How to Trade Options
You’ll find plenty of information about the dynamics of options and how to use them to make money in the options market. Almost no one discusses how to trade them, however. While it isn’t difficult to trade options, there are some nuances that you should take into to consideration.
Options trade much like stocks do. You have a bid and an ask price. Usually, the trade gets settled somewhere in between the two, but not always. With options however, you have something known as open interest, which is an important concept to understand.
Note: this article assumes you are familiar with the use of options. For a refresher, check out the following article.
When you purchase an option, you now have an open position with that option. This gives you three options to consider. You can sell the option any time before the expiration date or you can exercise your option. The third option is to let the option expire if the stock did not move in the direction you were hoping. Obviously, the option you choose depends on the market condition and the price of the stock.
Note: Early exercise is available for American options. European options must be help to expiration. However, the contracts for European options can be closed out before expiration.
If you decide to get out of your option, you are essentially reversing your open position, or you are closing it. When you buy an option, you sell it to reverse and close out your position. Conversely, when you sell an option, you would buy it to close it out.
Each brokerage will handle the transactions a bit differently but the concept is the same. Make sure you understand how your broker handles the transactions before making any live trades. Sometimes, they have tutorials that you can view to get a better understanding. Don’t ignore these if you are new to options trading.
When you get to the point of trading more advanced option strategies, be aware that you will have to pay commissions on each leg that you transact. For instance, if you were to trade a straddle, this is the simultaneous buying of a call option and a put option, you would pay commissions on both of those legs. A straddle is used when you expect a big jump in a stock in either direction but aren’t sure which direction the stock will go. One of the legs will expire worthless while the other will profit handsomely. If you decide to close one or both of the legs, you will need to pay commissions on those as well.
Make sure you understand which option in the chain you are buying. Some beginners think they are buying one leg, when in fact, they end up buying something else. They calculated their target profits on the strike price they thought they were buying, only to discover that the profit is smaller, or worse, it turns into a loss.