy is when I start selling covered call options for the shares that I now own. I collect more premium this way, as long as the stock stays below a certain strike price.
If the stock price rises above, then I sell those shares if the buyer of the call options exercises them. Then, the Wheel Strategy begins again as you find the next stock to sell puts on.
So those are the basic strategies of options trading. Like I said, you can get more complicated if you feel comfortable.
You can trade something called spreads as well. You might have heard of bull spreads. This is when you are buying and selling a call on the same stock at different strike prices.
There are also bear spreads where you buy and sell a put for the same stock.
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.
The opportunities are vast when it comes to options trading, but for now, let’s just start with mastering the basics. That was the goal of this article, and I hope you’ve learned from it!
Beginner Guide To Options: Summary
While they seem basic, these four strategies are the building blocks of every option strategy. It’s important for you to master these four strategies first before moving onto more complex strategies.
You can get as complicated as an iron condor or butterfly, which trades four different options contracts. All you’re really doing is buying and selling calls and puts.
If you’re still with me, thanks for reading along! It was a long article, but it is critical that you understand the principles we touched on before you begin trading 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.