A beginner’s guide to trading options

Options trading for beginners: what to know

Options contracts are financial instruments that derive their value from an underlying asset. For the sake of simplicity, on this page, we’ll focus on options on equities (ie options where the underlying asset is a stock), but keep in mind that other types of options are available. Each standard equity options contract represents 100 shares of the underlying stock, and any explanations or examples given will use this as their basis.

Options are derivative contracts that give you the right, but not the obligation, to buy an underlying asset (100 shares of a stock in the case of equity options) at a fixed price before or at a specific expiration date. The time until expiration can range from the same day (ie zero days to expiration or 0DTE) to a year or more.

These contracts are conditional, as the right to open the stock position is typically only exercised when certain conditions are met. When the contract owner exercises their right, the counterparty must provide 100 long or short shares of the specific security per options contract.

The key components of an options contract include:

• Underlying asset: the stock or other security the option is based on
• Strike price: the price at which the option can be exercised
• Expiration date: the last day the option can be exercised
• Premium: the price paid for the option

There are two basic types of options:

1. Call options give you the right to buy a specific asset at a certain price within a limited time
2. Put options give you the right to sell a specific asset at a certain price within a limited time

Every options strategy, no matter how complex, is built upon four basic types of option positions:

1. Buying call options: this approach is typically used when expecting the underlying asset's price to rise
2. Buying put options: traders often employ this method when anticipating a decline in the underlying asset's value
3. Selling call options: this strategy is generally used when expecting the underlying asset's price to remained stable or fall
4. Selling put options: traders might choose this approach when they believe the underlying asset's price will stay steady or increase

Options trading offers several strategic advantages, such as:

• Leverage to increase potential return (and risk). Note this is only available on a margin account
• Hedging to potentially offset portfolio risk
• Non-linear exposure, enabling you to trade ranges instead of a static direction
• Extensive flexibility to suit different objectives

Remember, though, that options are complex instruments and you should have a thorough understanding of how they work before you start trading them.

How to trade options in 6 steps

1. Understand options basics
2. Open an options trading account
3. Create a trading plan
4. Do your research
5. Manage your risk
6. Open and monitor your position

Understand options basics

Options contracts have two types of value:

1. Intrinsic value: the real value to the option holder at expiration, linear with the stock price relative to the strike price
2. Extrinsic value: the premium associated with implied volatility and time value. The time value component gradually decreases, reaching $0 by expiration

When it comes to ‘moneyness’, options can be:

• In the money (ITM): where they have intrinsic value
• At the money (ATM): where strike price equals current stock price
• Out of the money (OTM): where they have no intrinsic value

For example, if a stock is trading at $50, a call option with a strike price of $45 would be ITM, while a put option with a strike price of $55 would be ITM.

Understanding the 'Greeks' is also crucial for options trading. These are risk measures named after Greek letters:

• Delta: measures the rate of change in the option's price with respect to the change in the underlying asset's price
• Gamma: measures the rate of change in delta with respect to the change in the underlying asset's price
• Theta: measures the rate of change in the option's price with respect to time
• Vega: measures the rate of change in the option's price with respect to the change in the underlying asset's implied volatility

Traders with open positions can view their portfolio's overall beta-weighted delta, theta, gamma, extrinsic value, vega exposure, and much more in our US options and futures platform.

Leverage in options trading

Options trading on a margin account offers significant leverage compared to trading stocks directly. This means you can control a large amount of stock with a relatively small capital outlay. However, it's important to note that while leverage can amplify gains, it can also magnify losses. Always consider your risk tolerance when using leverage in options trading.

Open an options trading account

To start trading listed options, you'll need to open a US options and futures account with us. This specialised account gives you access to our advanced trading platform for listed derivatives, developed in collaboration with our friends at tastytrade. Alternatively, you can open a spread betting or CFD trading account if you want to trade options contracts over the counter (OTC).

