Beginner’s Guide: How to Start Trading Options and Diversify Your Investment Portfolio

Table of Contents

Options trading is a financial instrument that allows traders to buy or sell an underlying asset at a specified price and time. This is a popular way to diversify investment portfolios and manage risk. Investing beginners can benefit from learning about options trading as it is an accessible way to enter the stock market. Options trading involves different trading strategies, such as call options and put options, which can be used to profit from market movements.

To start trading options, one needs to open a trading account with a broker that offers options trading. The trader should also learn about options trading basics, such as options contracts, strike prices, and expiration dates. It is important to have a sound understanding of options trading strategies to make informed decisions and maximise profits.

Beginners can start trading options by learning the basics, exploring different strategies, and utilising available resources such as trading platforms, books, and courses. Successful options trading requires discipline, psychology, and a sound understanding of the options market.

Understanding options trading

Options trading is a financial instrument allowing traders to buy and sell contracts based on the underlying asset’s price movements. Options are derivatives that provide the right, but not the obligation, to buy or sell an asset at a predetermined price and time. Unlike stocks, options trading involves buying and selling contracts, not the underlying asset itself.

Types of Options

There are two types of options: call options and put options. 

• A call option gives the buyer the right to purchase an underlying asset at a predetermined price, known as the strike price, within a specified time frame. The buyer of a call option hopes that the underlying asset’s price will increase, allowing them to buy the asset at a lower price and sell it at a higher price, generating a profit.
• On the other hand, a put option gives the buyer the right to sell an underlying asset at a predetermined price within a specified time frame. The buyer of a put option hopes that the underlying asset’s price will decrease, allowing them to sell the asset at a higher price and buy it back at a lower price, generating a profit.

Benefits and Risks of Options Trading

Options trading provides some benefits for traders. One of the main benefits is the ability to hedge against potential losses in an investment portfolio. Traders can use options to protect their investments against market downturns or to generate additional income through covered call writing. Options trading also allows traders to make speculative bets on the market’s direction, providing potential for high returns.

However, options trading also involves significant risks. Options contracts are complex financial instruments that require a deep understanding of the underlying asset and the market. Traders can lose their entire investment if the underlying asset moves in the opposite direction of their bet. Options trading also requires discipline and a strong psychological mindset, as traders need to manage risk and make quick decisions in a volatile market.

Building your options trading knowledge

When it comes to options trading, there are several key terms and concepts that investors need to understand before they start trading. Here are some of the most important ones:

• Strike Price: The strike price is when the underlying asset (such as stock) can be bought or sold when exercising an option.
• Expiration Date: The expiration date is when an option contract expires. After this date, the option is no longer valid and cannot be exercised.
• Implied Volatility: Implied volatility measures the market’s expectation of how much an underlying asset will move over time. It is an important factor in determining the price of options contracts.

Choosing the Right Options Contracts for Your Trading Strategy

When choosing options contracts, it’s important to have a solid trading strategy in place. Here are a few things to consider:

• Time Horizon: Options contracts have expiration dates, so choosing a contract with an expiration date that aligns with your trading time horizon is important.
• Risk Tolerance: Options trading can be risky, so choosing contracts that align with your risk tolerance is important.
• Market Outlook: The type of option you choose will depend on your outlook for the underlying asset. For example, consider buying a call option if you are bullish on a stock.

Setting up your options trading account

Options trading is a great way to diversify your investment portfolio and increase your returns. However, you must set up an options trading account with a broker before starting trading options. 

How to Open an Options Trading Account with a Broker

The first step to start trading options is to find a reputable broker and open an options trading account. Here are the basic steps to open an options trading account with most brokers:

1. Choose a broker: Look for a broker that offers options trading, has a good reputation, and meets your specific needs.
2. Complete the application: Fill out the broker’s application form and provide the required information, such as your details, employment information, and investment experience.
3. Provide documentation: The broker will require documentation to verify your identity and eligibility to trade options, such as a government-issued ID, Social Security number, and financial statements.
4. Fund your account: Deposit funds into your trading account to start trading options.

Different Types of Accounts and Their Requirements

Different types of accounts are available for options trading, and each has its requirements and benefits. Here are the most common types of accounts:

1. Individual account: This is a standard brokerage account owned by one person. The requirements for opening an individual account vary by a broker but usually require a minimum deposit and identification verification.
2. Joint account: A joint account is owned by two or more people, such as spouses or business partners. The requirements for opening a joint account are similar to an individual account.
3. IRA account: An IRA allows trading options within a tax-advantaged retirement account. The requirements for opening an IRA account include eligibility to contribute to an IRA, minimum deposit, and identification verification.
4. Margin account: A margin account allows you to borrow money from your broker to trade options. Opening a margin account is more stringent than other accounts and usually requires a minimum deposit, identification verification, and a credit check.

Remember always to do your research, understand the risks involved, and develop a solid trading strategy before investing in any financial instrument. Investing for beginners can be overwhelming, but it can be profitable with the right knowledge and preparation.

