In Options Trading Explained we’re going to help get your started in setting up your business. I’ve always said that trading is a business and if you don’t treat it as a business you are destined for the poor house. Now obviously, I don’t know if you have ever had your own business or not but if you want to trade for a living, or just to supplement your income, you need to “set up your business”. But if you want learn how to trade options you are at the right place. My course, Common Sense Options, according to my students, is the best options trading course on the market to learn new option trading strategies. Hopefully in this blog, you will also learn a lot and will consider this your own options trading tutorial.
I doubt that you would open any business without having the proper tools or equipment, without a complete business plan, without knowing what your anticipated expenses will be, without a cash flow analysis, etc. Well you get the picture; or at least I hope you do. Your trading business should be no different. I don’t know of a single long term successful trader that did not have a business plan, as well as a solid trading strategy and stuck with. Successful traders are running a successful business!
This is just common sense, yet so many people want to jump right in the water and start trading without the proper training. This would be kind of like trying to learn to swim by just jumping right in the deep end of the swimming pool. Your chance of survival by doing that would not be really good, would it? Well, your chance of survival by just jumping right in and starting to trade are not any better.
I don’t want to scare you away and I’ll help guide you through the forest helping you avoid many of the pitfalls I experienced. There is a learning curve and during this time you may get frustrated. If you do, that’s okay, because sooner or later, if you stick with it long enough, the light will come on. When it does, it’s a day for great celebration!
Options Trading Explained: Go Full-Time
I have students who want to know how long it will take for them to start trading full-time and replace their current income. Well in an effort to always be completely honest; my answer to that is that I don’t know. There are just too many variables involved and each person is different.
You must first decide how much income you need to go full-time. Then you have to decide how much money you can start your trading account. After you have done that, then you need to carefully think about how much you can make, percentage wise, every year.
Do the math and see how long it will take you to be able to go full-time. Maybe you want to make $50,000 a year and you can make 100% a year (optimistic for most people) then of course you need a trading account with $50,000. If you open an account with $10,000, and make 100% a year, how many years would it take for you to go full time and make $50,000 a year? Also do the math using 25% a year return and 50% a year return.
Do several different scenarios and at the end pick one that best suits your own circumstances. Be conservative on this! If you can’t live with that answer, then trading options is not for you.
I hate it when I try and read a book or take a course where the author uses terms that he or she thinks I should already know. This only leads to confusion and I have to go to the glossary to look up the word I don’t understand, then go back a read the text again. So, based upon some of my own past frustrations, I will assume you don’t know even the basic option terms. If you already know these terms then you might want to skim over them, or even skip, the following section.
Options Trading Terms
Assignment: A notice to an option writer that the option has been exercised by the option holder.
At-The-Money: An option whose strike price is the same as the underlying futures contract. An example would be that sugar is trading at 10.00 and the strike price of the option is also at 10.00. It does not have to be exactly at the same price but very close to it. You know, like they say, close enough for government work!
Beta: This is a measurement of the options market and how it correlates to the movement in price of the underlying market.
Call Option: When someone buys a Call, they have the right to buy the futures contract at the agreed upon strike price. The seller then has the obligation to deliver the futures contract at the strike price on or before the expiration date of the option.
Covered Option: An option written against an opposite position in the futures market. An example would be that you are long Gold in the futures market but you sold a further out-of-the-money Gold call.
Credit: This is money you receive from the person who you sold an option to or when you offset an option. In other words, it’s money that is deposited into your trading account.
Debit: Just the opposite of a Credit. Its money you pay to buy an option and it’s deducted from your account.
Delta: No, this is not an airline. It’s the amount an option price will change in relation to the underlying futures price. Options will change in value when the futures market goes up and down.
Exercising Options: Most options, I’ve heard that it’s as high as 98%, are liquidated (closed out) before they expire or they expire worthless which is the case most of the time. An example is that you have a gold call option with a strike price of 425.00, gold is selling for 475.00 and you still have time on your option before it expires. But you offset it, in other words you would sell your option on the open market to someone and take your profits. Of course you would only take profits if it was worth more than you paid for it. If it’s worth less than you paid for it then you could probably still sell it but you would sell it at a loss.
Of course if you are the seller of the option, in other words you sold someone an option, you can also offset your option at a profit or a loss anytime before the option expires by buying your option back. Both these examples would be like buying back your short futures position or selling your long futures position.
But an option buyer also has the right to “exercise” his option any time prior to the expiration date. If you were the buyer of a call option, you would give notice to your broker that you want to turn your call option into a long futures position. Now if you were the buyer of a put option you would do the same thing with your broker but you would then be short the market by having a short futures contract. In each of these scenarios, you would be long or short the market from the Strike Price of your option. Of course you would only offset (sell) your option if it was “in-the-money” or in other words if it had Intrinsic value. And you will learn its best not to even do that.
Expiration Date: Every option has a specific date which up until that time, the option can either be sold to someone else or exercised and turned into a futures contract.
