Options Trading For Beginners: A Step by Step Guide

Options Trading for Beginners

 Your best friend or a work colleague keeps mentioning options trading.  They tell you about their extraordinary gains.  You are intrigued. Trading options sounds like a really good way to add some extra income and you want to get into the game, too.  But where do you start? 

I am glad you are asking that question rather than just start throwing trades on and hoping they work.  I am going to give you an Options Trading For Beginners Check List to get you on the right track to trade options.  Let’s assume you don’t know much other than the little your friend has shared.

Understand What an Option Is 

Here is the standard definition of what options are.

Options are financial derivatives that give the buyer the right to buy or sell the underlying asset at a stated price within a specified period. 

Fine, but it is still hard to imagine what they are and how they work.  Let’s break it down into something even your 10-year old child could understand.

Your neighbor has a piece of land you would like to own someday, just not today.  You go to him and say “I’m willing to buy your land for $100,000”.  Your neighbor agrees and you have just struck a deal for $100,000.  

The STRIKE:  The agreed upon price you are willing to pay and the other party is will accept.  In this case the strike is $100,000.

“But wait”, you say. “I don’t want to take possession of the land for 8 months on January 15^th of next year”.  When you neighbor looks at you quizzically, you say “tax reasons” and your neighbor nods his head knowingly.  You have just agreed on the time when the agreement expires – January 15^th.

 The EXPIRATION:  The  last day the agreement is valid. You will have to decide to buy or not to buy the land that date.  In this case the expiration is January 15^th of next year.

Now your neighbor says to you, “Look I am taking a risk.  I am holding my land off the market for you.  What if you decide not to take it by January 15^th?”  So, you offer him $5,000 to hold the land for you.  If you don’t take possession of the land by the January 15^th expiration date, he gets to keep the money.  You both agree these terms.

 The PREMIUM:  A fee that the buyer pays for the right to buy at a pre-set price when the contract’s time limit expires.  $5,000 is the premium on your deal with your neighbor.

January 15^th rolls around and you have to decide if you want to own the land or not. Let’s say land prices have dropped and your neighbors land is now only worth $70,000 so you decide not to buy it.  In that case your neighbor gets to keep the land but he also gets to keep the $5,000 premium you paid to hold the land off the market.  You just lost the $5,000 but it is better than paying $100,000 for land worth only $70,000.  

Same scene but now the land value is higher at $115,000 than the Strike at $100,000.  You decide to consummate or exercise the deal.  The total you will have paid is $105,000 - $5,000 for the Premium plus $100,000 for the land.  But remember the land is now worth $115,000 - $10,000 higher than what you will pay.  What you have done is Exercise the contract.

 EXERCISE A CONTRACT: To Exercise you put into effect the right to buy or sell the underlying security that is specified in the options contract.

 Now you have a basic understanding options trading for beginners and the language of options. 

But let's keep going.

Why Trade Options versus Trading Stocks

 Again, I want to explain this so your 10-year old will understand.  Let’s use Google for an example to understand the power of options.  GOOGL had a 20:1 split on 7/15/2022.  The stock is now more affordable for traders.  GOOGL had their earnings announcement on 7/26/2022 and we saw the buyers step in and push prices higher. 

We will illustrate two ways to trade GOOGL as prices are going up.  The first is trading the stock itself.  Let’s buy 100 shares when the price was $110 per share and subsequently sell it when the price leveled out at $119 per share.

Now we are going to do the same trade on GOOGL but this time with Options.

In each trading scenario- Stock and Options, we were dealing with 100 shares and staying in the trades equal number of days.  My investment for the stock was $11,000 and for the options $410.  That’s over 26 times the capital required to trade the stock.

•  POINT 1:  Options allow you to leverage your capital.

 Notice that we made more money per share trading stocks over options but the percentage of gain to capital outlay is much, much better trading options..

•  Point 2:  Option trading allows for higher gain percentages 

The Ins and Outs of Options

 There are two kinds of options:  CALLS and PUTS.  And two ways to trade each kind of option: You can buy an option to open a trade or you can sell an option to open a trade.

•  Buying an Option to Open a Trade

CALL Options gives the holder the right to buy shares of a stock at a specific price (Strike) before a specific date (Expiration).  The bought option becomes more valuable as the strike price goes up.  

It is much like the land example we laid out for the 10-year old.  You buy an option for a strike of $100,000 and if the price goes up you can buy the land for $100,000 and turn around and sell it for the $115,000 higher price.  You win!

PUT Options gives the holder the right to sell shares of a stock at a specific price (Strike) before a specific date (Expiration).

When you buy a PUT to open, you want the price to go down.  You buy the stock at new lower price and force the other side of the contract to buy it at the higher strike agreed upon when the trade was opened.  You win!

