Mastering Stock Options: A Beginner’s Guide to Profits and Risk Management

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Understanding Stock Options:

Stock options are financial contracts that grant the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price (strike price) within a specified period. Calls provide the right to buy, while puts provide the right to sell. Options allow investors to profit from price movements without owning the underlying asset.

Now that we’ve got the basic definition out of the way, let me explain this concept using an example that will make more sense:

Imagine you’re interested in purchasing a house but don’t have all the funds required immediately. Instead, you approach the homeowner and negotiate a unique agreement called a “stock option.”

In this analogy, the house represents a specific stock, while the option contract mirrors your agreement with the homeowner. Here’s how the key elements of stock options align with buying a house:

1. Strike Price: The strike price is similar to the agreed-upon purchase price for the house. Let’s say the strike price is $200,000. This means that within a specified timeframe, you have the right to buy the house at that price.
2. Expiration Date: Like stock options have an expiration date; the house-buying option contract also has a specific time limit. Let’s assume the expiration date is one year from the contract’s inception. This means you have one year to exercise your option to buy the house at the agreed-upon strike price.
3. Contract Price: In the context of buying a house, the contract price is the amount you pay upfront to secure the option. Let’s say the contract price is $5,000. You gain the right to purchase the house at the strike price within the specified timeframe by paying this fee.

Now, let’s consider a scenario to illustrate how stock options work using our house-buying analogy:

Example: You secure a stock option to buy a house with a strike price of $200,000, an expiration date of one year, and a contract price of $5,000.

Situation 1: House Appreciation After a few months, the housing market booms, and the value of the house skyrockets to $250,000. Since you hold the stock option, you have the right to buy (not obligation) the house at the strike price of $200,000, even though it’s worth $250,000. This allows you to make an instant profit of $50,000 if you exercise the option and sell the house immediately.

Situation 2: House Depreciation On the other hand, imagine the housing market experiencing a downturn, and the house’s value drops to $180,000. In this case, you have the choice not to exercise your option. Doing so limits your losses to the contract price of $5,000, as it wouldn’t make financial sense to buy the house for $200,000 when it’s valued at $180,000.

So now you might be thinking, why is the homeowner keen to sell me the house in either of those situations? In both cases, the Owner collects a $5000 premium regardless of the house price. Maybe this particular homeowner bought this house for $100,000 five years ago, so even if they have to sell it for $180,000, they’re better off because they collected a $5000 premium.

So now that you have basis understanding of Stock options, let’s move further.

Types of Options You can buy

As you enter Stock Options, you’ll soon learn you can play options in many ways. In the examples above, we discussed buying a house, and if you bought the house with the intention that prices will go higher, you’re buying a Call Option; similarly, if you expect the price to drop, you can buy Put Option. Besides these, there are a few other advanced options for buying strategies like Vertical Spreads, Straddles and Strangles, and many more, we won’t get into those. I hardly use any of those strategies and won’t recommend them if you’re new to Options.

I stick to Call Options for 90% of my trades, sometimes, I exercise Put options, but since my bias is usually positive, I stick to the Call Options. This is something you’ll develop over time. 

Illustration of a Call Option

Illustration of Put Option

What Timeframe Stocks Option I buy?

When I first started with Stock Options, I used to buy Weekly Options; these are Options that expire in a week or less. They are typically used by traders looking to profit from short-term price movements. These are much more volatile than longer-term options contracts. This means that the price of a weekly option can change more quickly than the price of a longer-term option. This can make it difficult for traders to predict the market’s direction and make profitable trades. In other words, you can earn 50% profit within an hour AND lose 80% within hours. The closer you’re to the expiration date, the faster and more volatile the Stock Option price moves due to Time Decay. We won’t get much into Time Decay in this article, but understand this; weekly options give you a small window to be right; if you’re right in your prediction, you can earn quickly; if you’re wrong, the opposite can happen, and usually, the downside is faster.

To Avoid this and after many lessons learned, I switched to buying options that expire at least one month or, in some cases, six months out. I am also starting to look for Stock Options that expire in a year or more; these are referred to as LEAPS (Long-Term Equity Anticipation Securities). LEAPS have expiration dates extending beyond one year, offering greater flexibility and reducing the impact of short-term market volatility.

So can you sell the Stock Option before the expiration date?
Yes, and that is usually what you want to do. Just because I am buying an Option that expires in 60 days, that does not mean I have to wait 60 days to sell it. If the price of that option goes in my direction, I can start selling all or some part of it as it goes up.