Free Trade: You are really going to like this one when you get to it in the course. But a free trade is when you institute a spread (see below) by purchasing a close-to-the-money call or put and then later complete the spread by selling a further out-of-the-money (see below) call or put of the same expiration period at the same or greater premium than you paid for the first call or put. Once you have completed this type spread, there is no margin required and the best part is that you can’t lose money once this spread is complete! Read that again!
Hedge: This is when you buy or sell an option or futures contract to offset your current position in order to have protection in case the market goes against you.
In-The-Money: When an options strike price is lower than the current futures market price for a call and when the strike price is higher than the current futures market price for a put. In each case the option would have intrinsic value.
Intrinsic Value: This is the amount of money that you would make if the option were to be exercised immediately. Keep in mind that Out-of-The-Money options have zero intrinsic value.
Margin: This is the amount of money that you have to deposit AND maintain (just like a futures contract) when you SELL an option. No margin is required on options you buy.
Naked Writing: This is when you sell an option on a futures contract and you don’t have a futures position in that market.
Neutral Option Position: This is when you put on an option spread and sell an out-of-the-money put and call of the same expiration month to collect a premium. This is usually done in a flat or choppy market.
Option: A contract between two people to buy or sell a futures contract at a predetermined price (strike price) on or before a future date. Every option has both a buyer and a seller.
Option Buyer: When you buy a put or a call, you have the right, but not the obligation, to buy (with a call option) or to sell (with a put option) the underlying futures contract at a specific strike price anytime before the option expires. The seller is paid a premium by the buyer. The most the buyer can lose is the amount he paid in premiums. So even if the market goes against you thousands of dollars, as a buyer, you can only lose your premium. However if the market goes in your favor, you have unlimited upside profits.
Option Seller: When you sell an option, you get paid a premium by the buyer. This is what you “earn” for taking the risk of selling the option. When you sell a call option, you have the obligation of selling the buyer a futures contract at the agreed upon strike price any time before the option expires. When you sell a put option, you have the obligation of buying a futures contract at the agreed upon strike price any time before the option expires.
In layman’s terms if you sell a Call option you must go to the market and buy a long futures contract at the option strike price if the buyer wants to exercise the option. They would never do that unless the futures market was trading above their strike price. And it’s the opposite for a Put option; where you must go to the market and sell a short futures contract at the option strike price if the buyer wants to exercise the option. They would never do this unless the futures market was trading below their strike price.
For doing this, the seller gets to keep the premium even if the option is never exercised. In other words, the seller never has to give back the premium to the buyer. So as a seller of an option if you were to collect $500 in premium and the trade went against you, and you wanted to buy it back for $600 then your net loss would only be $100.
Out-of-The-Money: An option that has no intrinsic value (only has time value) is called out-of-the-money. In other words, a call option that is above the current price or a put option that is below the current market price.
Premium: This is the amount of money you are paid by the person who buys the option from you. The total risk that the buyer has is the amount that he pays the seller in premium. The maximum amount of profits that the seller of the option can make is the amount of the premium collected.
The amount of premium is set by the floor traders by negotiating between the option buyers and sells and of course depending on what the underlying markets are doing. In flat markets options are cheaper and in volatile markets options are more expensive.
Put Option: When someone buys a put, they have the right to sell the futures contract at the agreed upon strike price. The seller then has the obligation to deliver the futures contract at the strike price on or before the expiration date of the option.
Spread: When someone has two or more options in the same market, but it does not have to be on the same contract. You would still be in a spread if you had an option in the January contract and one in the March contract of the same commodity. The latter is called a Calendar Spread.
Strike Price: This is the agreed upon price of the option. The buyer of a call can purchase the futures contract and the buyer of a put can sell the futures contract at this price. Every option that is sold must have a strike price as well as an expiration date.
Theoretical Value: This is the price of an option that is calculated by a complex mathematical formula developed by two men, known as the Black -Scholes formula. This value is based on several factors, volatility, time until expiration, interest (a minor part) strike price and the current price of the underlying commodity.
Time Value: The amount of the premium that exceeds the intrinsic (if any) value of the option. An out-of-the-money option has only time value. It does not have any intrinsic value.
Volatility: This measures the change in the options price during a specific period of time. In very volatile markets option prices can jump up or down very quickly.
The more volatile the market is, the more the option will cost. As a general rule, you want to sell options in a volatile market, not buy them, since they are usually overpriced giving you an opportunity to receive a higher premium.
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* Testimonials are not a guarantee of future success. All information is for educational use only and is not investment advice. Trading financial instruments, including Stocks, Futures, Forex or Options on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in any of these financial instruments you should carefully consider your investment objectives, level of experience, and risk appetite. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. The possibility exists that you could sustain losses exceeding your initial investment. You should be aware of all the risks associated with trading and seek advice from an independent financial adviser if you have any doubts. Past performance, whether actual or hypothetical, is not necessarily indicative of future results. All depictions of trades whether by video or image are for illustrative purposes only and not a recommendation to buy or sell any particular financial instrument and do not factor in trading costs in trading examples due to varying commission and fees among traders. The impact on market prices due to seasonal, market cycles or news events may already be reflected in the price. See full risk disclosure. See full risk disclosure.