Developing your options trading strategy

Options trading is a financial instrument that allows traders to buy or sell options contracts, giving them the right to buy or sell an underlying asset at a specific price at a future date. If you’re a beginner investor and want to start trading options, developing a trading strategy that suits your investment portfolio and financial goals is essential.

Options Trading Strategies

• Covered Calls

Covered calls are one of the most popular options trading strategies for beginners. It involves selling call options on your underlying asset and generating income while limiting potential loss. Covered calls are a conservative approach to options trading and are suitable for investors looking to generate income while protecting their investment portfolio.

• Spreads

Spreads are a trading strategy that involves buying and selling options contracts on the same underlying asset with different strike prices and expiration dates. The goal of a spread is to profit from the difference between the two contracts’ prices, limiting potential loss. Spreads are a more advanced trading strategy that requires a higher level of expertise.

• Straddles

Straddles are a trading strategy that involves buying both calls and putting options on the same underlying asset with the same strike price and expiration date. The goal of a straddle is to profit from the underlying asset’s price movement, regardless of its direction. Straddles are a more advanced trading strategy requiring a higher risk tolerance.

Factors to Consider When Developing a Trading Strategy

• Risk Tolerance

Risk tolerance is the degree of risk an investor is willing to take to achieve their financial goals. It’s essential to consider your risk tolerance when developing a trading strategy to ensure it aligns with your investment portfolio and financial goals. Investors with a low-risk tolerance may prefer a conservative approach to options trading, while those with a higher risk tolerance may prefer a more aggressive approach.

• Market Conditions

Market conditions play a significant role in options trading. It’s essential to consider the current market conditions when developing a trading strategy to ensure it aligns with the market’s direction. Investors should also consider the underlying asset’s volatility and liquidity, as they can impact the options contract’s price.

Executing your options trades

Options trading is a popular and exciting way to invest in the stock market and other financial instruments. If you’re just starting, it’s important to understand how to start trading options and use different types of orders effectively to maximise your profits and minimise your risks.

To start trading options, you’ll need to open an account with a broker that offers options trading. Many online brokers offer options trading as part of their services, so be sure to do your research and choose a reputable and reliable broker.

Once you’ve opened an account, you must fund it with money to start trading. From there, you can start placing options trades through your broker. Most brokers offer a variety of options trading strategies and tools, so it’s important to choose the right ones for your investment goals and risk tolerance.

Different Types of Orders in Options Trading

There are several different types of orders available in options trading, each with its own advantages and disadvantages. Here’s an overview of the most common types of orders and how to use them effectively:

• Market Orders: A market order is to buy or sell a stock at the current market price. Market orders are executed immediately, but the price may differ from what you expect, especially in volatile markets.
• Limit Orders: A limit order is buying or selling a stock at a specific price or better. Limit orders ensure that you only pay what you’re willing to or sell for what you want.
• Stop Orders: A stop order is an order to buy or sell a stock once it reaches a certain price, known as the stop price. Stop orders can be used to limit losses or lock in profits.
• Stop-Limit Orders: A stop-limit order combines stop and limit orders. It allows you to set both a stop price and a limit price so that the order will only be executed within a certain price range.

Managing your options trades

Options trading is a financial instrument that allows investors to speculate on the price movement of underlying assets, such as stocks. While it can be a complex investment strategy, options trading can also be a valuable addition to your investment portfolio. 

There are many different strategies that investors can use when trading options. Some popular strategies include buying call options to profit from an increase in the underlying asset’s price, selling put options to generate income, and using spreads to limit risk.

Regardless of your chosen strategy, it’s important to understand the risks involved in options trading. Options trading can be a high-risk investment, as the underlying asset’s price can be volatile and unpredictable. Therefore, it’s crucial to have a well-thought-out plan for managing your trades.

How to Manage Options Trades

Managing your options trades involves monitoring the underlying asset’s price movement and keeping an eye on the expiration date of the options contract. When managing your trades, it’s important to understand your investment goals and risk tolerance clearly.

• One technique for managing your options trades is to use stop-loss orders. Stop-loss orders allow investors to set a predetermined price at which their options contract will be automatically sold if the price of the underlying asset drops below a certain level. This can help limit losses and protect your investment.
• Another technique for managing your options trades is to use trailing stop orders. Trailing stop orders allows investors to set a predetermined percentage or dollar amount by which the stop-loss price will follow the underlying asset’s price. This can help protect profits while also limiting losses.

Stop-loss and trailing stop orders can minimise risk and maximise profits when trading options. If you’re new to investing, it’s important to research and seeks guidance from a reputable source before diving into options trading.

Conclusion

Options trading can be an effective way to diversify an investment portfolio. It allows investors to use various trading strategies with call-and-put options, which are financial instruments that give the holder the right to buy or sell underlying assets at a predetermined price within a specific time frame. Investing for beginners in options trading can be daunting, but understanding options trading can be simplified with the right education. Knowing how to trade options for beginners involves learning the option trading basics, such as options contracts, options market, and options trading platforms. 