•  Selling an Option to Open a Trade

Selling an option to open a trade is a little trickier to understand. Stick with it and the concept will become clear with time.

When selling a CALL Options to open a trade, you assume the obligation to sell shares of a stock at a specific price (Strike) before a specific date (Expiration).

In this case you want to price to go down. No one in their right mind would force you to sell stock at the higher strike price because you could buy the shares at the new lower prices to complete the exercised contract.  Bottom line, if the price of the stock dropped the contract would expire worthless. 

If the stock price goes up, however, you lose because you would have to buy the stock at the new higher price and then sell at the lower strike prices

When selling a PUT Options to open a trade, you assume the obligation to buy shares of a stock at a specific price (Strike) before a specific date (Expiration). 

In this case you want the stock price to go up and the contract would expire worthless.

A personal note to beginners:  I very seldom exercise my positions.  Rather I just trade the option positions and profit from the change of the option prices over time.

The Mechanics of Trading Options

Choosing the right trading options trading platform is a critical factor to your success as an option trader.  There are good platforms; there are bad platforms.  At first glance a platform may seem great until you dive deeper into the mechanics of how the platform works. This can cause options trading for beginners to seem daunting and overwhelming.  Which options trading platform to choose is a big decision and my best advice is to ask a lot of questions before deciding which is right for you.  Some critical points to consider:

•  Trade fill prices.  Some platforms bundle their trades and submit them to the stock exchanges
•  Speed that trades are filled
•  Is the platform in real time reflecting the current pricing or is there a lag time
•  Commissions and fees charged
•  Charting flexibility
•  Trade structure flexibility – multiple legged trades, stop losses, trailing stop losses, ability to time stamp a position to trade
•  Online education
•  Customer service

Good advice is talk to other traders about their trading background and their experiences with various platforms.  My very best advice is finding unbiased trading guru to guide you through the process of choosing the best trading platform.

Option Charts

All Option Charts on all platforms are pretty laid out the very same.  The charts always show the various option expiration periods available for each stock.  

Open an Expiration Period and you will find the CALL positions are always on the left and the PUT positions are always on the right.  The strikes are usually listed in the middle between the CALLS and PUTS.

The opened period shows the strikes prices and the bid and ask as well as the mark prices for each option.  

•  The Bid is what the platform wants you to pay for the option
•  The Ask is the price the platform would like to sell you for the option
•  The Mark is the price ½ way between the Bid and Ask

A good platform will have other factors you can add to the chart such as the Greeks, open interest and your positions..  Here is an example of an Options Chart.  

Some other terminology important to Options are:

•  At the Money ATM – where the stock price is currently trading
•  In the Money ITM
•  Out of the Money OTM

On most charts the ITM are shaded as they stand out better

Getting Started In Options Trading For Beginners

1. Most Important:  Get some solid education about options and trading before blindly putting your hard earned cash on the line.  You shouldn’t start a journey to learn Math in a calculus class.  Start with basic arithmetic functions and work your way up.
2. Start simply:   Work your way up to more complicated trading.  To start. I would suggest finding a stock that is going up and buy a CALL option at the money 30 days in the future.

1. Don’t trade tips.  I think of that as the blind leading the blind.  Do you own thinking.
2. Find a mentor.  When I first started teaching there were just a few places to go for a good solid education and a mentor.  Now they are everywhere with more coming on the scene every day.  Some are very good.  Most are not.  Some are just one-hit wonders who haven't even traded through all kinds of Market scenarios. 

So there you have it! A comprehensive overview of options trading for beginners! We can't wait to see what you do with options trading!

About the author:  Maggie Roth, Investing Buddies 

Maggie placed her first stock market trade in 1972.  She had graduated, got a good job and saved $1,000.  She went to a stock broker who advise she buy some GE stock.  She made some money and was hooked on trading.  Maggie stayed with the same broker for a little under 30 years.  

In early 2000 she saw the dot.com bubble ready to implode.  Having been through some major downturns and losing huge chunks of her gains, she begged her broker to move her to cash positions.  He talked her out of it and when the market did implode a short time later, she decided to part ways.  “I figured I could learn to trade on my own and electronic trading was starting up so I really didn’t need a broker.  Best decision I ever made.”

She began her journey with Investools education.  Again, another great decision.  In 2009 she was sitting in the audience at a one of their large seminars when she had the thought that she would like to teach trading someday.  And that was the start of another incredible journey.  In 2012 she started actively teaching and mentoring folks from all over the world.

Maggie typically doubles her trading account balances every quarter.  Her subscription service, Investing Buddies, offers a weekly seminar with her market insights and ticker she is trading as well as online educational courses.

You will want to check out her DATA class (Double Account Trading Adventure). It is 10 weeks long and given 4 times a year.  It is a little about becoming a thinking trader but more important is the goal of doubling your account balance every 10 weeks. Learn more about DATA HERE