How to learn trading options

Options Basics Tutorial.

Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, known as options, presents a world of opportunity to sophisticated investors who understand both the practical uses and inherent risks associated with this asset class.

The power of options lies in their versatility, and their ability to interact with traditional assets such as individual stocks. They enable you to adapt or adjust your position according to many market situations that may arise. For example, options can be used as an effective hedge against a declining stock market to limit downside losses. Options can be put to use for speculative purposes or to be exceedingly conservative, as you want. Using options is therefore best described as part of a larger strategy of investing.

This functional versatility, however, does not come without its costs. Options are complex securities and can be extremely risky if used improperly. This is why, when trading options with a broker, you'll often come across a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Options belong to the larger group of securities known as derivatives. This word has come to be associated with excessive risk taking and having the ability crash economies. That perception, however, is broadly overblown. All “derivative” means is that its price is dependent on, or derived from the price of something else. Put this way, wine is a derivative of grapes; ketchup is a derivative of tomatoes. Options are derivatives of financial securities – their value depends on the price of some other asset. That is all derivative means, and there are many different types of securities that fall under the name derivatives, including futures, forwards, swaps (of which there are many types), and mortgage backed securities. In the 2008 crisis, it was mortgage backed securities and a particular type of swap that caused trouble. Options were largely blameless. (See also: 10 Options Strategies To Know .)

Properly knowing how options work, and how to use them appropriately can give you a real advantage in the market. If the speculative nature of options doesn't fit your style, no problem – you can use options without speculating. Even if you decide never to use options, however, it is important to understand how companies that you are investing in use them. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

This tutorial will introduce you to the fundamentals of options. Keep in mind that most options traders have many years of experience, so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with how the stock market works, you might want to check out the Stock Basics tutorial first.

How to Trade Options – Options Trading Basics.

All investors should have a portion of their portfolio set aside for option trades. Not only do options provide great opportunities for leveraged plays; they can also help you earn larger profits with a smaller amount of cash outlay.

What’s more, option strategies can help you hedge your portfolio and limit potential downside risk. No investors should be sitting on the sidelines simply because they don’t understand options.

This Guide to Options Trading Basics provides everything you need to quickly learn the basics of options and get ready for trading. So let’s get started.

— Two Basic Types of Options.

— At the Money, In the Money, Out of the Money.

Understanding Options Risk – How to Trade Options.

— Prices Can Move Very Quickly.

— Losses Can Be Subtantial on Naked Short Positions.

— Other Common Pitfalls.

— The Price Tag Problem.

— Buying Call Options.

— Buying Put Options.

— Margin – Getting “Approval” to Trade Options.

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Getting your feet wet.

Without getting in up to your you-know-what.

Option trading is more complicated than trading stock. And for a first-timer, it can be a little intimidating. That’s why many investors decide to begin trading options by buying short-term calls. Especially out-of-the-money calls (strike price above the stock price), since they seem to follow a familiar pattern: buy low, sell high.

Educational videos and webinars.

Just getting started? Watch our first-class video content in the comfort of your home. Go »

But for most investors, buying out-of-the-money short-term calls is probably not the best way to start trading options. Let’s look at an example of why.

Imagine you’re bullish on stock XYZ, trading at $50. As a beginning option trader, you might be tempted to buy calls 30 days from expiration with a strike price of $55, at a cost of $0.15, or $15 per contract. Why? Because you can buy a lot of them. Let’s do the math. (And remember, one option contract usually equals 100 shares.)

Call option risk profile.

When you buy a call option with a strike price of $55 at a cost of $0.15, and the stock currently trading at $50, you need the stock price to rise $5.15 before your options expire in order to break even. That’s a pretty significant rise in a short time. And that kind of move can be very difficult to predict.

Purchasing 100 shares of XYZ at $50 would cost $5000. But for the same $5000, you could buy 333 contracts of $55 calls, and control 33,300 shares. Holy smokes.

Imagine XYZ hits $56 within the next 30 days, and the $55 call trades at $1.05 just prior to expiration. You’d make $29,921.10 in a month ($34,965 sale price minus $4,995 initially paid minus $48.90 Ally Invest commissions). At first glance, that kind of leverage is very attractive indeed.

All that glitters isn't a golden options trade.