Our US options and futures platform offers several key features:

• Real-time quotes and charting tools
• Risk management features
• Educational resources
• Mobile trading capabilities

Create a trading plan

Developing a comprehensive trading plan is crucial before diving into options trading. Your plan should consider:

• Risk parameters: what's your maximum position size? How much are you willing to risk per trade?
• Asset selection criteria: which underlying assets will you focus on? Stocks, indices, exchange-traded funds (ETFs)?
• Trading style and strategies: will you focus on directional trades, income generation or volatility strategies?
• Understanding of implied volatility: how will you factor in market expectations of future volatility?
• Trading psychology: how will you manage emotions and stick to your plan?

Remember to grasp the difference between defined and undefined risk strategies. Defined risk strategies, like long calls and puts, have a known maximum loss. Undefined risk strategies, such as short calls and puts, have potentially unlimited losses.

Do your research

Our US options and futures platform empowers you with tools to boost your market knowledge:

• Follow Feed: see what other traders are doing in real time
• In-platform video feed: access live trading content and expert analysis
• Preset market watchlists: stay updated on popular markets
• Watchlist sort and filter capabilities: customise your market view

You might, for example, use these tools to identify a stock with high implied volatility, which could present opportunities for options strategies like straddles or strangles.

When researching potential trades, consider:

1. Technical analysis: study price charts to identify trends and potential trade entry and exit points
2. Fundamental analysis: in the case of stocks, evaluate the underlying company's financial health and growth prospects
3. Volatility analysis: assess current implied volatility levels compared to historical averages
4. Upcoming events: be aware of earnings reports, economic data releases or other events that could impact the underlying asset

Manage your risk

To help manage your risk, consider:

• Using smaller trade sizes
• Allocating a small percentage of your funds to options trading
• Limiting the number of your trades
• Choosing defined risk strategies for beginners
• Having a clear exit strategy for both profitable and unprofitable trades

Our US options and futures platform provides several tools to help you manage your positions:

• Customisable portfolio metrics
• Liquidity indicators
• Email communications for upcoming events (eg expiration dates and earnings reports)
• Risk management features like stop-loss and take-profit orders

It's crucial to have an exit strategy for both profitable and unprofitable trades. This might include taking profits at predetermined levels, cutting losses at a certain percentage or adjusting positions based on changes in the underlying asset or implied volatility.

Remember, options trading carries significant risks. Always ensure you fully understand these risks and never trade with money you can't afford to lose. Continuous education and practice are key to developing a successful options trading strategy.

Open and monitor your trade

When selecting an options strategy, consider:

• Your directional assumption (bullish, bearish or neutral)
• The timeframe (expiration date)
• The strike price

For instance, if you're bullish on a stock currently trading at $100, you might buy a call option with a strike price of $105 expiring in one month. This would give you the right to buy the stock at $105, even if it rises above that price.

Here are some common options strategies:

1. Long call: buy a call option when you’re bullish on the underlying asset
2. Long put: buy a put option when you’re bearish on the underlying asset
3. Covered call: sell a call option on stock you own with the aim of generating profit
4. Bull call spread: buy a call option and sell another with a higher strike price to potentially reduce cost and risk
5. Bear put spread: buy a put option and sell another with a lower strike price to potentially reduce cost and risk

Remember, long options have defined risk but require the stock to move in your favour, while short options are more neutral trades but come with undefined risk.

When placing your trade, pay attention to:

• Bid-ask spread: the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept
• Volume and open interest: these indicate the liquidity of the options contract
• Implied volatility: higher implied volatility generally means higher options premiums

Once you've opened an options position, it's essential to track its performance. You have three choices when your option is in the money:

1. Close the position: sell the option to realise your profit or limit your loss
2. Roll the position: close the current option and open a new one with a different strike price or expiration date
3. Let the option expire: if it's in the money, it’ll be automatically exercised (or you can manually exercise it)

For example, if your $105 call option is now worth $3 and the stock is trading at $110, you might choose to close the position for a profit. Alternatively, if you believe the stock will continue to rise, you could roll the option to a later expiration date or a higher strike price.

By following these steps and continuously educating yourself, you can develop a robust options trading strategy. Our US options and futures platform provides the tools and resources you need to navigate the complex world of options trading.