6 Steps On How To Trade Options In The Stock Market
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If you’ve always been curious about how to enter the stock market and find yourself overwhelmed or confused when trying to learn from YouTube or signing up for stock or trading options group, then this article can simplify it for you.
What is the Stock Market and Trading Options?
The stock market is a system that allows individuals and businesses to buy and sell shares in publicly traded companies. When someone purchases a stock, they are buying a small piece of ownership in that company. The value of the investment will fluctuate based on a variety of factors, including changes in the company’s financial performance, economic conditions, and investor sentiment. These shares are then bought and sold on exchanges, such as the New York Stock Exchange or NASDAQ, where their prices fluctuate based on supply and demand.
Trading options is an investment contract that allows investors to buy or sell 100 shares of a stock within a certain time frame. Trading options consist of learning about strike prices, expiration date, and volatility of the underlying stock. It is an effective way to manage risk in the stock market, but it is complex and risky.
Now that you have the definition of what the stock market is and what it means to trade options, we’re going to get into the seven steps you need to learn to actually jump right into trading.
How To Get Started Trading Options
1. Learn the Educational Basics
As mentioned above, when you trade options, you are purchasing a temporary contract that lets you buy or sell a minimum 100 shares of a stock at a specific price. These contracts will expire depending on the contract date you purchase. The range of expiration dates can be at a minimum of one day, one week or range as far as up to three years.
In order to accurately estimate where the market will go, you must learn options and strategies to develop a trading technique before purchasing a contract.
Options are special contracts that allow people to buy or sell things in the future at a certain price, and there are ten strategies you can utilize when buying an option.
Strategies
1. Call Option —is a contract that allows you to purchase the rights.
2. Put Option — is a contract that gives you the right to sell.
3. Long Call — a type of strategy where you buy a call option to profit from a rising price.
4. Short Call — a strategy where you sell a call option when you expect the price to drop and receive a premium now for the right to sell later at a lower price.
5. Long Put — is when someone buys a put option to protect against falling prices, allowing them to sell at a higher price even if the market drops.
6. Short Put — a method of selling a put option when you expect the price to rise and earn a premium for taking on the risk of buying at a lower price in the future.
7. Covered Call — is when you own a stock and sell a call option on it, allowing someone else to buy the stock at a set price. If the stock doesn’t rise enough, you keep the premium from selling the option.
8. Straddle — This strategy involves buying both a put option and a call option for the same stock at the same price, allowing profit whether the stock price goes up or down.
9. Strangle — Similar to the straddle, where you buy both a call option and a put option for the same asset, but at different strike prices, betting on significant price movement.
10. Iron Condor — This complex strategy is used when you believe the asset’s price will remain within a specific range, involving buying and selling both put and call options in a structured way.
It’s important to choose a strategy that aligns with your investment goals to help you manage risk and profit but to keep it simple purchasing a “Call” or a “Put” are the first two you must learn.
2. Choose a Broker
In order to trade options, you must register with a broker. Brokers are SEC-registered firms that facilitate buying and selling securities like stocks and bonds. They provide investment advice, market research, and online trading platforms. Brokers earn money through commissions, fees, and interest on client deposits. Popular brokers include TD Ameritrade, E*TRADE, Charles Schwab, Fidelity, Interactive Brokers, and Robinhood.
The best way to figure out which Broker suits your needs is to find out if the platform has a good reputation, feels comfortable to use, and suits your financial budget.
Low Income Level Earners
Individuals with low income should choose brokerage firms with low fees and commission-free trades.
Some recommended brokerage firms for low income earners are:
Robinhood
Webull
Charles Schwab
E-Trade
Note: It is crucial to verify that these firms do not impose hidden fees that could diminish your investment gains.
Middle Income Level Earners
Individuals earning a medium income should focus on brokerage firms that offer a diverse range of investment options such as Robo-Advisors, ETFs, mutual funds, bonds, and retirement accounts.
Firms well-suited for middle-income earners are:
Fidelity
Charles Schwab
Vanguard
Ally Invest
These firms also provide competitive fees and commissions, making them ideal for building a diversified portfolio.
High level income earners
Individuals earning high income should seek brokerage firms that provide personalized investment advice and exclusive opportunities like hedge funds and private equity.
Typically used firms are:
Morgan Stanley
Goldman Sachs
JP Morgan Chase
UBS
These firms also impose high fees and commissions.
It is crucial to weigh the benefits against the costs before choosing a firm.
After you’ve selected a broker, deposit some funds into your account and start trading. Some brokers offer demo accounts with fake paper money that allows you to practice trading options without risking real money. Whether you are trading real or fake money, it’s important to not risk more than you can afford to lose by utilizing risk management strategies like a stop-loss order.
3. Determine Your Trading Style
There are two types of traders, Day Traders and Swing Traders. A day trader is someone who buys and sells multiple contracts all day long at any time. A swing trader is someone who buys a contract one day and sells it on a different day. Your trading style is pretty much determined by the broker you use rules and the budget you have.
