Stock Options Trading for Beginners

Stock options let investors buy or sell a stock at a set price within a defined timeframe. Options offer unique strategies for maximizing profits while limiting risks. This guide covers everything beginners need to understand and start trading stock options successfully.

What are Stock Options?

Stock options are financial derivatives that give buyers the right, but not the obligation, to buy or sell shares of an underlying stock at a preset price, called the strike price, before the expiration date. The two main types are:

Call Options

Call options grant the holder the right to buy 100 shares of the underlying stock at the strike price before expiration. Investors buy calls if they expect the stock to rise.

Put Options

Put options give the holder the option to sell 100 shares of the underlying stock at the strike price before expiration. Investors buy puts if they anticipate the stock price will fall.

Every options contract controls 100 shares of the underlying stock.

Why Trade Options?

There are several advantages of using options:

Leverage – Control large numbers of shares with smaller upfront investment
Risk management – Hedging stock positions to limit potential losses
Income – Generate steady income from options premiums
Directional bets – Speculate on upside or downside moves in stocks
Diversification – Additional asset class with different behaviors than equities

However, options carry substantial risks as complex instruments if utilized incorrectly.

Options Elements

Here are the key components of options contracts:

Underlying security – The stock in which options give the right to buy or sell.
Strike price – The fixed price at which the holder can exercise the option.
Expiration date – Date option expires and can no longer be exercised.
Premium – Price paid to purchase the option contract.
Contract size – Standardized to 100 shares per contract.
Moneyness – Relationship of strike price to current market value of underlying stock.

Options Greeks

Several “Greeks” describe key attributes of options contracts:

Delta – Rate of change in premium relative to stock price. Higher delta means higher sensitivity.
Gamma – Rate of change of an option’s delta relative to stock movement. Rises with options nearing expiration.
Vega – Change in premium based on volatility. Higher vega means premium changes more with volatility shifts.
Theta – Rate of decline in premium value over time. Accelerates as option nears expiration.

Learning Greeks helps traders understand how options values change.

Options Trading Strategies

Common beginner options trading strategies include:

Covered Calls

Investors sell call options against shares of a stock they already own. This provides income from options premiums and is relatively low risk.

Married Puts

Investors who own a particular stock purchase put options as a form of insurance in case the stock price falls sharply. Doing both together is considered a very safe strategy.

Long Calls

For bullish investors, buying call options allows benefiting if the underlying stock rises substantially with capped downside if wrong.

Long Puts

For bearish traders, buying put options offers big profit potential if the stock price falls sharply while limiting losses.

Step-by-Step Process to Trade Options

Follow these steps to make your first options trade:

Choose an Options Trading Platform

Select a reputable brokerage firm that offers options trading. Look for low commissions and strong educational resources.

Determine Your Strategy

Decide if you want to buy or sell options based on your market outlook and risk tolerance. Common first trades are covered calls, married puts or speculative long positions.

Pick an Underlying Stock

Select a stock you want exposure to. Stick with liquid large cap stocks to start. Avoid high volatility names.

Check Options Chain

Review available strikes and expiration dates to select the right contract. Near the money strikes with at least 2-3 months to expiration are a good place to start.

Place Your Trade

Enter the details of your options order – whether to buy or sell, put or call, strike, expiration, number of contracts. Then confirm and submit.

Monitor Your Position

Track the underlying stock price relative to your strike. Be ready to sell or exercise before expiration per your strategy. Don’t hold to expiration initially.

Best Practices for Beginners

Stick to these guidelines when first trading options:

Start small – Trade only 1-2 contracts in the beginning. Slowly increase position size over time.
Focus on liquid options – Select active options with tight bid-ask spreads. Illiquid options come with extra risks.
Give yourself time – Choose options expiring 3-6 months out. Shorter durations are riskier for beginners.
Manage risk – Set stop-losses and size positions appropriately. Options carry greater risks if used incorrectly.
Go long options – Buy calls or puts to limit losses to premium paid. Selling options has unlimited downside risk.
Get educated – Read, paper trade, take classes. Knowledge is key with more complex instruments.

Common Beginner Options Mistakes

Avoid making these common missteps early on:

Trading options with very short expirations
Holding options to expiration date
Selling options without understanding the risks
Trading illiquid options or thinly traded stocks
Not closing positions quick enough when wrong
Using excessive leverage relative to portfolio size

Following disciplined position sizing, trade duration, and risk management helps prevent costly mistakes.

Key Options Trading Tips

Keep these essential tips in mind:

Define maximum loss you’re willing to take on each trade
Use limit orders and spread trades to control risks
Adjust positions as fundamentals or technicals change
Hedge stocks using options to limit downside
Stay up to date on earnings, dividend dates, and other news
Don’t rush into advanced strategies like iron condors until consistently profitable

Take time to learn options thoroughly before attempting complex strategies.

Options Trading Tax Treatment

Understand these options trading tax implications:

Profits on options held less than one year taxed as short-term capital gains
Long-term capital gain rates apply to options held more than 12 months
Losses can be used to offset capital gains or up to $3,000 of ordinary income
Wash sale rule applies if new options contract replaces closed position

Consult a tax professional regarding your specific situation.

Is Options Trading Right for You?

Options offer advantages for savvy investors but carry higher risks. Consider if options align with:

Your risk tolerance and personality
Growth objectives for your money
Ability to absorb potential losses
Interest in educating yourself thoroughly
Time commitment for research and monitoring

Evaluate your motivation and willingness to learn before trading options. The versatile instruments can provide long-term value in the right hands.

Conclusion

Options provide unique ways to profit from stocks with capped downside. But utilize caution when first trading options and commit to learning how they work. Take time to gain experience with basic strategies and managing risks before attempting more advanced techniques. Patience and education pave the path to success.