• Nick Burgess

Options Trading for Beginners - A How To for Aspiring Millionaires

Updated: Apr 6

Learning Options Trading - Investing's Advanced Class

Chances are, if you're reading this article, you've been exposed to the stock market in a greater capacity than "how do I buy shares of Apple?" You might have a brokerage account and you've probably seen the "Options" tab of your preferred platform and wondered "what is that?" or "how is that different than what I'm doing?" Then maybe you put it in the back of your mind and go about your day, perusing Twitter and seeing a screenshot of someone making $1 million off of a $500 call option in Tesla and it reminds you "I still have no idea what's happening here."


Well today, I'm here to demystify one of the most misunderstood financial instruments in the stock market. Today, I'm going to explain what options are, how you can make money when a company moves up or down (or sideways), and how options directly influenced popular culture early this year. First up, what the hell are these things anyway?

reddit logo and r/WallStreetBets options trading logo
Options contracts were popularized by Reddit's WallStreetBets community in 2021

What Is An Option?

Simply put, an option is the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. It's essentially a contract that you're buying your way into with another person in the market that represents 100 shares of an underlying asset.


If you're purchasing an option, you are betting on a company moving either up or down against the person you're purchasing the option from, who is betting that the opposite happens. If you're betting on the company's share price increasing, you would purchase a call option, which increases in value as the company's price increases. If you think it's going down, you would purchase a put option, which increases in value as the company's price decreases.


If you'd like to get started in your own investing journey, my friends at Robinhood are giving new users up to $200 in FREE stock when they sign up using this unique link. Thanks for reading, and thanks for supporting the site!


But how does this happen? It happens because options contracts are a class of financial instrument known as a "derivative." That's because the contract is derived from the underlying financial instrument, the company, but is not a direct buy or sell of that company. It's company adjacent. Confusing, I know. But let's use a real world example.

Let's say that Company X (we're just going to call it "CX" from here) is trading at $100 per share. You think that CX is going to release a new product that will be successful and drive a large amount of revenue, so you think the stock price will increase. Instead of purchasing 100 shares of CX, which would cost you $10,000, you instead purchase a call option that expires in December with a strike price of $110, and the contract premium costs $60. That's a lot of terms, so let's break them down:

  • Strike Price - this is the dollar amount your underlying company has to hit for you to "win" the contract. Once this dollar amount is hit, it's referred to as "in the money" or "ITM" and you can exercise the contract to purchase the 100 shares at that strike price

  • Expiration Date - contracts aren't valid forever. They have agreed upon expiration date, and if your underlying company doesn't hit the strike price by then, your contract expires "out of the money" or "OTM" and you "lose" the contract, unable to exercise

  • Contract Premium - this is the amount you're purchasing the contract for in the first place. Contract premium amounts are decided by a variety of factors, including demand, expiration dates, strike prices, etc. Generally, the higher the strike price, the cheaper the premium as the chance of profit is less. Also, the further out the expiration date is, generally the more expensive the premium is because it gives the company more time to increase/decrease in value.

Explaining Options Trading Greeks

I've spoken a bit about the fundamental definitions of a contract, but now it's time to talk a little math. I know, I know. This is everyone's least favorite part, but we need to chat about the forces at work that are behind every movement of a contract: The Greeks.

Delta, Gamma, Theta and Vega

Defined as Delta, Gamma, Theta and Vega, these all measure different aspects of the value of a contract. Here's how the break down:

  • Delta - this is the expected amount an option contract value will change based on a $1 to the underlying company. Effectively, it's a measure of sensitivity of the option you're purchasing in relation to the underlying asset. You'll typically see this number measured between -100 and +100, indicating the overall sensitivity level in dollar terms.

  • Gamma - Gamma actually directly impacts Delta. "Gamma is the rate of change in delta for each one point increase in an underlying asset." This is essentially used to forecast changes in the change forecast. Finance guys, ya know?

  • Theta - this measure time decay. Remember the expiration dates we talked about earlier? As that date approaches, the contract prices move more aggressively as the underlying asset moves, due to time decay, measured in Theta. This is because of the potential value of the contract as you near the expiration date, as the value is more "real" closer to the expiration.

  • Vega - This one is a little more abstract. It's the measurement of sensitivity in relation to the volatility of the underlying asset. Think of this one as the one to understand last, as each contract will have its own Vega based on expiration, contract price, strike price and all sorts of variables that make this one tough to track down.

Do you have to calculate all of these on your own? God no. That's one of the beautiful parts of the digital brokerage world: they do it for you. Now you may be asking "what's a good or bad Greek?" The answer is: that doesn't exist. Greeks don't necessarily equate to good or bad. They are purely concepts to understand in forecasting the potential performance of the contract you're about to lock yourself into.


