Options Trading Tutorial for beginners

Options are among the most diverse trading instruments. The advantage over a direct investment in an underlying asset is primarily the significantly lower capital requirement. In addition, options can be used in a wide variety of combinations to profitably implement expectations of price performance.

Likewise, option writer strategies can be used to generate continuous income. As a supplement to existing investment portfolios, they are an effective instrument for optimizing returns. This premium income is often counted as a second dividend.

In the same way, the portfolio can be hedged against losses at relatively low cost. Depending on the investment horizon, both short-term and long-term risks can be covered to a scalable extent.

Due to the leverage effect, options, like any other financial instrument, require precise knowledge of their function. In this series of articles, I would like to create the necessary conditions for successful options trading.

In this article you will find an overview of the parts already published on the topic of “trading options”. This way you can directly access the section that interests you most or read the articles in ascending order.

The brokers for a successful start

Options can be traded via an appropriate broker. The variety of providers is just as large as the performance promises. For option trading, there are a number of things to consider when choosing a broker.

In general, the broker must route the order to a futures exchange. According to my information, only Interactive Brokers and their Introducing Brokers, such as CapTrader, Lynx Broker and Banx Broker, currently offer this possibility in Germany.

IG.com offers another possibility. With a corresponding account you can trade vanilla options on certain underlying assets. I have not had any real money experience with this option myself. In the demo version, options can also be sold and combined. This is how the strategies presented here would also work at IG.com.

Under the links you will find the respective test reports on the brokers. Here you can get an overview of the fee structure and account models.

With some offers the term “option” is used misleadingly. Then it can be warrants, or even constructions of the respective broker himself. If in doubt, it is advisable to read the small print or contact the provider’s customer service department.

For an entry into options trading I recommend a minimum capital of 5000 Euro. Based on my own experience and the margin requirements of the brokers, this is a good way to take your first steps in options trading.

Differences between options and warrants

Due to some common features, it often happens that options and warrants are rated equally. Similarities can be found between the purchase of an option and the purchase of a warrant in the key data, such as exercise price and term.

Probably the most significant difference is that options are always subject to a defined standard. They are always issued by the futures exchanges. There is always only one option of the same type.

And the factor that makes options the most attractive financial instrument for me must not be forgotten:

You can also sell options without having to own them. This means that you can act as a provider / writer yourself.
Warrants, on the other hand, are issued by financial institutions, mainly banks. So it can happen that warrants with the same basic data can be found, but from different providers. They are provided with a WKN/ISIN and can be traded on the stock exchange.

Off-exchange trading – OTC

Alternatively, warrants can also be purchased from the corresponding provider. With most brokers the stock exchange “OTC” (Over the Counter) is available for this purpose. This enables over-the-counter trading between market participants.

Warrants and certificates can only be sold if you own them.

In addition to a large number of providers, there is a wide variety of products. The rules and regulations are different for each variant of a warrant. In addition, some providers reserve the right to extraordinary termination. In any case, you should always consult the information sheet available for the respective product before making an investment.

Determine the financial instrument

In the TWS trading software, which is used by Interactive Brokers, the characteristics of the financial instruments can be displayed. It is important to note the type of security. Options are marked “OPT”, warrants are marked “WAR” for Warrant.

In the following screenshots the differences are marked:

Function of SMART Routing for IB

)* For Interactive Brokers (IB), SMART Routing refers to the intelligent matching of the available stock exchanges in order to obtain the best possible execution, taking fees into account. From my own experience, I can confirm that, above all, fast and fair execution takes place. You can find more information about this at IB or for example CapTrader > SMART Routing

The multiplier

For warrants, the multiplier is also referred to as the subscription ratio. This determines the ratio of the derivative to the underlying instrument. With an options contract, you trade the equivalent of 100 shares accordingly. With the warrant from the screenshot, you need 10 warrants to participate in the price movement of a share.

Furthermore, I would like to recommend the following articles from the Kagels Trading Blog as a further enrichment to the topic:

  • Overview of certificates and leverage certificates (Update 2020)
  • Warrants – Understanding and acting (2020)

For my personal trading style, warrants and certificates have not proved to be a good choice. In the course of time, it has become clear that I can optimally implement my trading ideas with options. Therefore I will continue with a small example.

