Options Trading: A Beginners Guide

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December 29, 2022, 12:08 PM

Businessman checking stock market data on tablet on night background.

Options trading can sound complicated and risky to novices, so beginners often steer clear. While their hesitation is understandable, not much is required to get started — but the process, terminology, strategies and potential risks are different from those associated with traditional stock investing. So while novices shouldn’t be intimidated, they should learn the ropes before putting their money into play.

Read: 5 Things You Must Do When Your Savings Reach $50,000

Here’s what you need to know about options trading for beginners.

Options Trading Explained

Options are tradeable contracts that let investors bet on the future performance of individual securities or the stock market as a whole. They give the purchaser the right, but not the obligation, to buy or sell a security at a specified price, called a strike price, on a predetermined day, called an expiration date.

There are two types of options:

  1. Call options: Give you the opportunity to buy a security at a set price on a set date.

  2. Put options: Give you the opportunity to sell a security at a set price on a set date.

A standard options contract is for 100 shares of stock.

There are also two types of positions:

  1. Long: You own the security in question because you think it will increase in value.

  2. Short: You don’t own the security because you think it will decrease in value. You are borrowing the stock at one price with the hope that the stock drops in value. If it does, you make a profit. If the stock price rises, you will incur a loss. Selling short is only recommended for more experienced investors.

Options are derivative securities because their performance is derived from an underlying asset, security or index. The price to purchase an option, called a premium, is based on the value and cost of the underlying asset.

Here are some other types of derivatives:

  • Futures: These are standardized, exchange-traded contracts to buy or sell a commodity, such as silver, at a future date for a specified price. These settle daily.

  • Forwards: Forwards are private contracts that can be customized between two parties to buy or sell an asset on a future date for a specified price.

  • Swaps: These contracts allow one party to exchange the values of one asset for another.

Futures, forwards and swaps are typically used by more experienced traders.

How Do Beginners Learn Options Trading?

Before spending all day on social media and reading websites, you should decide what it is you hope to achieve. According to Schwab, options traders typically have one of three main objectives:

  • To generate profit on stocks you own or plan to own.

  • To hedge against risk on an existing stock position.

  • To use leverage to make speculative bets or to profit during a neutral market.

Once you determine your objective, your job is to learn as much as you can about options trading.

Same as with every facet of investing, the internet and social media are rife with misinformation and charlatans looking to sell foolproof strategies for getting rich and secrets to guaranteed success. There are no guarantees and very few secrets. As you explore and learn, stick with trusted publications and influencers that don’t charge money for knowledge.

Can a Beginner Trade In Options?

You’re not required to demonstrate a minimum skill or experience level to get started, but you must open a brokerage account that allows options trading. Different brokerages might approve different types of options trading for different accounts.

According to the SEC, most brokerages require you to have a margin account, but don’t allow you to purchase options contracts on margin.

But just because you can doesn’t necessarily mean you should. The very first thing a novice should understand is the unique risk level associated with different options trading strategies. Consider this starkly worded warning from the SEC:

“Options strategies that involve selling options contracts may lead to significant losses and the use of margin may amplify those losses. Some of these strategies may expose you to losses that exceed your initial investment amount — i.e., you will owe money to your broker in addition to the investment loss.”

How Much Can a Beginner Make in Options Trading?

Beginners, experts and everyone in between can enjoy big gains or suffer steep losses in options trading. Variables like strategy, risk and market behavior all play a role. As with all investments, the best bet is to start small while you learn.

Which Trading Option Is Best for Beginners?

A good way to begin is to sell covered calls on stocks you already own. It’s like renting your stock for a set period of time. This works particularly well if you own a stock with a price that tends to move sideways or slowly upwards.

Another lower-risk way to get your feet wet is by selling puts. Perhaps you have your eye on a certain stock but aren’t willing to pay the current price for it. You can sell a put that obligates you to buy the stock at a price in the future.

Once you have perfected these option strategies, you can move on to more complicated methods of trading.

Avoid Common Mistakes

Here are some common errors that can lead to losses when trading options:

  • Choosing the wrong expiration date

  • Ignoring volatility

  • Choosing the wrong position size

  • Trading without a plan

One of the most important steps before trading options is to develop a sound trading plan. Think through the level of risk you are willing to take and build an understanding of how to find the best trading opportunities. Next, determine when to enter the trade. Finally, know your exit strategy.

John Csiszar contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: Options Trading: A Beginners Guide