If you'd like to get started in your own investing journey, my friends at Robinhood are giving new users up to $200 in FREE stock when they sign up using this unique link. Thanks for reading, and thanks for supporting the site!


How Can I Make Money With Options Trading?

So far, I've said a lot of words that probably don't mean anything to you, so I'm going to put this very plainly: contracts can make you a ton of money, but they can also lose you a ton of money.

Let's chat downside first to get that out of the way. Options contracts carry quite a bit of downside when purchasing them, namely that you can lose your entire premium you paid if your contract expires OTM. If you're writing an option (something I'll cover at a later time), your downside could technically be infinite, so you definitely need to understand what you're doing when writing options.


Ok, let's get to the fun stuff: how to make some cash. First, you make money if either event happens:

  1. Your contract expires ITM and you exercise the contract, so you're able to purchase 100 shares of the underlying business for the agreed upon price, or

  2. At some point during the life of the contract, you sell the contract itself for more than you purchased it for

Both options are good. For short term gains, you're likely looking at option two. For long term holds and getting stocks "on the cheap," you're definitely looking at option one. Both of these are equally valid "git gud" strategies, and are very straight forward options. However, there are some advanced strategies that you can learn, or ignore. Either one. It's up to you.


The Most Popular Options Trading Strategies

Strategy

Execution

Reasoning

Covered Call

Purchase the underlying stock and write an option on those shares

Generate contract income while protecting the downside risk

Vertical Spread

Purchasing calls/puts at a strike price and selling calls/puts at a higher price

Offsets the premium paid for the contracts if the person has a strong sentiment on the direction of the company

Strangles

Purchasing OTM options in both directions

You believe that the underlying asset will experience a big price swing, but you're unsure of the direction

Iron Condor

Simultaneously holding both a call vertical spread and a put vertical spread

Generates income based on an underlying asset that you believe has low volatility

Again, these are just a few advanced options strategies that a person can employ to attempt to take advantage of an underlying asset's movement. Keep in mind that this is Wall Street. No matter the situation a company is in, someone somewhere has figured out how to make money from it.


Options Trading On Robinhood

Robinhood has established itself as the go-to platform for options trading for beginners. The ease of use, fun confetti animations and commission-free business model has made Robinhood the ultimate trading platform for millennials.


How To Trade Options On Robinhood

Not every account gets access to trade options in Robinhood from the jump. Essentially, the platform is trying to protect you from yourself by disabling options trading when you first sign-up. It would look bad to have a new user sign up, gamble away their life savings and then cry foul on the platform, so you do have to go in and manually enable the setting.


If you'd like to get started in your own investing journey, my friends at Robinhood are giving new users up to $200 in FREE stock when they sign up using this unique link. Thanks for reading, and thanks for supporting the site!


Options Trading In The Real World - GameStop and AMC

January of 2021 saw one of the most remarkable investing stories in modern stock market history. Retail traders with too much free time and free cash sat on message boards for months, pouring through financial documents and investigating big money moves. One user, RoaringKitty on Reddit, discovered dramatically over-leveraged short interest in one company in particular: GameStop.


At one point in January, GameStop's short interest was 141% of float, meaning that 41% of the short interest wasn't backed by the underlying shares of the company. The Reddit community saw weakness in the market and pounced. Their weapon of choice? Call options. Purchasing call options en masse, the Redditors used the inherent leverage in the instruments to overwhelm the short markets, driving the stock price of GameStop up. When the short sellers were forced to cover their positions, buying back the stock, the demand outstripped supply dramatically and the price continued to be forced up, in turn creating a call option snowball effect that forced prices into astronomical territory extremely quickly. On January 20, you could purchase a GME Feb. 19 $40 call option for $7.40 ($0.74). The next day, these same options were worth $740. One week later, they were worth $2,600.

Of course, options are zero-sum. For every winner, there must be a loser. As retail traders across the globe were winning in their Robinhood accounts, the big loser turned out to be hedge funds, especially Melvin Capital. Melvin's biggest position was its short in GameStop, so when the bloodbath started, they couldn't stop it. The fund lost 53% in Q1 2021, and saw their assets decline 49% over the same period.


Is Trading Options Worth It?

Please don't read this article and now think you're qualified enough to write naked puts on Tesla. Options are a complicated financial instrument that, despite my best efforts, is still a tough topic to write about without putting you through a six-hour finance course. If you don't feel confident in what you're doing, you could lose a lot of money. Take it slow! Finance isn't a race. Pace yourself, take the time, read a bit more and really learn the trade before diving in.

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