If you can afford to be a Day Trader based on your Broker’s platform rules, be a Day Trader.
If not, be a Swing Trader, or do both. If you do both, please note that you are only allowed to execute day trades on a limited basis if you have a portfolio less than $25,000.
For example, on Robinhood platform, you can only execute 3 Day trades every 5 days, or else you’re hit with penalties and the possibility of getting banned from trading.
4. Learn an Analysis
Trading options require learning a trading technique. There are many ways to analyze the market, but the two most popular are fundamental analysis and technical analysis.
Fundamental Analysis
Fundamental anaylsis analyzes the option to determine its instrinic value. This involves reading financial statements, economic indicators, industry trends, and other factors that may affect a stock price.
Nine platforms and sources you can use are:
1. EDGAR — provides free access to corporate financial reports from publicly traded companies. This includes 10-Ks, 10-Qs, and other financial information. You can access EDGAR at SEC EDGAR.
2. Yahoo Finance — traders can find key financial data such as income statements, balance sheets, cash flow statements, and historical performance metrics of various companies and use it’s stock screeners to filter stocks based on specific criteria.
3. Morningstar — provides financial data along with qualitative assessments of companies' fundamentals. Some features require a subscription but, it is still a valuable resource for investors.
4. FRED — grants access to a wide range of economic data like GDP growth rates, unemployment rates, inflation indices (CPI), interest rates, and more. This data can help you understand the macroeconomic conditions that affect market movements.
5. Trading Economics — a platform that provides current economic indicators around the world along with forecasts and historical data. It covers metrics such as consumer confidence indices, manufacturing indexes, and trade balances, which are used to assess economic health globally.
6. BEA — contains official economic statistics like GDP data, personal income levels, and spending patterns to analyze economic trends over time.
7. IBISWorld — provides industry reports that include market size estimates, competitive landscape analyses, industry growth forecasts that are used to identifying potential investment opportunities within specific industries.
8. Statista — pulls data from industries and provides insights into market trends through charts and graphs. It ranges from consumer behavior to technological advancements impacting industries today.
9. MarketResearch.com — offers market research reports of industries with detailed analyses on trends, forecasts, competitive landscapes, and consumer insights.
Technical Analysis
Technical analysis analyzes past market data to identify patterns and trends to predict future price movements. This involves using charting tools and technical indicators to identify support and resistance levels, trend lines, moving averages, and other key metrics.
Technical Indicators — are mathematical calculations derived from the price and/or volume of a security. Examples include moving averages and the relative strength index (RSI).
Relative Strength Index (RSI) — shows whether a stock is oversold (trading at a low price). An oversold condition may signal a good buying opportunity for a call option trade.
Moving Averages — shows moving averages of the stock’s price. If the short-term moving average crosses above the long-term moving average, it may indicate a price reversal.
Identify Support and Resistance Levels
When traders use technical analysis, they look for “support” and “resistance” levels to determine when to enter or exit a call option trade.
Support levels are when the price of something might be at its lowest, and it suggests it’s a good time to buy it. Resistance levels are when the price of a stock might be at its highest and indicates it is a good time to sell it.
Example
The stock symbol "AAPL" is currently trading at $50 per share.
Identifying Support:
1. Open a stock trading chart for AAPL.
2. Look for the last two lowest price candle markers that are at the same price level.
3. Once identified, this price level becomes a support level.
In this example, we will use $45 as the support level.
Identifying Resistance:
1. Similarly, look for two or more previous highest candle markers above the current price of $50.
2. This identified price level will be considered a resistance level.
In this example, we will say the resistance is at $55.
Charting the Levels:
1. On your chart, draw a horizontal line at the support level of $45.
2. Draw another horizontal line at the resistance level of $55.
Additional Levels
You can identify multiple support and resistance levels by continuing to find additional candle markers above or below your initial levels.
Each subsequent resistance line should be higher than the first. In this case, the additional resistance level would be above $55.
Each subsequent support line should be lower than the first. In this case, the additional support level would be below $45.
Note: A high trading volume is essential for breaking through support or resistance levels.
Timeframe Consideration
Charting is a way to visualize these price movements over time. It’s also important to chart on a timeframe that aligns with your trading strategy (e.g., daily, weekly). We will share a breakdown of charting timelines we’ve learned, used, and developed when we traded.
*This is not financial advice. We are sharing calculations we’ve used and observed when charting.
Day Trading
We recommend charting as follows:
1. 1 Minute Timeframe
Chart support and resistance on the same day and purchase contracts that expire within the current week.
2. 5 Minute Timeframe
Chart support and resistance on the same day and purchase contracts that expire within the current week
3. 10 Minute Timeframe
Chart back up to one day to identify support and resistance levels and purchase contracts that expire within the current week.
