Complete Guide to Options Trading for Beginners

If you're new to investing, you may have come across the term "options trading." While it may sound complicated at first, with a bit of understanding, you can unlock the power of options and add them to your investment toolkit. 

Options trading has emerged as one of the fastest-growing segments in financial markets, with over 12.2 billion options contracts traded in 2024, representing a 10.6% increase from the previous year. However, with great potential comes significant complexity and risk.

This guide will walk you through the basics of options trading, key terminology, and strategies for beginners, making it easy to get started.

What Is Options Trading?

Options trading involves buying and selling contracts that give you the right (but not the obligation) to buy or sell an underlying asset at a specific price, within a specific time frame. These assets could be stocks, commodities, or even indices.

Unlike traditional stock trading, where you own a piece of the company, with options, you're simply trading the right to buy or sell an asset at a predetermined price. This makes options a more flexible, but riskier, trading instrument.

Key Terms Every Beginner Needs to Know

• Call Option: A contract that gives you the right to buy an underlying asset at a specified price before the option expires.
• Put Option: A contract that gives you the right to sell an underlying asset at a specified price before the option expires.
• Strike Price: The price at which the underlying asset can be bought or sold when exercising the option.
• Expiration Date: The date by which the option must be exercised, or it expires worthless.
• Premium: The price paid for an option contract. This is the amount the buyer pays to the seller for the right to buy or sell the underlying asset.
• In the Money (ITM): When an option has intrinsic value. For call options, this means the current price of the underlying asset is above the strike price. For put options, it means the current price is below the strike price.
• Out of the Money (OTM): When an option has no intrinsic value. For call options, the current price of the asset is below the strike price. For put options, it is above the strike price.
• At the Money (ATM): When the price of the underlying asset is equal to the strike price of the option.

2 Main Types of Options

Options come in two main types: calls and puts.

Call Options

These options give you the right to buy an asset at a set price within a specific time frame. Traders usually buy calls if they believe the price of the underlying asset will increase.

For example, if Tesla stock is trading at $200 and you buy a call option with a $210 strike price for a $5 premium, you profit if Tesla rises above $215 (the strike price plus the premium paid).

Put Options

These options give you the right to sell an asset at a set price within a specific time frame. Traders often buy puts when they believe the price of an asset will decrease. If you think a stock's value will drop, buying a put allows you to sell it at a higher price than the market price.

Using the same Tesla example, if you bought a put option with a $190 strike price for a $4 premium, you would profit if Tesla falls below $186

How Does Options Trading Work?

Options trading works through the purchase and sale of contracts. These contracts give traders leverage, meaning they can control more stock with less capital. Here's how it works:

1. Choosing Your Option: You’ll need to select a stock (or other underlying asset), pick whether you want a call or put, decide on the strike price (the price at which you'll buy or sell the asset), and determine the expiration date.
   
2. Paying the Premium: As the buyer of the option, you'll pay a premium for the contract. The price of the premium is influenced by several factors, including how far the strike price is from the current price of the asset, the time until expiration, and the volatility of the asset.
   
3. Exercising the Option: If the price of the asset moves in your favor (e.g., the price goes up for a call option or down for a put option), you can choose to exercise your option. This means you will buy or sell the underlying asset at the agreed-upon strike price.
   
4. Selling the Option: You can also sell the option contract itself without exercising it. If the price of the asset moves in your favor, you may be able to sell the option at a higher premium.
   
5. Letting It Expire: If the asset price doesn't move as you hoped and the option becomes worthless (i.e., it’s out of the money), you simply let the option expire, losing only the premium you paid.
   

Pros and Cons of Options Trading

Like any form of investing, options trading has both advantages and disadvantages:

Pros:

• Leverage: With options, you can control a large amount of stock for a small upfront cost (the premium).
• Flexibility: Options allow you to profit in various market conditions—whether prices are rising, falling, or staying flat.
• Limited Loss: The maximum loss when buying options is limited to the premium you paid.
  

Cons:

• Complexity: Options are more complex than regular stock trading, and there is a learning curve.
• Risk of Total Loss: If the option expires worthless, you lose the entire premium.
• Short-Term Nature: Most options have an expiration date, meaning you need to be right within a limited time frame.
  

Also check out How To Swing Trade Crypto Like a Pro

Basic Options Trading Strategies for Beginners

1. Covered Call

A covered call strategy involves owning a stock and then selling a call option on that stock. A call option gives someone else the right to buy your stock at a set price, called the strike price, before the option expires. In exchange for selling the option, you collect a premium.

