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How to Start Options Trading for Beginners

Saying options are dangerous is like saying knives are dangerous. 

Sure, there are some dangerous knives out there, but my life has never been at risk spreading butter. 

It’s all about how the options are used.

Options can give you the ability to lose a thousand times more than what you invest. They can be incredibly risky. But on the other hand, they can be used like an insurance policy. I can spend a little bit of money to buy an option that protects my whole portfolio from a market crash.

I’m going over the 3 levels of understanding options, everything from degenerate gambling to responsible investing. 

On the go? Watch the video HERE.

Let’s get into it.

Level 1

There are tons of different combinations of options, but when you drill down to the core, it’s always the same thing.

This is the most basic level of understanding. No matter how complicated the combination of options are, this interaction is always happening.

I am a spicy ramen fiend, so I like to buy it in bulk. In 6 months, I’m gonna need to replenish my supply. And right now, the price of ramen is very cheap at just $1 per cup. But, I can’t buy it right now because I just don’t have the storage space.

I can’t just risk the price of ramen going up in 6 months, so I do the natural thing. I enter an options contract with Walmart. And yes, Walmart actually does carry the best spicy ramen. Unironically. This stuff is legit and it is ridiculously spicy.

So I pay Walmart a fee of $5 to lock in my pricing of $1 per cup for 100 cups of ramen over the next 6 months, just in case the price of ramen skyrockets to $2 per cup. 

Illustration by author

One one hand, if the price of ramen does go up to $2 over the next 6 months, then I can execute my contract and spend $100 on this ramen instead of $200, giving me a total savings of $95 after you account for the $5 fee that I paid Walmart.

On the other hand, if the price of ramen actually dropped to 50 cents per cup, then I would not want to execute my contract to buy ramen at $1 per cup. I would just go to Walmart, I would pay the market rate for ramen and spend $50. However, Walmart would still get to keep my $5 fee that I paid, so I would end up spending a total of $55.

Illustration by author

Level 2

The second level of options understanding is being familiar with the four basic building blocks. 

The ramen example I just gave was one of those building blocks. Now I’m going to go back and add in the actual terminology.

In the ramen example, I was the long and Walmart was the short.

The next thing to think about is what does the contract actually do? 

Call Options

Sometimes the buyer known as the long wants the ability to buy shares at a certain price. This is known as a call option. 

Sound familiar? That was the type of option used in my noodle example.

Call Option Illustration by author

The other type of option is where the long wants the ability to sell shares at a certain price. This is called a put option.

That’s how I remember it anyway.

Put Options

A ramen example for a put contract would be a manufacturing company of ramen needs to sell a load of ramen in a few months. 

However, they don’t want to risk the price in the market dropping before they have a chance to sell it to a distributor like Walmart. So Brian Ramen Manufacturing would buy a put option with Walmart, and I would be able to lock in my price to sell ramen.

Put Option Illustration by author

A short call contract wouldn’t work in that situation. That’s what Walmart had in the first example, because in the short position, you don’t get to control whether the option is executed or not.

So the four building blocks are long call, long put, short call, and short put.

Level 3

The third level of options mastery is understanding in what situations you gain money and in what situations you lose money with different types of option plays.

The ramen examples were fun, but now let’s use some examples with actual stocks. For starters, let’s do an example where we just own the shares of a company. No options at first. 

This is how much money you could expect to gain or lose if you bought 100 shares of META. The stock price is currently $500 so 100 shares would cost a staggering $50,000. Not a small investment.

META Stock Profit Loss Graph by author

The Y axis shows gain and losses while the X axis shows the share price. As you can see when the share price goes up by a dollar, you gain a dollar per share. When the share price drops by a dollar, you lose a dollar per share. 

Pretty straightforward.

Long Call Options

Now let’s compare this graph to a long call graph. 

If I have a $500 long call that expires in 6 months, then I can buy 100 shares at $500 per share anytime in the next 6 months. Of course, I have to pay a fee to enter this contract, which is currently $5,000. Now, $5,000 is a large fee, but we’re talking about $50,000 worth of stock.

On the surface, this seems horrible. 

Why would I pay $5,000 for the ability to buy shares of META at $500 when I could just buy shares of META at $500 right now?

The answer is downside protection. 

META Long Call VS Share Graph by author

If I buy 100 shares of META at $500 right now, then I am putting at risk $50,000. Very unlikely, but if the share price of META went down to zero like if the company went bankrupt, then I would lose my entire investment. Whereas if I just spent a $5,000 on a long call, my maximum loss is just the $5,000 that I put up.

