As a beginner in options trading, a novice trader can start by playing the simplest strategy – buying options.
Buying call options
A trader that buys a call option or a put option is doing so in anticipation of a major price move in the underlying security that will cause option premiums to increase. If he is right, he can sell the options that he is holding onto for a profit.
A trader buys a call option to profit from price moves of the underlying security to the upside. When the underlying security of the call option increases, the option price or premium increases as well. When he sees that he can profit from the trade, he sells to close the position.
But if the underlying security’s market price goes lower, the price of the call option will decrease. The trader may have to sell the call option at a loss in this case.
Hence, a trader that is buying a call option is actually bullish on the market price of the underlying security.
Buying put options
When a trader buys a put option, he is hoping that the price of the underlying security will decrease. When that happens, the price and premium of the put option he is holding onto increases. When that happens, he attempts to sell for a profit.
If the underlying security’s price increases, the options price(options premium) of the put option decreases. In this scenario, the trader may sell out for a loss.
Considerations when buying options
- A trader wants to buy as at low a price as possible and sell as at high a price as possible
The option premium that a trader has to pay to purchase an option in a long strategy is dependent on the moneyness of the option, the time to expiration and the underlying volatility. He may also choose limit orders over market orders because he wants to purchase his options for as low as price as possible. Market orders will be executed and filled swiftly but filled prices may be undesirably high when buying an option. But in urgent cases where he needs to get in on the trade in order to make a quick profit, he may use market orders instead.
- A trader should consider the moneyness of the option that he is buying, whether it is in the money, at the money or out of the money.
In the money options are the most expensive while out of the money options are least expensive. If you are day trading options and see an impending price move within the day, you may want to select at the money options because it is cheaper than in the money options but it also allows one to capture maximum profit with a price move with all things being equal.
- A trader should be concerned about the option’s time to expiration
The time value is always in decay. Time value is a component of the option price. The decay in time value must be offset by increases in the option premium caused by price moves of the underlying security.
The greater the time to expiration, the greater the time value of the option.
So a trader should ask himself if the underlying security would make a price move within the life of the option itself. He should also ask himself if his exit price will be greater than the entry price. If the underlying security does not make a price move that the trader expects, the option may expire out of the money and hence be worthless on expiration date. In this way, the options trader loses the premium which he paid for the option.
- A trader should be concerned about the implied volatility
With all things being equal, when the implied volatility is high, the options price will be high. When the implied volatility is low, the options price will be low as well.
Buying options as hedging instruments
A trader can buy a call options to protect his short positions on stocks. As the price of the stocks go up, a trader would lose money on the shorted stocks. However, the value of his call option would increase. In this way, he is protecting the his short positions.This is called the protective call strategy. You can think of this as insuring the short positions on the underlying security.
Conversely, if a trader owns stocks in a particular company and wants to protect the value of his long positions, he will buy put options. As the price of the underlying security(company) decreases the price of the put options will increase. In this way, his long positions are protected. This is also known as the protective put strategy.
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