Trading options – An example of the call option

The trading instrument “option” offers an option on the purchase of an underlying. In order to make the subject more understandable, the purchase of an everyday object is often used. Let’s embed this in a story:

In a conversation with your neighbour, he tells you that he would like to buy a used car. He has precise ideas about the make, model, equipment and even the mileage. Of course, he has also already asked what prices are currently being charged for it.

On the way home from work, you see the vehicle you want with a “For Sale” sign in a driveway. You stop and contact the owner. During the conversation it turns out that the vehicle could be purchased for a good 2000 Euros less than your neighbour thought. You get an idea.

Options are agreements between parties to the contract

You offer the seller 200 euros if he reserves the vehicle for you at the agreed price. If you have not picked it up after three days, he can keep the 200 euros. Since not too many interested parties have contacted us so far, he agrees. So you go home and tell your neighbour that you have found his dream car.

At this point the example is a little bit limping, almost everyone prefers to buy a car himself, of course, before letting the neighbour bring it to him. The principle of a purchase option is nevertheless well illustrated:

  • The vehicle represents the base value of an option…
  • The 200 Euro is the price of the option, also called option premium
  • The term of the option is three days
  • The price you negotiate with the seller symbolizes the strike price of an option
  • The price that your neighbour is willing to pay represents the current market value of the underlying
  • The formula for your profit is: Price – strike price – option premium = profit/loss

The rules and regulations are monitored by the stock exchange

Since in the current case (call option) the price is above the strike price, the option is in the money.
If your neighbour has already purchased a vehicle when you return, the chances of winning are suddenly worse. Then you still have three days to find another buyer. If this is not successful, your option expires.

The calculation is simplified here to show how an option works. The pricing of an option is explained in more detail in the following chapters.

The seller is allowed to keep the premium, but is obliged to deliver the underlying asset at the agreed price. You therefore still have the option of buying the vehicle and keeping it “in your safekeeping”. To do this, you would of course need to have the purchase sum ready.

Or you could declare the project a failure and only lose 200 Euros. This is roughly how the purchase (long) of a purchase option (call), also known as “long call”, works. In the following part of the series (under this >link) I will go into this in more detail.

Rights and duties of a call option

An extremely important and interesting feature of call options becomes clear in this example: You do not have to own the underlying asset to generate a profit. And you don’t even have to hold the capital to buy the underlying asset if you don’t want to buy it.

When you buy a call, you pay the option premium for the right to buy the underlying asset at the agreed price during the term.
The seller receives the premium and in return enters into the obligation to deliver the underlying asset at the agreed price on demand.

Trading Options – An Example of the Put Option

The function of a put option is similar. You acquire the right to sell an underlying asset at an agreed price.

In what cases does this make sense? It can be deduced from history that stock markets rise moderately over time. This rise was interrupted abruptly by crises and unforeseen events.

Sudden price slumps in the market as a whole can also hit a diversified equity portfolio hard. At least in the past, the markets have subsequently recovered to new highs. A young person can sit this one out in a buy and hold portfolio, and even that takes nerves.

Impact of price losses on the personal situation

If someone has geared their portfolio towards a relaxed retirement, a crash in the markets can destroy most of their dreams. Here, the need to hedge against price losses increases.

For this reason, a put can be compared very well with classic liability insurance: You pay an insurance premium to insure yourself against the financial consequences of a defined event. As a rule, your risk is limited to the payment of the premium and is therefore calculable. The term of the insurance cover is also contractually regulated.

The purchase of a putt can also be classified:

  • You can choose individual shares or an index corresponding to the portfolio (e.g. the DAX) as the underlying instrument.
  • You can choose the strike price based on your portfolio structure so that losses above a certain threshold are limited.
  • The option price is the premium you have to pay for this protection.
  • By choosing the term of the option, you determine the time window during which the hedge is effective.

If you hedge individual stocks with a put, you have a choice of two options if prices fall sharply:

  • You can sell the shares via the put at the strike price.
  • You can sell the put option, take the profit less the premium and keep the shares.

