Top 9 Things You Must Know About Options Trading (Explained Simply!)

Options trading might sound complicated, but don’t worry—we’ll break it down in a way that’s easy to understand! Options trading is like playing a game with stocks where you can make money whether the stock price goes up or down. Let’s look at nine important things you should know to get started!

1. What is an Option? 📝

An option is like a special contract that lets you buy or sell a stock at a certain price in the future. You don’t have to buy or sell the stock, but you have the option to do it if you want.

A call option lets you buy the stock.
A put option lets you sell the stock.

Think of it like this:

Imagine you have a coupon that lets you buy a new video game for $20, even if the store raises the price to $30. The coupon gives you the option to buy the game at the cheaper price, but you don’t have to use it if you don’t want to.

🔑 Key takeaway: Options let you choose whether to buy or sell a stock at a special price in the future.

2. Call vs. Put Options 🔄

There are two main types of options:

Call Options: You use these when you think the price of a stock will go up.
Put Options: You use these when you think the price of a stock will go down.

Example:

Let’s say you think Tesla’s stock will go up. You buy a call option for Tesla. If the stock price goes up, you can make money! But if the stock price doesn’t go up, you don’t have to buy the stock, and you only lose a small amount called the premium.

On the other hand, if you think Apple’s stock will go down, you can buy a put option. If the price drops, you can sell the stock at the higher price, making money!

🔑 Key takeaway: Use call options if you think prices will go up and put options if you think prices will go down.

3. What is a Strike Price and Expiration Date? 🗓️

The strike price is the price at which you can buy or sell the stock if you use your option. The expiration date is the last day you can use the option.

Example:

If you have a call option for Apple with a strike price of $150, and the stock goes up to $170, you can buy it at $150, which is cheaper! But you have to do this before the expiration date. After the expiration date, the option disappears, and you can’t use it anymore.

🔑 Key takeaway: The strike price is the price you’ll buy or sell the stock, and the expiration date is the last day you can use the option.

4. In the Money vs. Out of the Money 💵

Options can be either In the Money or Out of the Money. Here’s what that means:

In the Money (ITM): This happens when an option is valuable. For call options, it means the stock price is higher than the strike price. For put options, it means the stock price is lower than the strike price.
Out of the Money (OTM): This happens when the option isn’t valuable yet. For call options, it means the stock price is lower than the strike price. For put options, it means the stock price is higher than the strike price.

Example:

If you have a call option with a strike price of $50 and the stock price is $60, your option is In the Money because you can buy the stock for $50 and sell it for $60, making a profit.

But if the stock price is only $40, your option is Out of the Money because buying the stock at $50 wouldn’t make sense since it’s cheaper to buy it for $40.

🔑 Key takeaway: In the Money options have value because the stock price is in your favor. Out of the Money options don’t have value (yet) because the stock price isn’t favorable.

5. Intrinsic and Extrinsic Value 🔍

When you buy an option, its price is made up of two parts:

Intrinsic Value: This is the real value of the option if you used it right now. It’s the difference between the current stock price and the strike price.
Extrinsic Value: This is the extra value added to the option based on things like time and how much the stock price could move in the future. It’s also called time value.

Example:

If you have a call option to buy a stock at $50 and the stock is currently worth $60, your intrinsic value is $10 (because you could make $10 per share if you bought the stock).

But the option might be priced at $12. The extra $2 is the extrinsic value, which comes from things like how much time is left until the option expires or how much the stock might change in price.

🔑 Key takeaway: Intrinsic value is the real profit you can make right now, while extrinsic value is the extra potential based on time and market factors.

6. Understanding the Greeks 🧮

The Greeks might sound complicated, but they’re just simple ways to measure how options work. Let’s look at three important ones:

Delta: This tells you how much the option’s price will change when the stock price changes. If the stock goes up $1, the delta tells you how much your option will change in value.
Theta: This measures time decay, or how much the option loses value as time passes. The closer you get to the expiration date, the less your option is worth.
Vega: This shows how much the option’s price will change if the stock becomes more or less volatile (bounces up and down in price).

Example:

If you buy an option and the delta is 0.5, that means if the stock price goes up $1, your option price will go up by 50 cents.

🔑 Key takeaway: The Greeks help you understand how the option will change in value based on things like time, price changes, and volatility.

7. What is a Premium? 💵

When you buy an option, you have to pay a small amount of money called the premium. Think of it like paying for a ticket to a concert—you pay the ticket price (premium) to reserve your seat (option).

Example:

Let’s say you buy a call option for Tesla for $4 per share, and each option covers 100 shares. So, the premium would be $400 (because $4 x 100 shares = $400). If the stock goes up, you can make a lot more money than you paid for the premium.

🔑 Key takeaway: The premium is the price you pay to have the option to buy or sell a stock.

8. What is a Credit Spread? 💡

A credit spread is a type of trade where you buy one option and sell another option at the same time. This helps you manage your risk and protect yourself from losing too much money.

If you sell a call spread, you’re betting that the stock price will go down.
If you sell a put spread, you’re betting that the stock price will go up.

Example:

Let’s say you sell a call spread on Disney stock. You sell one option at a price of $105 and buy another at a price of $110. The difference between these prices ($5) is the maximum amount you can win or lose.

🔑 Key takeaway: A credit spread helps you limit how much you can lose on an options trade.

9. Why Options Give You Leverage 🎢

One of the coolest things about options is that they give you leverage. This means you can control a lot of shares of stock without paying a lot of money upfront.

Example:

Instead of paying $20,000+ to buy 100 shares of Apple, you can spend just $500 on a call option that lets you control the same 100 shares. If the stock goes up, you can make a big profit, and all you paid was $500!

🔑 Key takeaway: Leverage lets you control more shares of stock with less money, giving you bigger profit opportunities.

Conclusion: You’ve Got This! 🙌

Options trading may seem tricky at first, but once you understand the basics, it becomes much easier. By learning about calls, puts, strike prices, premiums, intrinsic and extrinsic value, and leverage, you’ll be on your way to making smart trading decisions. Start slow, practice, and remember: options trading is a powerful tool when used wisely!

Disclaimer:

The information provided in this article is for educational and informational purposes only and should not be construed as financial or investment advice. Always conduct your own research and consult with a licensed financial advisor before making any investment decisions. Trading and investing involve risks, including the loss of principal, and past performance does not guarantee future results. The author and publisher of this article are not responsible for any financial losses or damages incurred as a result of following the information provided.