You've probably learned some basic vocabulary and the benefits of using options before coming across this article. If not, check out "What Are Stock Options?" You're probably all giddy to enter your first option trade. So, in this article on options trading for dummies, we are going to cover what you need to know to execute an actual order for an option contract.
Options Trading For Dummies Basics On How To Buy An Option:
Purchasing one option contract gives you the right, but not obligation, to buy or sell 100 shares of an underlying instrument at a given price on a set date. The primary area of focus in determining what type of option you want to buy is the direction that the underlying is moving. The trend will dictate whether you want to buy a call or a put. If the underlying is moving in an uptrend, then you want to buy a call. If the underlying is moving in a downtrend, then you want to buy a put. Your goal is to sell your option contract at a price that is higher than you paid for it.
Once you have identified the direction of the underlying, you need to select your strike price and time frame. The strike price is the price at which you are buying the right to buy or sell the underlying. A strike price can be "In the Money," "At the Money," or "Out of the Money" and determines the intrinsic and extrinsic value of the option (I will cover these in future articles). To buy a call in a stock that is in an uptrend, you want to select a strike price that is higher than or near to the price at which the underlying is trading. As the underlying moves higher, your call will increase in value. To buy a put in a stock that is in a downtrend, you want to select a strike price that is at or just a little lower than the price at which the underlying is trading. As the stock moves lower, your put will increase in value.
The time frame is the number of days that you have for your trade idea to work. To select your time frame, you want to look at the weekly and monthly options. Weekly options are best for day trading, but not all stocks offer weekly options. It is important to be mindful of the expiration date and to sell your option contract before it. Otherwise, you could find yourself automatically owning 100 shares of the underlying if you were to have an open call contract that expires in-the-money.
Finally, you need to learn some simple terminology to execute an order. In buying a put or call option, you are "buying to open" a position. When you sell that same call or put option, you are "selling to close" that position. This terminology is a little more specific than simply buying or selling an option and it can be confusing when you are entering your order. It will become meaningful as you get into more complex strategies so it is important to get into the habit of using the terms, "buy to open" and "sell to close" from the start.
When entering your "buy to open" order, you will see a bid and ask price listed. Sometimes the spread between the bid and ask can be significantly wide. For an immediate fill, enter the ask price. If you want to buy at a lower price and are willing to wait for a fill, enter the bid price or something that is between the two. When entering your "sell to close" order to exit your position, do the reverse. Enter the bid price to get an immediate fill and enter the ask price if you are willing to wait for a higher price. If your option is thinly traded, lacks liquidity, or is moving quickly, then going for an immediate fill may be your best bet.
Options Trading For Dummies Basics Tips On How To Buy An Option:
1) Use limit orders! A limit order is a type of order that every broker offers and is just a set price that you are willing to buy or sell. As I mentioned above, prices in certain options can be very wide. We don't always want to pay up for an option. To help with better fills, define what you are willing to pay and enter that price with your broker as a limit order.
2) In the beginning, it is ideal to stay away from stocks that are thinly traded in the options market. You will not have to worry as much in trading the indices because there are generally enough participants to provide liquidity and be able to trade with you. When you get into a thinly traded name, it is like entering a roach motel, you can check-in, but you can't check-out.
3) Don't be cheap! Options can yield some amazing returns and that is why you are probably starting to explore them more and more. However, one thing I have learned while working with hundreds of students is that beginners tend to gravitate toward the cheap options. Options are cheap for a reason. Until you get a better understanding of why they are cheap and learn how to utilize cheaper options effectively, I suggest giving yourself enough time and getting as close to the price at which the underlying is trading for the most success.
Options Trading For Dummies Conclusion:
There you go! I hope you enjoyed this article that is part of my new series, Options Trading for Dummies. Now I challenge you to go out there and purchase your first option. Once you do, leave a comment below to share your experience and be sure you sign up for the next installment of my series.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.