Rights and obligations of a put option

  • When you buy a put, you pay the option premium for the right to sell the underlying asset at the agreed price during the term.
  • The seller receives the premium and in return enters into an obligation to purchase the underlying asset at the agreed price on demand.

In the article “The Long Put” the purchase of a put option is explained in detail with all the key data.

Hedging the portfolio with a put

Apple’s share is currently quoted at 315 US dollars. After the pain of the corona correction, we as portfolio holders are glad that the price has come close to its last high relatively quickly. Based on the experience of the last few months, we would like to hedge against renewed price losses.

In the chart the situation can be easily understood (Source: CapTrader TWS-Software)

The option chain / option chain of the broker represents the basic data such as term, strike price, premium, etc. The representation can also be adapted to personal requirements. Here we look for a suitable strike price:

At first glance, the option chain may contain a lot of numbers and data. Since we are looking for a put, let’s take a look at the right page. In the middle we find the base prices. In the line with the chosen strike price, we can then see the price of the option. In the example I take the put with strike $ 280 at a price of $ 19.85.

The term of the put is 240 days. The expiration date of the option is therefore January 15, 2021.

Now the multiplier comes into play

We know from the financial instrument description that Apple options have a multiplier of 100. This means that one option contract (= one option) relates to 100 Apple shares. The displayed price is a unit price, so to speak, and must be multiplied by 100. The premium for this put option is therefore $1985.

If we choose a strike price below the current price for a put option, the option has no intrinsic value. It’s out of the money. If Apple’s price doesn’t drop below $280 by the expiration date, this option will not build up intrinsic value. The premium paid consists entirely of time value, which will decrease until expiration. Then the option expires worthless.

This time value can be seen as a kind of odds. In my understanding, it is the monetary value of the probability that the option can make a profit during the term of the option or, as in the example, the price of insurance against falling prices.

Costs of the protection

Apart from the brokerage fees, I would like to put the costs of hedging into perspective:

  • A position of 100 Apple shares is worth $31,500
  • Hedging below a rate of $280 costs $1,985
  • This will allow you to sell the 100 shares for $28,000 during the term
  • After deducting the premium, you have $26,015 left, even if Apple’s share price drops to $10
  • That’s about $8.28 a day for the entire term

The example is exemplary and should of course be chosen individually for each portfolio. Nor does it take into account an expected price increase of the option if the market value of the underlying asset falls. The time value may well develop dynamically. The implicit volatility, to which I will also devote myself in the course of this series of articles, is decisive for this.

An option price is calculated using the Black & Scholes model. This is a mathematical formula that includes various parameters in the calculation. How option prices can be estimated in relation to the market will be discussed in the course of this series of articles. I will use simplified procedures.

Why I prefer options on US stocks

Liquidity is an important factor in options trading. When I place an order, I want (depending on the limit of course) an execution in the foreseeable future. This means that someone must be willing to accept my price at that moment. The more participants are active in a trading instrument, the greater the probability that a counterpart will be found.

Regardless of the number of these players, there are market makers on every exchange. These are specialists who commit themselves to the exchange to set a buy and sell price for the corresponding trading instrument. This guarantees fair execution in most cases, even if nobody else wants to buy or sell.

No option trading without a contractual partner – who is the counterparty?

A comparison of the contracts traded last year on the futures and options exchanges is an indication of available liquidity. More than twice as many contracts were traded via the CME Group than at Eurex. (Sources: CME Group and EUREX)

My trading focus is on US stock options. The main exchanges for these are the CBOE (Chicago Board Options Exchange) and the NASDAQ (National Association of Securities Dealers Automated Quotations). About 70 to 80 percent of the total volume of stock options on the US market is traded here.

On a five-day average, this represents a daily value of almost 15 billion US dollars. (Source: CBOE Market Statistics) As of 18.05.2020. In addition, there is a large number of optionable stocks that can be evaluated well on the charts. With the screener of finviz.com you can choose the shares on which options are available. Currently there are over 4000 shares available.

With some fine tuning, the list can be reduced step by step to stocks that offer interesting trading opportunities. Two to four trades are possible every week. Through a clever combination of options, the possible price development of shares can be traded with built-in loss limitation and manageable capital requirements.