When to Use It:

The covered call strategy works well in a neutral to moderately bullish market. This strategy is ideal if you think the stock will stay at the same price or go up slightly. It helps you earn extra income from the option premium while still holding the stock.

How It Works:

1. You own 100 shares of a stock (for example, XYZ stock).
2. You sell a call option with a strike price of $55 when the stock is priced at $50.
3. You receive the option premium, which is yours to keep.
4. If the stock price goes over $55, the buyer of the call option may buy your stock at $55.
5. If the stock price stays below $55, you keep the stock and the premium.
   

Example: You own 100 shares of Microsoft at $300. You sell a call option with a $320 strike price for a $5 premium, collecting $500. If Microsoft stays below $320, you keep the premium. If it rises above $320, you must sell your shares at $320

Pros:

• Earn extra income from selling options.
• Protects you a little from slight declines in the stock price.
  

Cons:

• Limits your profit potential. If the stock price rises above $55, you’ll miss out on gains above that level.

2. Protective Put

A protective put strategy is like buying insurance for your stock. You buy a put option, which gives you the right to sell your stock at a set price (strike price) if the stock’s value drops. This protects you if the stock price falls significantly.

When to Use It:
This strategy works well if you're worried about a stock dropping in value but don’t want to sell it. It allows you to protect your investment from big losses.

How It Works:

1. You own 100 shares of a stock priced at $100.
2. You buy a put option with a strike price of $90.
3. If the stock price drops below $90, the put option lets you sell your stock for $90, limiting your loss.
4. If the stock price goes up, you lose the premium you paid for the put, but you still profit from the stock’s increase.

Pros:

• Limits your potential losses.
• Lets you hold onto the stock for the long term while protecting against short-term declines.

Cons:

• You lose the premium you paid for the put if the stock price doesn’t fall.
• Adds extra cost to your investment.
  

3. Long Call

A long call strategy involves buying a call option on a stock when you think the price will go up. It’s a simple strategy that gives you the chance to profit if the stock price rises above the strike price.

When to Use It:
You use a long call when you expect a stock’s price to increase, and you want to profit from that rise.

How It Works:

1. You buy a call option for XYZ stock with a strike price of $50.
2. You pay a premium for the option.
3. If the stock price goes above $50 (for example, $60), you can exercise the option and buy it at $50, making a profit of $10 per share (minus the premium).
4. If the stock price doesn’t go above $50, the option expires worthless, and you lose the premium paid.

Example: Apple trades at $180. You buy a call option with a $185 strike price expiring in 2 months for a $3 premium ($300 total). Your maximum loss is $300. You profit if Apple rises above $188 (strike + premium) at expiration

Pros:

• Unlimited profit potential if the stock price rises.
• Limited loss (you only lose the premium paid).
  

Cons:

• The stock must rise enough to cover the cost of the premium for you to make a profit.
• If the stock doesn’t go up, you lose the premium.

Risk Management in Options Trading

Effective risk management isn't optional in options trading—it's essential for survival. Research shows that approximately 66% of active retail investors predominantly hold simple one-sided positions, while institutional investors use more complex strategies. 

Position Sizing

Never risk more than 1-2% of your total portfolio on any single options trade. This conservative approach ensures that even a series of losses won't devastate your account. For example, with a $50,000 portfolio, limit individual option positions to $500-$1,000.

Understanding and Managing Different Risk Types

• Time Decay Risk: All options lose value as expiration approaches. Plan your trades with specific time frames and exit strategies to avoid excessive time decay.
• Volatility Risk: Changes in implied volatility can dramatically affect option values, sometimes overshadowing the underlying stock's price movement.
• Assignment Risk: When selling options, you may be assigned at any time if the option is in-the-money, requiring you to fulfill your obligation to buy or sell shares.
• Liquidity Risk: Ensure the options you trade have sufficient volume and narrow bid-ask spreads to allow easy entry and exit.

Conclusion

Options trading can be an exciting and profitable way to engage with the stock market. While it carries risk, with the right strategies, knowledge, and risk management practices, beginners can learn to trade options successfully. Always start small, be mindful of the risks, and continue to build your knowledge as you go.

As with any investment, remember that education is key. The more you understand about how options work, the more confident you will be in making your trading decisions.

If you’re ready to take your options trading to the next level, check out Fat Pig Signals for expert insights, tips, and trading signals that can help you make more informed decisions.