Alternatively, if the price of META goes up to $600 per share, then I stand to gain quite a bit. I can execute my contract to buy shares at $500 per share, and then I can immediately turn around and sell them for $600 per share. That means I would gain $100 per share in stock, and then I would subtract my premium that I paid for the contract. Since I would be making $10,000 in shares, but I would have to pay $5,000 in premium, I would end up making $5,000 in total.

META Long Call Profit Loss Graph by author

If the price of META goes up even more to $700 per share, then I can make $200 when I execute the contract: buy for $500, immediately sell for $700. Then I’m making $20,000 in stock gains minus the $5,000 from fees. This leaves my total at $15,000 in total gains, but I only had to risk $5,000.

If this trend continues and the price goes higher and higher, I continue to make more and more money. 

Short Call Options

Now let’s look at the other side of the trade, the short call option.

Remember, there are always two sides to every contract. You can literally flip the previous graph 180 degrees to see the gain loss profile for the short call option position.

If the price of META drops to $250 per share, then the long will not execute the contract to buy at $500 per share. Instead, the option will expire worthless, and I, the short, will profit the $5,000 premium.

If instead, the price goes up to $550 per share, then the long side of the call option will execute and they will buy shares from me for $500. 

Short Call Profit Loss Graph by author

This is where things start to get scary.

If I did not already own $100 shares, then I would have to buy $100 shares at $550 per share and then immediately turn around and sell them for $500 per share, losing me $50 per share. In this case, I would lose $5,000 in share difference, but that would at least cancel out with the $5,000 premium that I picked up when I sold the contract.

This would be the break even price for the call contract which is an important stock price to understand when you’re thinking about entering a call option or a put for that matter.

If the price continues to go up to $1,000 per share, then I could be forced to buy $100,000 worth of META stock and then immediately turn around and sell it for $50,000. 

Short Call Profit Loss Graph by author

You can see how this gets really scary when your losses can be potentially infinite if you don’t already own the shares of META.

That’s the key.

Fortunately for Walmart, their short call option with me to buy ramen isn’t likely to go as bad as this, unless the ramen spontaneously turns into gold, and then they would be forced to sell it to me for $1 per cup.

Long Call VS Short Call Options

– When you go long call option, generally speaking, you profit when the price of the underlying stock goes up significantly, and then you lose money if the underlying stock either stays the same or goes down.

– On the other hand, when you go short call options, it is the exact opposite. If the price stays the same or goes down, you make your premium. If the price goes up, then you could potentially lose an infinite amount of money.

Long Put Options

Next up we have put strategies.

If I have $500 long put option that expires in 6 months, then I can sell $100 shares of META at $500 per share at any time in the next 6 months. Once again, I will have to pay a premium to the seller of the put option, the short, also about $5,000 in this case, or a $50 premium per share would be another way to look at it.

For instance, if the price dropped to $400 per share, then I could go out and buy $100 shares at that price, I could execute my contract, turn around and immediately sell those shares for $500. That would give me a share profit of $100 per share minus the premium that I paid, which was $50 per share for a net of a $50 gain per share, which once again equals $5,000.

META Long Put Profit Loss Graph by author

For instance, maybe I plan to sell my shares of META in 6 months for a down payment on a house. I don’t want to risk the price of META dropping significantly and then I can’t afford the down payment.

META Put Profit Loss Graph by author

So if I still want access to the upside potential of META over the next 6 months, then I could go with a long put option that would act as an insurance policy. It would ensure that no matter what the stock price does, I would be able to sell my shares of META for $500 per share. 

Short Put Options

Just like with the call options, if you wanna look at the short put gain loss profile, you can rotate the graph by 180 degrees.

In the worst case scenario, if META went bankrupt and the share price went to zero, and you have the short put, then you would be forced to buy somebody’s $0 shares of META for $500 per share representing your maximum loss which is $50,000.

META Short Put Profit Loss Graph by author

Selling a put is not quite as risky as selling a call because your losses are not infinite, but it can be quite risky.

Long Put VS Short Put Options

– If you go with a long put option, you’re going to make money if the company goes down significantly in value, but you will lose money if it’s stays roughly the same or if it goes up in value.

– The short put option is the exact opposite. You will lose money if the stock price drops significantly, however you will make money if the stock price stays rough the same or goes up in value.

I use META for this example, but you are not limited to buying options contracts on individual companies. You can also run options plays on ETFs.

This can be very powerful because ETFs are not subject to the same types of risk that a single company has. For instance, a single company can go out of business, but an ETF is far less likely to go to zero.

Of course, a successful options play starts with a successful underlying asset. If you are interested in learning how to pick ETFs that outperform the S&P 500, watch the video HERE or read the article HERE.

Catch on the flip side.

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