How to trade options: A step-by-step guide

Trading options can lead to significant gains or losses due to the financial leverage they provide. This leverage allows investors to safeguard their investments while giving speculators a chance to maximize profits from price changes. These dynamics create appealing prospects in the options market. However, potential traders must grasp the mechanics of options pricing, comprehend associated risks, and adopt effective strategies for selecting a suitable trading platform. Our guide on trading options covers fundamental knowledge every novice trader should grasp, addressing common queries to facilitate understanding and informed decision-making.

How to trade options

New traders venturing into options trading should grasp several key concepts:

Understanding options and types: Calls vs. puts

Options provide traders with leveraged opportunities to speculate on future price movements of securities. Each standard option controls 100 shares and includes a specific strike price and expiration date. Holders of option contracts have the choice not to exercise their rights to buy or sell shares. They can let the option expire worthless, sell the contract to another trader, or profit from changes in the contract's value without owning the underlying stock.

Differentiating between calls and puts

Call options grant the right to buy the security at a predetermined strike price anytime before expiration. At expiry, if the underlying shares surpass the strike price, the option is automatically exercised by the broker. Put options, on the other hand, allow the sale of the security at the strike price before expiration. The broker exercises a put option at expiry only if the underlying shares' price is below the strike price.

The value of call options typically rises as the underlying security's price increases, while put options gain value as the security's price declines. However, option pricing involves various factors beyond the underlying stock price, essential for traders to understand.

American vs. European options

Call option buyers can exercise their right to purchase shares, establishing a long position, while put option buyers can exercise their right to sell shares, establishing a short position. However, the exercise rules differ based on the option style.

American-style options permit exercise at any time up to the expiration date's close, whereas European-style options allow exercise only on the expiration date itself. Both styles can be traded until expiration. Typically, exchange-traded securities use American-style options, whereas index-based options favor European-style options.

Physical vs. cash settlement

Upon option contract expiration, settlement occurs, ensuring each party receives their due. For call options on stocks or exchange-traded securities, settlement involves assigning shares to the call option buyer and assigning the obligation to deliver those shares to the call option seller. If the seller possesses the shares, they are transferred from their account to the buyer's. If not, the seller is assigned a short position.

Options on indexes settle in cash. Buyers of in-the-money options receive a cash amount equivalent to the option's intrinsic value, while sellers must provide this cash. Out-of-the-money options expire worthless, with no cash exchanged at expiration.

Steps to open an options trading account

Step 1: Choose a broker

Begin by selecting a reputable online broker like Interactive Brokers, tastytrade, or E*TRADE. Ensure the chosen broker provides essential options trading tools such as options calculators, comprehensive charting tools, screeners, demo accounts, robust trading technology, extensive educational resources, and transparent fee structures.

Step 2: Complete the account application

After selecting a broker, complete the account application process, typically conducted online and straightforward. This involves providing necessary personal information and financial details.

Step 3: Request options trading approval

Once your account application is submitted, you can request approval for options trading. Brokers may have varying levels of approval criteria, often categorized into tiers. Lower tiers usually allow basic options buying and selling, while higher tiers may permit more complex strategies like spread trading or trading uncovered options.

Some brokers might require you to complete a questionnaire or undergo an online course to demonstrate your understanding of options trading. These measures help brokers manage risk. Generally, brokers are less stringent with requirements for clients with higher net worth or larger accounts.

By following these steps, you can open an options trading account and start exploring the opportunities available in the options market.

Step 4: Study option strategies

Effective options trading involves complexities beyond stock trading, requiring consideration of essential factors such as volatility and time decay. Options trading strategies encompass a spectrum from straightforward single-leg strategies, such as buying puts or calls, to intricate multi-leg strategies like iron condors. Each strategy varies in sensitivity to time passage, price fluctuations, and shifts in implied volatility, necessitating a thorough understanding of the trade-offs associated with each strategy.

Key considerations when opening an options trading account

Customer support: As an options trader, it's essential to have access to responsive customer service that can provide prompt assistance online or via phone. This includes addressing inquiries about account balances, margin requirements, margin calls, and other critical notifications. Brokers should also offer support for trade-related issues like expiration, assignment, and closing out spread trades.

Fees and commissions: Some brokers impose commissions on option trades, even if they don't charge for stock trades. The costs associated with commissions and fees can vary significantly among brokers, with some opting to eliminate commissions entirely or partially. It's advisable to review this guide for a comprehensive breakdown of fees charged by leading options trading platforms.

Account minimums: The traditional requirement of depositing several thousand dollars to open a stock or options trading account has largely diminished. Many brokers now allow customers to open accounts without an immediate funding requirement.