Learn to Trade Options: How to Get in the Options Game

For an individual trader who has stuck to buying and selling stocks for many years, breaking into the options market can be intimidating. If one can learn the basics, though, options open up a new set of possibilities that can lead to significant gains. I asked Schaeffer's Senior Equity Analyst Joe Bell, CMT, several questions about how options rookies can get in the game. Here is what he had to say:

Why might a trader want to consider buying options rather than sticking to traditional securities?

One of the big benefits of buying options is leverage. An investor can purchase an option that will allow him or her to participate in the upside (or downside) of a stock at a fraction of the cost of buying the shares. Each option contract represents 100 shares of the underlying stock. If the stock moves in your desired direction, the option gain could be a multiple of the stock’s gain.

Options generally require a limited amount of capital, which means an investor may have fewer dollars at risk. This enables the investor to allocate risk effectively and set aside a small portion of his overall portfolio to options. 

Options are also a great tool for times when the market is going down. Put options increase in value when the underlying stock decreases in value, so instead of sitting on the sidelines or experiencing losses during market downturns, option traders have the ability to profit during these time periods. Put options also don’t require a margin account like short selling does.

Options can also be great as a hedge for your overall portfolio, without having to close long-term positions and experience short-term capital gains. The ability to hedge a much larger portfolio at a fraction of the cost makes options a popular choice for those wanting to add hedges to an existing portfolio.

What strategies would you recommend for traders who are new to the options market?

Buying calls and puts is probably the most basic type of option strategy. For those new to the strategy, it makes sense to buy options that are a little deeper in the money. The further in the money an option is when you purchase, the less risk and less reward you will experience. Taking big risks when you are new to the game would not be a good idea.

Premium-selling strategies, while more complicated to many newcomers, are also lower-risk strategies that have higher win rates. If an investor takes the time to educate himself on these strategies, they can be a good tool for successful trading.

How do you decide which option to buy?

It all depends on my outlook and the stock I am buying an option on. If I think it will move quickly to my target, I will purchase a shorter-term option. If I think the stock has shown a tendency to consolidate or chop around in the short term, perhaps I will buy a little more time, giving the move time to play out.

It also depends on what my drivers are. Certain sentiment drivers lend themselves to different time frames. For example, I may think there is the potential for analysts to upgrade or downgrade a stock, but there is little chance of this happening over the next week or two. It may take several months for this to occur, and buying more time increases the chance of this possibility.

Strike selection is also very important. Out-of-the-money options are very aggressive and have high risk and high reward. At-the-money options are risky as well, but a little less risky than out-of-the-money. In-the-money options are the least aggressive of the three types, and the further in the money one goes, the less risk one takes. In general, an investor needs to assess what type of risk he is willing to take, because, no matter what option strategy you choose, reward is always relative to risk.

How do you decide how much capital to devote to each options trade? 

This greatly depends on the individual investor's financial situation. I would generally allocate a small portion to risky trades, relative to my overall portfolio. You should also never risk your entire trading capital at any one time in the options market.

Once you decide on the option and the amount of capital, how do you go about placing an order?

This entirely depends on what brokerage platform an investor has his account with. Normally investors will select the option from the option chain, click the "buy" button, and place a limit orderthat basically states that they would like to buy it at a specified price or lower.

How do you know when it's time to close a position?

It is important to structure trade parameters when you are opening the trade. Define levels on the underlying stock that indicate the trade, or your thesis, is not correct. It will be different for every stock and every option and must be evaluated on a case-by-case basis. Technical analysis can be a useful tool in defining levels of risk and stop-loss points. The level of risk a strategy has will also factor into the decision.

Is there anything else rookies should know about getting into the options game?

Educate yourself as much as possible. Options are generally much riskier than buy-and-hold strategies or even stock trading. With this additional risk comes additional reward. Read and learn as much as possible before putting your money at risk -- our Education page is a great place to start. Try some paper trades, and get comfortable with them before putting any money at risk. When you are ready to start trading, start small and get your feet wet without putting a large bulk of your account at risk. Don’t get greedy, stick to a plan, and stay disciplined with trade management.