One of the problems with short-term, out-of-the-money calls is that you not only have to be right about the direction the stock moves, but you also have to be right about the timing. That ratchets up the degree of difficulty.

Furthermore, to make a profit, the stock doesn’t merely need to go past the strike price within a predetermined period of time. It needs to go past the strike price plus the cost of the option. In the case of the $55 call on stock XYZ, you’d need the stock to reach $55.15 within 30 days just to break even. And that doesn’t even factor in commissions or taxes.

In essence, you’re asking the stock to move more than 10% in less than a month. How many stocks are likely to do that? The answer you’re looking for is, “Not many.” In all probability, the stock won’t reach the strike price, and the options will expire worthless. So in order to make money on an out-of-the-money call, you either need to outwit the market, or get plain lucky.

Being close means no cigar.

Imagine the stock rose to $54 during the 30 days of your option’s lifetime. You were right about the direction the stock moved. But since you were wrong about how far it would go within a specific time frame, you’d lose your entire investment.

If you’d simply bought 100 shares of XYZ at $50, you’d be up $400 (minus Ally Invest commission of $4.95). Even if your forecast was wrong and XYZ went down in price, it would most likely still be worth a significant portion of your initial investment. So the moral of the story is:

Don’t get suckered in by the leverage you get from buying boatloads of short-term, out-of-the-money calls.

Hey, don't get us wrong.

On the other hand, don’t get the false impression that you should avoid calls altogether — this site outlines several ways to use them. In fact, this section alone includes three plays for beginners to get their feet wet, and two of them do involve calls.

These strategies are:

The reason we chose these strategies is because they’re designed to enhance your stock portfolio. For now, rookies should aim for a balance between trading stocks and using options when you feel it’s appropriate.

Getting Your Feet Wet Writing Covered Calls Buying LEAPS Calls as a.

Stock Substitute Selling Cash-Secured Puts on Stock You.

Want to Buy Five Mistakes to Avoid When.

Learn trading tips & strategies.

from Ally Invest’s experts.

Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

Multiple leg options strategies involve additional risks, and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point. The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct.

Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. System response and access times may vary due to market conditions, system performance, and other factors. You alone are responsible for evaluating the merits and risks associated with the use of Ally Invest’s systems, services or products. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns.

Securities offered through Ally Invest Securities, LLC. MemberВ FINRAВ andВ SIPC. Ally Invest Securities, LLC is a wholly owned subsidiary of Ally Financial Inc.

Introduction to Options Trading.

Puts, calls, strike prices, premiums, derivatives, bear put spreads and bull call spreads — the jargon is just one of the complex aspects of options trading. But don’t let any of it scare you away.

Options can provide flexibility for investors at every level and help them manage risk. To see if options trading has a place in your portfolio, here are the basics of what options are, why investors use them and how to get started.

What are options?

An option is a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price and by a certain date.

Just as you can buy a stock because you think the price will go up or short a stock when you think its price is going to drop, an option allows you to bet on which direction you think the price of a stock will go. But instead of buying or shorting the asset outright, when you buy an option you’re buying a contract that allows — but doesn’t obligate — you to do a number of things, including:

Buy or sell shares of a stock at an agreed-upon price (the “strike price”) for a limited period of time. Sell the contract to another investor. Let the option contract expire and walk away without further financial obligation.

Options trading may sound like it’s only for commitment-phobes, and it can be if you’re simply looking to capitalize on short-term price movements and trade in and out of contracts — which we don’t recommend. But options are useful for long-term buy-and-hold investors, too.

Why use options?

Investors use options for different reasons, but the main advantages are:

Buying an option requires a smaller initial outlay than buying the stock. An option buys an investor time to see how things play out. An option protects investors from downside risk by locking in the price without the obligation to buy.

If there’s a company you’ve had your eye on and you believe the stock price is going to rise, a “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out you get to buy the stock for less than it’s selling for on the open market. If it doesn’t, your financial losses are limited to the price of the contract.

You also can limit your exposure to risk on stock positions you already have. Let’s say you own stock in a company but are worried about short-term volatility wiping out your investment gains. To hedge against losses, you can buy a “put” option that gives you the right to sell a particular number of shares at a predetermined price. If the share price does indeed tank, the option limits your losses, and the gains from selling help offset some of the financial hurt.

How to start trading options.