Options trading courses, books, and tutorials can provide education and trading tips. Successful options trading requires options trading psychology and options trading discipline. To start trading options, investors can use options trading software or a simulator to practice trading techniques and strategies before entering the options market.

FAQs

Q. What are options trading strategies?

Options trading strategies refer to a set of techniques and methods traders use to maximise their profits and minimise losses when buying and selling options contracts. There are many options trading strategies, including bullish, bearish, and neutral strategies, such as covered call, protective put, straddle, strangle, butterfly, and iron condor.

Q. How can I learn options trading?

Learning options trading requires a combination of theoretical knowledge and practical experience. Many free and paid resources are available online, including books, online courses, and webinars. A good way to start learning options trading is by understanding the basic concepts, such as options contracts, strike price, expiration date, and the difference between call and put options. It is also essential to learn how to use trading platforms and tools to analyse options data, such as implied volatility, delta, and theta.

Q. What is the difference between call and put options?

A call option gives the buyer the right but not the obligation to buy a specific underlying asset at a predetermined price (strike price) before the expiration date. A put option gives the buyer the right but not the obligation to sell a specific underlying asset at a predetermined price (strike price) before the expiration date.

Q. What is a stock option contract?

A stock option contract is a financial instrument that gives the buyer the right but not the obligation to buy or sell a specific underlying stock at a predetermined price (strike price) before the expiration date. Traders and investors use stock options to hedge their risks or speculate on the direction of the stock’s price movements.

Q. What are options trading for beginners?

Options trading for beginners involves buying and selling options contracts on an exchange. It requires a basic understanding of options contracts, pricing, and trading platforms. Beginners should start with simple options trading strategies, such as buying call or put options, and gradually move on to more advanced strategies.

Q. How do I start trading options?

To start trading options, you need to open a trading account with a brokerage firm that offers options trading. Once you have an account, you can place orders to buy or sell options contracts on an exchange. Before placing any trades, it is essential to understand the risks involved and have a solid options trading strategy in place.

Q. What are the best options for trading books?

Many excellent options trading books are available, depending on your level of expertise. Some of the best options trading books for beginners include “Options Trading Crash Course” by Frank Richmond, “Trading Options for Dummies” by Joe Duarte, and “The Options Playbook” by Brian Overby. “Option Volatility and Pricing” by Sheldon Natenberg and “The Option Trader’s Hedge Fund” by Mark Sebastian is highly recommended for more advanced traders.

Q. What are some common options trading mistakes?

Common options trading mistakes include needing a solid trading strategy, needing to understand the risks involved, overtrading, not using stop-loss orders, and not diversifying your portfolio. Avoiding emotional trading and not chasing short-term gains is also essential.

Q. How important is options trading psychology?

Options trading psychology is essential as it can affect your decision-making process and influence your trading outcomes. Developing a disciplined and patient trading approach is essential as avoiding letting emotions such as fear, greed, and anxiety control your trading decisions.

Q. Can I make money trading options?

Yes, it is possible to make money trading options. However, it requires a combination of knowledge, experience, and discipline. Options trading can be risky, and traders should only risk capital they can afford to lose. Successful options traders have a solid trading strategy, manage their risks, and have a disciplined trading approach.

Q. What are the best options for trading courses?

The best trading course options depend on your experience level and budget. There are many excellent options for trading courses available online, including free and paid courses. Some of the best options trading courses for beginners include “Options Trading Simplified” by Udemy, “Options Trading Basics” by Skillshare, and “Options Trading for Beginners” by Warrior Trading. “Advanced Options Strategies” by Investopedia Academy and “Options Trading Mastery” by Option Alpha are highly recommended for more advanced traders.

Q. What is the options trading discipline?

Options trading discipline refers to a trader’s ability to follow the rules and principles when trading options. It involves having a solid trading strategy, managing risk, being patient and disciplined, and avoiding emotional trading. Traders who have good options trading discipline are more likely to make rational decisions, avoid costly mistakes, and achieve their trading goals.

Q. How do I choose the best options trading platform?

Choosing the best options trading platform depends on your trading needs and preferences. When choosing an options trading platform, factors include trading fees, ease of use, trading tools and features, security, and customer support. Some popular options trading platforms include thinkorswim by TD Ameritrade, E-Trade, Charles Schwab, and Interactive Brokers.

Q. What is the options market?

The options market is a financial market where traders and investors buy and sell options contracts. Options contracts give the buyer the right but not the obligation to buy or sell an underlying asset at a predetermined price before the expiration date. The options market allows traders to hedge their risks, speculate on the direction of the underlying asset’s price movements, and generate income through options trading strategies.

Q. How do I start investing in options?

To start investing in options, you need to open a trading account with a brokerage firm that offers options trading. Once you have an account, you can place orders to buy or sell options contracts on an exchange. Before placing any trades, it is essential to understand the risks involved and have a solid options trading strategy in place. It is also recommended to start with small positions and gradually increase your exposure as you gain experience and confidence in your trading abilities.