Sell options – earn premium

Let’s get back to the seller of the car from the example with the Long Call. He got a 200 euro bonus for something that was standing around in his driveway anyway. In return he promised to sell the car at a price he accepted. Basically it doesn’t matter what happens, all he has to do is keep still and he gets 200 euros extra.

If you own shares, you can do the same. You sell calls with base prices that you assume the price will probably not reach those marks. You can keep the premium in any case. Even if the price approaches the strike price, this does not necessarily mean that the buyer wants the shares. Maybe he just sells the call at a profit and is satisfied.

Selling a call option

The thought play with the car can be further spun when you watch the call of a prominent lady in front of the television in the evening. She looks for exactly the vehicle with the chassis number on which you have the option. She is willing to pay almost any price, as personal memories are attached to it. That would be the jackpot, and similarly unlikely.

But how does our still-car owner feel at that moment? Probably not supple enough to bite himself. But wait a minute, nothing bad has really happened to him. The situation is still the same as before the news, he gets the premium and the agreed purchase price.

It’s similar to selling a call on shares you own. Only the price even changes in your favour, since you can still take the profits from the stock position for the price increase up to the strike price (which you have deliberately chosen to be a little higher). This method is also called “Covered Call” and is explained in more detail in the article “The Short Call” – Selling a call option.

Are there unlimited losses in option trading?

On the other hand, a ruinous scenario emerges if you do not own the shares. When in the evening in front of the TV the news comes on the ticker that Microsoft wants to buy the company, every price fantasy goes crazy. It is possible that your portfolio will be forced to be cleared when the market opens. Mathematically, you would then have to buy back the call and realize the losses.

If the buyer exercises the call, you would have the obligation to deliver the corresponding number of shares. You would then have to buy these at the current market price.

Since the price of a share theoretically knows no upper limit, the sale of a call is often used by option-critical people as a negative example. In this constellation, the much-cited “unlimited loss” can arise. Certainly the broker would close your account if there was a lack of cash and, in the worst case, claim the amount of the loss from you.

Nevertheless, every trader with the appropriate knowledge of the tool option trading can protect himself from exactly such situations. The simple combination of different options can determine a profit zone and a predetermined maximum loss. Such trades on selected stocks require little time and little capital investment.

Selling a put option

The most common form of premium income is the sale of puts. Depending on the market situation, good premiums can be achieved with an increased need for cover. Since the price of a share can only fall to zero, the theoretical loss is limited here. Depending on the price and the strike price, immense losses can nevertheless occur.

Even when selling puts, there are possibilities to determine the maximum loss already at the beginning of the trade. Also interesting is a variant with which shares can be bought more cheaply. More about this can be found in the separate article on short puts under this link: Sale of a put option.

The profit and loss profile

In order to better assess the potential of an option trade, the graphical representation has proven to be a useful tool. A chart shows the course of the possible gain or loss as a function of the price of the underlying instrument. More complex strategies in particular can be better assessed in this way.

The TWS trading software from Interactive Brokers already contains a basic version of the profit and loss profile. In this screenshot I have plotted a put on the Apple share as a diagram.

In the diagram, the dotted line represents the current day. The solid line indicates the expiration date. Now you can see the price on the X-axis and accordingly the profit or loss on the Y-axis. You can estimate a risk assessment in the info area to the left of the diagram.

Further strategies can arouse the need for more information. For example, there are professional tools that show the development over time in addition to the chart on the expiration date. Furthermore the Greeks are calculated. In addition, there is even the possibility to simulate changes in volatility and their effects on the trade.

Some strategies react very sensitively to such influences, so that a simulation in advance can be a good decision support.

I myself use the P&L profile of Optionsuniversum. I have linked a detailed description of the content and prices here:
Analysis software for option trades from Optionsuniversum.

Christian Schwarzkopf presents the software and its application in practice in this video:

The “Trading Options” series of articles

The following parts of this series have already been published:

  1. Trading Options – The Successful Entry (this article)
  2. The Long Call
  3. The Long Put
  4. The Short Call
  5. The Short Put

You are welcome to follow me in the further course. I look forward to being able to make the topic dynamic with your questions, suggestions and constructive criticism.

Read my other articles about options:

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