In order to trade options, you’ll need a broker. Check out our detailed roundup of the best brokers for options traders, so you can compare commission costs, minimums, and more. Or stay here and answer a few questions to get a personalized recommendation on the best broker for your needs.

More about options and trading.

Here are some more of our articles on the ins and outs of trading options:

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: : dyochimnerdwallet. Twitter: DayanaYochim.

This post has been updated.

Options Trading 101.

Options Trading 101.

How to Trade Options.

How to Trade Options.

Options trading can be complex, even more so than stock trading. When you buy a stock, you decide how many shares you want, and your broker fills the order at the prevailing market price or at a limit price. Trading options not only requires some of these elements, but also many others, including a more extensive process for opening an account.

Indeed, before you can even get started you have to clear a few hurdles. Because of the amount of capital required and the complexity of predicting multiple moving parts, brokers need to know a bit more about a potential investor before awarding them a permission slip to start trading options.

Opening an options trading account.

Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks in options and their financial preparedness.

Before you can start trading options, a broker will determine which trading level to assign to you.

You’ll need to provide a prospective broker:

Investment objectives such as income, growth, capital preservation or speculation Trading experience, including your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year and the size of your trades Personal financial information, including liquid net worth (or investments easily sold for cash), annual income, total net worth and employment information The types of options you want to trade.

Based on your answers, the broker assigns you an initial trading level (typically 1 to 4, though a fifth level is becoming more common) that is your key to placing certain types of options trades.

Screening should go both ways. The broker you choose to trade options with is your most important investing partner. Finding the broker that offers the tools, research, guidance and support you need is especially important for investors who are new to options trading.

For more information on the best options brokers, read our detailed roundup to compares costs, minimums and other features. Or answer a few questions and get a recommendation of which ones are best for you.

Consider the core elements in an options trade.

When you take out an option, you’re purchasing a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price by a certain date. In order to place the trade, you must make three strategic choices:

Decide which direction you think the stock is going to move. Predict how high or low the stock price will move from its current price. Determine the time frame during which the stock is likely to move.

1. Decide which direction you think the stock is going to move.

This determines what type of options contract you take on. If you think the price of a stock will rise, you’ll buy a call option. A call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price (called the strike price) within a certain time period.

If you think the price of a stock will decline, you’ll buy a put option. A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires.

2. Predict how high or low the stock price will move from its current price.

An option remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for puts it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.

For example, if you believe the share price of a company currently trading for $100 is going to rise to $120 by some future date, you’d buy a call option with a strike price less than $120 (ideally a strike price no higher than $120 minus the cost of the option, so that the option remains profitable at $120). If the stock does indeed rise above the strike price, your option is in the money.

Similarly, if you believe the company’s share price is going to dip to $80, you’d buy a put option (giving you the right to sell shares) with a strike price above $80 (ideally a strike price no lower than $80 minus the cost of the option, so that the option remains profitable at $80). If the stock drops below the strike price, your option is in the money.

You can’t choose just any strike price. Option quotes, technically called option chains, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.

The price you pay for an option has two components: intrinsic value and time value.

The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike. Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while time value is $5.

This leads us to the final choice you need to make before buying an options contract.

3. Determine the time frame during which the stock is likely to move.

Every options contract has an expiration date that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out.

A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price. An option’s time value decays as expiration approaches, and options buyers don’t want to watch their purchased options decline in value, potentially expiring worthless if the stock finishes below the strike price. If a trade has gone against them, they can usually still sell any time value remaining on the option — and this is more likely if the option contract is longer.

More about the types of options trades.

What's next?

Find the best broker for options traders.

Dig into options trading strategies.

Learn the essential options trading terms.

James F. Royal, Ph. D., and Dayana Yochim are staff writers at NerdWallet, a personal finance website. : jroyalnerdwallet, dyochimnerdwallet. Twitter: JimRoyalPhD, DayanaYochim.

This post has been updated.

Options Trading 101.

Options Trading 101.

5 Tips for Choosing an Options Broker.

5 Tips for Choosing an Options Broker.

Options trading can be complicated. But if you choose your options broker with care, you’ll quickly master how to conduct research, place trades and track positions.

Here’s our advice on finding a broker that offers the service and the account features that best serve your options trading needs.