4. 15 Minute Timeframe
Chart back 3 to 4 days to identify support and resistance levels and purchase contracts that expire within the current week.
5. 30 Minute Timeframe
Chart back 3 to 4 days to identify support and resistance levels and purchase contracts that expire within the current week.
Swing Trading
We recommend charting timeframes as follows:
1. 1 Hour Timeframe
Chart back 1.5 weeks to identify support and resistance levels. Use this information to project price movements for the following week.
2. 4 Hour Timeframe
Chart back 3 to 3.5 weeks to find support and resistance levels. Prepare for trades that may last up to two weeks.
3. 1 Day Timeframe
Chart back 2 to 3 months to determine support and resistance levels. Plan for trades with a contract expiration of about one month.
4. 1 Week Timeframe
Chart back 4 to 5 months to identify support and resistance levels. Be prepared for trades with contracts expiring up to 3 months ahead.
5. 1 Month Timeframe
Chart back approximately 1.5 years to establish support and resistance levels. Determine your own estimated contract expiration date based on this analysis.
The rationale behind these timeframes guidelines we created is that market conditions can change significantly beyond three months, making shorter-term historical data more relevant for swing trading decisions.
Other Analytical Methods used are:
Quantitative analysis
Quantitative analysis uses math to predict future price movements based on historical data.
Sentiment analysis
Sentiment analysis analyzes market sentiment and investor behavior to gauge market direction.
Volatility analysis
Voltaility analysis analyzes the level of volatility in the underlying asset to determine the appropriate options trading strategy.
Option Chain analysis
OptionChain analysis examines an option’s strike prices, expiration dates, premiums, open interest, volume, implied volatility, and the Greeks.
Greeks Analysis
Greeks analysis helps traders understand how the greeks (Delta, Gamma, Theta, Vega, and Rho) are used in trading to measure the sensitivity of an option’s price to changes in various factors.
Delta — is a measure of how much an option’s price will change per $1. It ranges from 0 to 1 for call options and from -1 to 0 for put options.
Example
If you buy a call option on XYZ stock with a Delta of 0.5 and a Gamma of 0.1.
If stock XYZ increases by $1, the delta will increase by 0.1, making it 0.6. This means price will increase by $0.60 ($1 x 0.6 x 100 shares per contract).
If XYZ stock decreases by $1, the delta will decrease by 0.1, making it 0.4, and the price will decrease by $0.40 ($1 x 0.4 x 100 shares per contract).
Gamma — measures how much an option’s delta will change per $1. Gamma is calculated by Delta’s current value minus Delta’s new value divided by an asset’s current price subtracted by the asset’s new price.
For example, if stock XYZ price and call option is $60 with a delta of 0.3 and the stock XYZ rises to $70 per share and the $60 call option’s delta has risen to 0.5.
Gamma = (0.3 - 0.5) / ($60 - $70)
Gamma = (-0.2) / (-10)
Gamma = 0.02
The Gamma for stock XYZ $60 call option with a stock price of $60 stood at 0.02. Gamma is automatically calculated, so you don’t have to calculate this, but it is good to know how gamma is derived.
Theta — also known as time decay - measures the rate of decline in the value as it approaches its expiration date. Theta is expressed as a negative number because options lose value over time. For example, if you own a call option on a stock with a theta of -0.05, that means the option will lose $0.05 in value every day that passes, all else being equal.
Vega — measures the effect of changes in implied volatility on an option’s price. Implied volatility measures how much the market expects the asset to move in the future. Vega is expressed as a positive number because options increase in value when implied volatility increases. For example, if you own a call option on a stock with a vega of 0.10, that means the option will increase in value by $0.10 for every 1% increase in implied volatility.
Rho — measures the effect of change in interest rate in an option’s price. Rho is expressed as a positive number because options increase in value when interest rates increase. For example, if you own a call option on a stock with a rho of 0.05, that means the option will increase in value by $0.05 for every 1% increase in interest rates.
5. Monitor Your Trades
Keep an eye on your options trades by using charting tools to figure out when to take profit and exit a trade. Also, take note on, if something isn’t working, it’s important to learn how to cut your losses and move on.
Tools needed to monitor trade are:
Indicators (analyze past and current price information of securities to predict future market movements)
Oscillators (measure momentum and identify potential reversals)
Screeners
Learning Greeks
6. Prepare For Taxes
We have to pay taxes for everything, so find out how much taxes will be when you trade so that you can save that when you earn ahead of time.
A good rule of thumb is to prepare to pay 40% of taxes on short-term options and 60% of taxes for long-term options.
Additional Learning Resources
If you prefer to learn visually, here are a few YouTube videos we’ve found that can help you learn almost everything written in this article.
You can even take free courses with practice quiz questions at:
Conclusion
Trading options typically involve risk, but with the right knowledge, practice, and patience, it can also be a rewarding investment strategy. And remember, trading options is an evolving field, so it’s important to keep learning and staying, up to date on the latest trends and strategies.
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