First in a series of brief, instructional articles that start at the beginning and build to combining and applying basic option trading principles in more complex strategies, including spreads.
There’s only so much about the markets you can learn from books, right? At some point you have to jump in. Experiment. Struggle. Learn. Tinker. And, ultimately, grow more confident in adding options to your investing mix. That’s our goal here with a series of brief, instructional articles that start at the beginning and build to combining and applying basic principles in more complex (complex, sure, but also more versatile) strategies, including spreads. Now options trading isn't for everyone, but we’ll toss in links to archived The Ticker Tape articles and blogs on options that will appeal to traders of all grade levels.
Finding an awesome lab partner for you? That’s out of our scope. But we can say this: options trading (like all trading) is an increasingly social endeavor. We invite you to share and learn in a chat room such as myTrade. Or, follow the Twitter pages of the always-exploring, always-experimenting members of the TD Ameritrade trading team, Joe “JJ” Kinahan and Nicole Sherrod. Email the editors options article and blog topics you’d like to see.
paperMoney® gives you real market experience without real dough on the line. At the thinkorswim login screen, select paperMoney before signing in.
Practice helps traders evolve. But so does testing your market mettle in your live account. paperMoney is designed to help get you trading for real.
First, a little textbook time. Options are primarily used three ways:
. However, the strategy will limit the upside potential of the underlying equity position, as the stock would likely be called away in the event of substantial stock price increase.
Calls are options to buy an “underlying” asset, like a stock. The buyer obtains the right (but not the obligation) to purchase the underlying stock at a pre-set time and price. The seller of a call assumes the obligation to supply the underlying asset if the call contract is “exercised.”
Puts, then, are options to sell a stock. The buyer obtains the right (but not the obligation) to sell the underlying stock. The seller of a put assumes the obligation to purchase an underlying asset if the put contract is exercised.
Consider four basic option positions:
There are trade-offs between potential risk, the probability of realizing profit, and the size of that potential profit. Generally speaking, the lower the risk or the higher the probability of profit from a given trade, the smaller the potential percentage profit.
Part of your challenge is to balance these trade-offs. For example, an option’s value is continuously whittled down by time. Because of this, there’s a constant tug back and forth. On the one hand, you have the option’s value eroding as time passes. On the other hand, you may be waiting for a favorable move in the underlying stock price or an increase in implied volatility (more on this below) that will raise the value of the option. Therefore, you need to consider the timing and the magnitude of the anticipated rise in a stock price. When you trade options, you accept the interplay of these decisions as a form of speculation.
Log in to tdameritrade.com > Education > Education Center > Options
At expiration, an option can be worth whatever its intrinsic or in-the-money (actual) value is. It can also be worth nothing. In general terms, option values depend on the stock price, the option’s strike price, the stock price’s implied (or estimated) volatility, time to expiration, interest rates, and any dividends on the stock payable before the option’s expiration.
Pricing can’t be discussed without first taking on “volatility.” Accept it: volatility—the magnitude of price changes in a stock or index—happens. The rate of change might seem high or low (strong or weak). But no matter what volatility has done, will do, or is doing right now, trade through. Imagine you’re shooting an arrow at a target. The wind might push the arrow a little bit to the left or the right. To compensate, you aim the arrow a little bit left or right to account for the wind’s velocity affecting your arrow’s path to the target. Trading in the context, and presence, of volatility means you may need to adjust your trading strategy like you did with the wind.
Rules of thumb: The higher the volatility, the more expensive the option. The more days until expiration, the more expensive the option. Dividends reduce the value of calls and increase the value of puts. An increase in interest rates increases the value of calls and decreases the value of puts.
Today’s take-home: Remember that whenever an option trade occurs, the buyer thinks the option is too cheap and the seller thinks it’s too expensive. The fact that people disagree on value is why any trading occurs at all. Rather than worrying about an option’s value, you might concentrate on the trade’s risk/reward and your investment needs. Something to think about.
Do Not Sell or Share My Personal Information
Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
A covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.
The paperMoney® software application is for educational purposes only. Successful virtual trading during one time period does not guarantee successful investing of actual funds during a later time period as market conditions change continuously.
myTrade is a service of myTrade, Inc., a separate but affiliated firm. TD Ameritrade is not responsible for the services of myTrade, or content shared through the service.
Investools, Inc. and TD Ameritrade, Inc. are separate but affiliated companies and are not responsible for each other’s services or policies.
Investools® does not provide financial advice and is not in the business of transacting trades.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC, a subsidiary of The Charles Schwab Corporation. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2024 Charles Schwab & Co. Inc. All rights reserved.