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Trading options in the stock market is one way to profit on the price movement of the stock market or individual stocks. Whether stocks are going up or going down, options traders can make money. But to make money, the options trader needs to be correct in the direction of the price movement and the timing.
Opening a Brokerage Account
The first step to trading options is to open an account at a brokerage firm.
Brokerage firms will determine if you are allowed to trade options based on your trading experience, your understanding of the risks, and your net worth.
Depending on your answers, you might only be allowed to buy call and put options, which is fine for you to get started in options trading.
Choosing the Options
The first question most have is how much money do you need to trade options. The cost of options will depend on factors like the expiration date, strike price and volatility. The further away the expiration date is, the more the option will cost because you are also paying for the time value. The closer to the strike price the option is, or if it is in the money (at a profit), the more expensive the option will cost.
The cost of an option is the option cost multiplied by 100 because one option controls 100 shares of the underlying stock or index. If you find an option that costs $1.75, the cost of that option contract will be $175. According to the experts at Money Morning, “And don’t forget, with such a low up-front cost, your risk is also just a fraction of the stock’s risk.”
There are many strategies with option trading, but basically, you will buy a call option if you think the stock price is going higher. And you will buy a put option if you believe the stock price is going lower.
The variables of options are intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price. Time value is the time left to expiration. Volatility is another component to consider.
Determine the Strike Price
The strike price is the price you predict the stock will move to at or before the expiration date. To profit, the stock price has to be at or above the strike price for call options and at or lower than the strike price for put options.
For example, XYZ Corporation is trading at $10, and you believe it will move up to $15 at a future date. You could buy a call option with a strike price of less than $15, like a $14 strike price. If the stock ends up at $15 or higher at or before expiration, your option will be in the money, and you make a profit. If you believe the stock will drop in price, you will buy a put option.
Determine the Time Frame
You also have to accurately predict that the stock price will make this price move by the expiration date or before. Expiration dates range from days to years. The longer away from the expiration date, the more expensive the option will be, this is the time value.
Most options are what are called American options, which means you can sell your options at any time before the expiration date.
There are many strategies with options trading. For beginners, it is sometimes wise to practice trading before risking actual money.