This guide is all about building a strong foundation before moving on to the advanced parts of options trading. There are some fundamental things that you should be aware of before trading, and all of these things will prepare you for the trade. It is true that there are many ways in which you can make money, and options are considerably more dynamic than any other method, especially when compared to stocks. 

Now, you might be wondering why stocks and options are different. Well, in the case of stocks, you are buying it at a certain price, and then you are waiting until the price goes up and reaches a certain level. This is when you are buying ‘long.’ And then, you sell that stock to make a profit. Or, you can also go ‘short’ when you are selling the shares you bought only to get them back later on at a price lower than what it was initially. But in the case of options, you can make profits in dozens of ways. This is because, here, we are not only speaking of stocks but also about several indices, commodities, and currencies. But before you trade options, you need to educate yourself properly, and only then you can maintain a comprehensive approach to the trade. 

What Are Options?

Options are referred to as financial instruments. You can also call it a contract because when you purchase options, you obtain the right to trade the underlying asset of that option by a certain date at a specific price. But there is no obligation for you to do so. In short, an option is nothing but a security just like a bond or a stock. There are some defined properties and terms that strictly bind an option.

There are two types of contracts in the case of a stock option, and they are as follows – 

• Put Options – In these, you have the right to sell the underlying asset within a certain timeframe at a specific price.
• Call Options – In these, you have the right to buy the underlying asset within a certain timeframe at a specific price.

No matter which type of option we are talking about, both of them have a predetermined price at which you have to either sell the option or buy it, and this particular price is termed as the strike price.

Another thing that is common in both options is the expiration date. This date defines the fixed timeframe within which you have to trade the option; otherwise, it will not have any value and will expire. If you want to make a profit, then you have to give the option to someone else before it expires. But there is another factor which you must know of, that is, the closer the option gets to the expiration date, the more it loses its value.

In usual cases, the date of expiration is the Saturday, which is the immediate successor of the third Friday in a particular expiration month. So, every third Friday of an expiration month is of importance to a trader. The expiration date of any option varies. For some, it can be as long as a year, whereas some can be short term, for example, a week. The most commonly traded ones last between thirty to ninety days. 

The price of the option contract is denoted by the term premium. The conditions of the market keep affecting its value, and it also depends on the performance of the underlying security. The time value, when added with the intrinsic value, gives the value of the premium. Now, the time value depends on the time left until the expiration date. As already mentioned above, your time value will increase with longer time is left. Also, you will have to subtract the premium amount from the profit in order to sell the option. 

Advantages Of Options Trading

Here are some of the advantages of options trading that you should know of –

• Lesser Financial Commitment – When you are purchasing shares outright, you have to invest a lot of money, and on the contrary, the amount required to purchase an option is quite less than that. And I am not only talking about the premium but also the trading commission. So, you do not have to invest much upfront, and the money stays in your pocket so that when you make a profitable trade, the profit is of almost the same percentage as that of a stock trading. 
• Lesser Pitfalls For Option Buyers – Whether you are buying a call option or a put option, you do not have to keep up with the trade necessarily. In case you turn out to be wrong about the trajectory of the stock or the time frame, you only lose that much amount of money as you paid for the trading fees and the contract.
• Greater Flexibility – There are so many strategies open to investors to apply before the expiration date. They can expand their portfolio by exercising the option and then buying the shares. Or, they can sell all or some of the shares that they have bought. They can also choose to find another investor and then sell the contract of the ‘in the money’ options. Even if some of the money is lost on an ‘out of the money’ option, they can choose to get some of the money back by finding another investor before the expiration date and then selling it.
• Ability to Fix a Price of the Stock – In the case of options trading, the investors have the ability to fix a strike price. This means that before the expiration date, the investor will be able to sell or buy the stock at any given time at the strike price that they have set.

Disadvantages Of Options Trading

Just like any other thing, options trading also have some disadvantages 

• Chances of Huge Losses for Sellers – You saw that in case everything goes south, the buyer will not make many losses, but in the case of the seller, they can incur some huge losses. This is because whenever a call or put is written by an investor, they fall under the obligation to trade their shares no matter how unfavorable the conditions are before the expiration date of the contract. And now, you already know that the stock price can rise as high as it wants to.
• Limited Time for Results – The basic nature of options is that they have to play out in the short term. So, the investors are always on the lookout of a price movement in the short term that they can play out in their favor. And this movement should happen within weeks, or maximum – months. Sometimes, it even happens within days. So, there are two things involved. Firstly, the investor has to buy the contract at the right time, and secondly, they have to sell, exercise, or walk away before the expiration date of the option. But, on the other hand, stock investors can let their investments play out in years, and there is no deadline to worry about. 
• All Requirements Have to Be Met by the Trader – For starters, you need approval through a broker before you can start to trade options. Here you will have to talk about your experience in investing, your financial means, and also your knowledge about the risks involved. After judging how you have answered all these questions, you will be assigned a trading level by the broker. The level that you are assigned will determine the type of options that you can trade. Your brokerage account should have a minimum amount of $2000 if you are trading options. This is a requirement that is set by the industry. 
• There Are Additional Costs – Sometimes, you will have to make a margin account in order to exercise certain strategies. Now, this margin account is nothing but a collateral credit in case your trade does not happen in your favor. The margin account minimum requirement varies with the brokerage firm. In case the balance in the brokerage account falls below the minimum requirement, then you might get a margin call from the lender, and this means that your account might be liquidated unless and until you add more cash. Daily fluctuations in the market can easily lead your balance to fall below the minimum requirement.

Basic Terms To Learn

In order to complete the groundwork, you should understand each and every term, and so, here I am going to explain to you several key terms that are used very frequently in options trading.

Intrinsic Value

If I have to explain in very simple words, then I would say that the value of an asset is determined by the intrinsic value. There is a complex financial model and an objective calculation that is implemented in order to find the intrinsic value of an option. There are several meanings to intrinsic value, and it is based on the area of application. So, this is just an umbrella term. The strike price when subtracted from the price of the underlying security of the option when it is in the money, gives the measure of the intrinsic value. Here is an example to make it even clearer. Suppose the strike price of a call option is $25, and the stock underlying that option is being traded at $27, then the intrinsic value of that particular option is $2.

Extrinsic Value

The difference between the intrinsic value and the premium of a particular option gives the extrinsic value. In the above example, if the price at which the actual option is being traded is $2.50, then the extrinsic value is $0.50. There is another term that is used to denote the extrinsic value of an option; that is, time value.

In-the-Money

When an option has an intrinsic value that is when the term in-the-money or ITM is used. In simpler terms, if you compare with the underlying asset’s market price, then the value in the strike price is in your favor. These two points should make it even clearer – 

• When the holder of the option has a scope of buying the underlying security at a value that is lesser than the present market price, then that is referred to as in ‘in-the-money call option.’
• When the holder of the option has a scope of selling the underlying security at a value that is more than the present market price, then that is referred to as an ‘in-the-money put option.’ 

You should also be aware of the idea of parity whenever you are talking about in-the-option. There is parity in the option if the intrinsic value is equal to the option price. Similarly, the option will be trading at a level above parity, when the price of the option is greater than the intrinsic value. When the option price is less than the intrinsic value, then the option will be trading at a level below parity. Usually, the options trade at a level above parity. Let us assume that the trading price of each share of an XYZ company is $100, then it will be trading above parity when the May 95 call is greater than $5price of the option is greater than the intrinsic value. It will be trading at parity when the May 95 call is at $5 the intrinsic value is equal to the option price, and similarly, it will be trading below parity if the May 95 call is less than $5 option price is less than the intrinsic value.