Illustration of Option Chain for Tesla Stock

Which strategy is best for option buying? And How to manage Risk?

Implementing a solid risk management strategy is essential to successful options trading. I initially buy half of my desired position and incrementally add the remaining 50% if the trend moves in my favor. This approach allows for partial participation in potential gains while managing risk. I prefer to use Weekly and hourly charts to understand how the stock moves—more on this in the next article.

Furthermore, I am conscious of setting predefined stop-loss levels, typically around 20-30% below my entry point to manage risk. If the option’s value declines beyond this threshold, I sell the position to limit potential losses. Risk management is the cornerstone of options trading, preventing substantial financial setbacks and preserving capital for future opportunities.

Your job as a new Trader is to Stay in the game and never take a risk that put you out of the game! 

Which analysis is best for options trading?

Many options traders recommend and use Technical Analysis for options trading. Technical analysis is a method used to evaluate financial markets based on historical price data and indicators. It focuses on patterns, trends, and market behavior to predict future price movements. Traders use it to identify entry/exit points and develop trading strategies. I use both Technical and Fundamental analysis for options; Fundamental analysis is an approach to evaluating financial assets by examining relevant economic, financial, and qualitative factors. It involves assessing a company’s financial statements, industry conditions, competitive advantages, and management team to determine its intrinsic value. Part of this fundamental analysis is also to understand the Macro environment of a particular industry. For instance, the rise in chip stocks (NVDA, AMD, etc..) can be attributed to various factors, including the increasing demand for semiconductors driven by technological advancements such as artificial intelligence (AI).

Which options are best to trade?
I usually buy Stock options for the stocks I understand and know. Since I work in a Technology space, I stick to mostly Tech Stocks. Within tech stocks, I look for stocks with high volume. High Volume means that more people are trading these stocks, and there is more liquidity available for these stocks. Here is some of the popular stocks for Options:

• AAPL
• AMD
• AMZN
• GOOG
• META
• MSFT
• NFLX
• NVDA
• QQQ
• SPY
• TSLA

Option Real Example.

Let’s look at a real example of how to buy an option.

Suppose I am Bullish on Tesla Stock ($TSLA), and I think it’ll hit $300 soon; how soon? Today is July 5th, and the current stock is trading at $280.50. I could buy a Weekly call $300 Call (Strike Price) for July 21st (Expire in 16 days from today) for $7.80 ($780)

or

I can buy a $300 call for August 18th for $14.15 ($1415)

Which one would you buy? That depends on many factors, including your strategy and risk management which we discussed earlier.
I would buy the August 18th Call for $1415 because it suits my trading strategy and gives me leverage to get out if the position is not working in my favor.

It is also important to note that IF the stock price moves toward $300 quicker than I anticipated, July 21st Call will probably have a 2x higher profit than August 18th. Those are factors you should consider when making this decision.

See the illustration to see what the option chain looks like. This will vary from broker to broker. This screenshot is from Robinhood

Click on the “+” sign to see the details.

Which broker is best for Options trading?

All major brokers allow options trading; you must sign up for a Margin account to start. For the newer traders, I recommend the following:

• Robinhood – One of the most accessible brokers to get started with. Their UI is straightforward to understand, with Options for education. The best part? It’s $0 commission. Read the Robinhood Mobile App review here.
• WeBull – This is great for research, and there is a social community aspect of this App for stock recommendations and discussion. I used it for Pre-Market Data and news.
• ThinkorSwim – This is the platform I use, It is for advanced users, and the UI is not as friendly as Robinhood or WeBull, but once you get used to it, it is excellent. I use it for charting and setting up alerts.
• Vanguard – Terrible UI, and you cannot buy options from the mobile app, but since I have most of my funds on Vanguard, I use it often to buy options; you have to use the web interface to buy Options.
• Etrade – One of the oldest brokers, I recently started using it again, and the UI is pretty decent.

There are many more brokers, but as a new trader, don’t spend too much time picking the “perfect” broker; they all have pros and cons. If you already have an account with one of these, start with that. As a new trader, getting started is the key; you can always switch traders later depending on your Strategy and trading style.

Options Trading – Putting it all together

• Understand the basic concepts of options before digging deeper into advanced options strategies
• Study types of Options you can trade; the Main two are Call Options (bullish) and Put Strategy (Bearish)
• Learn about Option timeframe (Expiration dates)
• Learn about Various strategies to buy and sell options – I covered my basic strategy in the post.
• Pick and broker and sign up for a Margin account
• And finally, start! The best way to learn is by doing it. You can only buy one option and learn how it changes based on the underlying price movements.