1. Look for a free education.

If you’re new to options trading or want to expand your trading strategies, finding a broker that has resources for educating customers is a must. That education can come in many forms, including:

Online options trading courses. Live or recorded webinars. One-on-one guidance online or by phone Face-to-face meetings with a larger broker that has branches across the country.

It’s a good idea to spend a while in student-driver mode and soak up as much education and advice as you can. Even better, if a broker offers a simulated version of its options trading platform, test-drive the process with a paper trading account before putting any real money on the line.

2. Put your broker’s customer service to the test.

Reliable customer service should be a high priority, particularly for newer options traders. It’s also important for those who are switching brokers or conducting complex trades they may need help with.

Consider what kind of contact you prefer. Live online chat? ? Phone support? Does the broker have a dedicated trading desk on call? What hours is it staffed? Is technical support available 24/7 or only weekdays? What about representatives who can answer questions about your account?

Even before you apply for an account, reach out and ask some questions to see if the answers and response time are satisfactory.

3. Make sure the trading platform is easy to use.

Options trading platforms come in all shapes and sizes. They can be web - or software-based, desktop or online only, have separate platforms for basic and advanced trading, offer full or partial mobile functionality, or some combination of the above.

Visit a broker’s website and look for a guided tour of its platform and tools. Screenshots and video tutorials are nice, but trying out a broker’s simulated trading platform, if it has one, will give you the best sense of whether the broker is a good fit.

Some things to consider:

Is the platform design user-friendly or do you have to hunt and peck to find what you need? How easy is it to place a trade? Can the platform do the things you need, like creating alerts based on specific criteria or letting you fill out a trade ticket in advance to submit later? Will you need mobile access to the full suite of services when you’re on the go, or will a pared-down version of the platform suffice? How reliable is the website, and how speedily are orders executed? This is a high priority if your strategy involves quickly entering and exiting positions. Does the broker charge a monthly or annual platform fee? If so, are there ways to get the fee waived, such as keeping a minimum account balance or conducting a certain number of trades during a specific period?

4. Assess the breadth, depth and cost of data and tools.

Data and research are an options trader’s lifeblood. Some of the basics to look for:

A frequently updated quotes feed. Basic charting to help pick your entry and exit points. The ability to analyze a trade’s potential risks and rewards (maximum upside and maximum downside). Screening tools.

Those venturing into more advanced trading strategies may need deeper analytical and trade modeling tools, such as customizable screeners; the ability to build, test, track and back-test trading strategies; and real-time market data from multiple providers.

Check to see if the fancy stuff costs extra. For example, most brokers provide free delayed quotes, lagging 20 minutes behind market data, but charge a fee for a real-time feed. Similarly, some pro-level tools may be available only to customers who meet monthly or quarterly trading activity or account balance minimums.

5. Don’t weigh the price of commissions too heavily.

There’s a reason commission costs are lower on our list. Price isn’t everything, and it’s certainly not as important as the other items we’ve covered. But because commissions provide a convenient side-by-side comparison, they often are the first things people look at when picking an options broker.

A few things to know about how much brokers charge to trade options:

The two components of an options trading commission are the base rate — essentially the same as thing as the trading commission that investors pay when they buy a stock — and the per-contract fee. Commissions typically range from $3 to $9.99 per trade; contract fees run from 15 cents to $1.25 or more. Some brokers bundle the trading commission and the per-contract fee into a single flat fee. Some brokers also offer discounted commissions based on trading frequency, volume or average account balance. The definition of “high volume” or “active trader” varies by brokerage.

If you’re new to options trading or use the strategy only sparingly you’ll be well-served by choosing either a broker that offers a single flat rate to trade or one that charges a commission plus per-contract fee. If you’re a more active trader, you should review your trading cadence to see if a tiered pricing plan would save you money.

Of course, the less you pay in fees the more profit you keep. But let’s put things in perspective: Platform fees, data fees, inactivity fees and fill-in-the-blank fees can easily cancel out the savings you might get from going with a broker that charges a few bucks less for commissions.

There’s another potential problem if you base your decision solely on commissions. Discount brokers can charge rock-bottom prices because they provide only bare-bones platforms or tack on extra fees for data and tools. On the other hand, at some of the larger, more established brokers you’ll pay higher commissions, but in exchange you get free access to all the information you need to perform due diligence.

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: : dyochimnerdwallet. Twitter: DayanaYochim.

Options Trading 101.

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