How To Trade Options
Why trade options?
Have you ever wanted to trade a high priced stock like Amazon (AMZN) or Tesla (TSLA)? These stocks seem so expensive and so out of reach that a lot of people with smaller accounts get tricked into trading things like penny stocks or in low-priced Biotech stocks, both of which are extremely risky. Read on for a quick overview on how to trade options to trade these stocks even with a small account.
The nice thing about this is that an option contract gives you leverage to trade higher priced stocks with less capital. One option contract is the same as 100 shares of stock. For example, if Amazon stock is at $2,000 per share, instead of buying 100 shares for $200,000, you could use options to trade a short term move in Amazon for $5,000 per contract. You’ll see in the options chain, the price for the at-the-money option is listed at $50, but multiply that by 100 to get the actual price the option will cost.
I trade options to take advantage of short term moves in stocks. I trade big names, like Amazon, Tesla, Apple, Netflix, no obscure stocks. These are all big household names I’m trading with a lot less capital than it would take to buy 100 shares of stock. Most of the time, I enter an options trade and close it just a few days later.
I think of options as a way to create income. While you can trade options on crypto, if you’re looking for short-term payoffs, I think options on stocks are way more predictable and more manageable than crypto.
What is an option?
Let’s say that Tesla is $800 per share. If you want to buy 100 shares of Tesla at $800 per share, it’s going to set you back $80,000. If you’re day trading, you could use margin and possibly trade it with shares of stock. Alternatively, you could buy one option contract on 100 shares, and the price could vary, but on average it’s about $2,500 depending on which option that you choose. I buy options that are slightly in-the-money; they’re not the cheap out-of-the-money options.
The main point here is you could buy one option for $2,500 or you could buy 100 shares of stock for $80,000. One option contract is like trading 100 shares of stock, in fact, you can exchange it for 100 shares of stock if you wish. For $2,500, you can participate in nearly the same movement of the stock as if you owned 100 shares. If the stock price rises by $10, your option won’t necessarily go up dollar for dollar but it could go up $7. Overall, options are a way to participate in the price movement of legitimate stocks using leverage.
How to trade options?
In a nutshell, and to keep things very, very simple: if you think a stock is going to go up, buy a call option. If you think a stock is going to go down, buy a put option. As you can see, with options, you can play stock moves both ways. Whether a stock is going up or down, you can play the stock both ways.
This applies to the market as a whole too. If you see signals that the market is heading lower, you could buy a put option on the stock market itself, meaning you will make money as the market drops.
You can trade options on any brokerage platform – the two I use are Thinkorswim and tastytrade. You can also use Fidelity, Schwab, Robinhood, or eTrade. The platform I use most is ThinkorSwim by TD Ameritrade – they’re really dialed into what traders need to do technical analysis and have very customizable charting.
At first glance, the options chain can look complicated, but once you know the information you’re looking at it becomes easy to read. In the image below, you can see the options chain for the stock Square, trading at about $83. On the left are different expiration dates; there are options that expire in four days, there are options that expire in 46 days, there are options that expire in 228 days, etc. There’s different strike prices as well; you could get a strike price at $75, you could get a strike price at $110, and each strike’s contract will be priced differently based on the strike price.
Call options with a strike price below the current price are considered in-the-money. Call options with a strike price above the current price are considered out-of-the-money. Out-of-the-money options are cheaper because that represents a price area where the stock might go, but won’t necessarily get there, and certainly isn’t there right now. We don’t do a lot of out-of-the-money options.
Now, after you pick a direction, you want to figure out what strike price and expiration date to choose. There are different ways to decide this. For the strike price, we’re going to look at the current price of the stock. Say the price of the stock is $100 per share. That means we could get an option at a strike price of $100, we could get an option at a strike price of $90, and we could get an option with a strike price of $110. We want to pick out the option that’s going to give us the highest probability of success. In this case, since the stock price is at $100 per share, we would choose the $90 strike option because the stock price is above that, giving the option value.
Next we want to pick an expiration date, and really what that means is how long are we going to give this option to work out. A mistake a lot of people make is to think, ‘well today’s Wednesday, I will buy an option that expires Friday’ – only giving their trade two days to work out. If they’re not right over the next two days, they can lose all their money from buying the option. Oftentimes, if you give it more time to work out, you will have a better chance of success.
Alright, so how do we give out trade enough time to work out without giving it too much time? Let’s say that you think Apple will move above $390 in the next couple of weeks, so you buy an Apple call option at $390. If Apple moves above $390 before your option expires, your option gains value. Now, if you had bought an Apple $420 a call, which is way out-of-the-money, and if by expiration, the stock can’t even make it there, your option is going to go to zero. This just goes to show that out-of-the-money options are cheap for a reason.
It’s very, very low probability that it’s even gonna get there, okay, so we wanna be very careful that we’re not buying the wrong option, and that’s what I made a mis… Big mistake when I first started. So strike price is really important when you’re choosing which option to do, don’t just go for the cheapest one, the cheapest one is typically the worst one.
How to buy a call option?
To buy a call, we want to finalize the price and submit our order. Once you select the option you want to buy, you’ll see the order entry, just right click, review the order, then click confirm and send. My rule of thumb is to never use a market order for entries because you can get a bad fill price. Use a limit order and set the price that you want to get filled. Sometimes, you might have to use market orders for exits if you’re trying to get out in a hurry, but never do a market order for entry.
Using a market order for an entry is like going to the used car lot and saying ‘Hey, I really like that green BMW, here’s a blank check, please feel on the price that you feel is appropriate.’ The car salesman will likely jack up the price and rip you off. It’s kind of the same thing in the options market; if you do a market order to get in, you’re going to get the worst fill possible, so do a limit order. Typically, I set my limit order price in between the bid and the ask. If you have ThinkorSwim, you can use what’s called the midpoint price, and that’s a pretty good area to set your entry price.
When you review your order, you’ll see a string of characters that is the order. What you’ll see when you review is something like this:
BUY 1+ SQ 100 17 JUL 20 90 PUT @9.90 LMT [TO OPEN]
What is all this? The ‘Buy’ is the action, +1 is how many contracts you’re buying, SQ is the ticker symbol you’re trading, 100 is just the options multiplier. The date is written as ‘17 Jul 20’ and the strike price comes right after the date. You’re buying a put option, at a price of $9.90, to open a trade. The options multiplier (100) is just saying that each option contract represents 100 shares of stock. You multiply the price by 100 to get the actual cost of the option. In this example, $9.90 times 100 is $990 for a put option on SQ.
Remember, resist the temptation to get those cheaper options that expire in two days. Once you select the strike price, finalize the price, click the lock button next to the price to make sure that the price doesn’t change once you submit your order. Double check your max loss and max gain, then confirm and send your order. You’ll get an alert once the order is filled.
When you do buy a call option, the absolute most you can lose is the amount of money you pay, in the example above, the max loss is $990. This is a benefit to trading options, because if you were trading futures, you could put up $900 to trade futures, and if it gaps way far against you, you can owe your broker more than you have in your account. That won’t happen in this situation, the most you can lose when buying a long call or a long put is the amount you pay for the option. This gives traders a lot of control over the amount of money they put at risk for each trade.