Options Trading: Beginner to Advanced Concepts

There are various instruments available for trading in financial markets, each serving different purposes. Among them, options trading stands out for its flexibility, offering a strategic approach to managing risk and market exposure. Many investors begin their journey with stocks and may later explore options as a way to diversify their market strategies or enhance risk management. Since options can be used for hedging, generating income, and navigating market movements with greater precision, it is important to understand their characteristics and complexities before incorporating them into an investment strategy.

An options trading course is a great resource for anyone who wants to learn about options so they know how to skilfully enter this aspect of investing. This blog will guide you through the history of options trading, basic strategies and trends while offering insights that help both beginners and experienced traders.

History of options trading

Options trading is as old as ancient Greece, with the philosopher Thales of Miletus making one of the first options trades in history. He expected a good olive harvest and purchased the exclusive rights to olive presses for a set price. He was able to profit from this increased demand by renting out his olive presses, a precursor to contemporary options that leveraged the power of a contractual agreement.

However, the first known preference options trading occurred in the 17th century in the Netherlands during the Tulip Mania. Traders theorised about the future prices of tulip bulbs using contracts that closely resembled call options. But that speculative party ended with a crashing market and the consequences of playing with leveraged options if no risk management is put in place.

Modern Options Trading

The launch of the Chicago Board Options Exchange (CBOE)in 1973 marked a watershed for financial markets. It was also the first exchange to introduce standardised options, which opened up the area to more traders. This was around the time theBlack-Scholes modelwas developed that would revolutionise pricing of options, making for more complex strategies.

The evolution of financial markets was mirrored by the evolution of the way we trade. Algorithmic trading and quantitative strategies have further evolved options trading, and now it is an indispensable function for hedge funds, institutional traders, and even retail investors.

Getting to grips with options trading

Now, before jumping into advanced concepts, let us discuss the basics of options trading.

What are options?

An option is a derivative contract that grants the purchaser the right, but not the requirement, to purchase or exchange an underlying asset for a fixed price within a defined timeframe.

Options fall into two main categories:

1. Call Options – The right for a option buyer to purchase the asset at a set price before expiration.
2. Put Options – Right to sell an asset at a predetermined price before expiration.

Main terminologies in options trading

• Strike Price: The price at which the holder of the option can purchase or sell the underlying asset.
• Premium: In options, we have a premium, which is the amount paid to buy an option.
• Expiration Date: The date by which the option must be exercised.
• Implied Volatility (IV): The IV estimates the expected future moves in the stock price and thus determines the option price.
• In-the-Money (ITM): An option is considered in-the-money (ITM) when it holds intrinsic value based on the current market price of the underlying asset. A call option is ITM if its strike price is lower than the market price, meaning the holder can buy the asset at a discount. While a put option is ITM if its strike price is higher than the market price, allowing the holder to sell at a premium.
• Out-of-the-Money (OTM): An option is out-of-the-money (OTM) when it has no intrinsic value. A call option is OTM if its strike price is higher than the market price, making it more expensive than buying the asset directly. While a put option is OTM if its strike price is lower than the market price, meaning selling at that price would be unprofitable.

Option strategies for beginners

If you’re just starting out, it’s best to focus on simple, lower-risk strategies that help you build a strong foundation before moving on to more complex tactics.

Covered Call Strategy: A covered call means that you own a stock and sell a call option against it. This strategy is helpful for generating premiums on stocks a trader already owns.

Example:

• Example: A trader holds 100 shares of XYZ stock trading at $50.
• They then sell a call option at a $55 strike price for $3/share.
• If the stock stays under $55, they keep the $300 premium as profit.

Cash-Secured Put: This strategy contains selling a put option, with sufficient cash reserved to purchase the stock if assigned.

Example:

• For example, a trader writes a put option on XYZ stock with a strike price of $45 for $2 per share.
• If the stock sells below $45, they buy it at a bargain.
• As long as the stock does not rise above $45, they earn the premium.

These methods are helpful for learning risk management and generating passive income.

Intermediate options trading strategies

Once traders know some of the basics, they can progress to spread strategies that assist with mitigating their risk.

Bull Call Spread: With a bull call spread, you purchase one call option with a lower strike price and sell a second call option with a higher strike price. It also works well on slightly bullish market condition.

Example:

• Sell one ABC stock call option with a $55 strike price

The profit will be limited to the difference between the two strike prices minus the net premium paid.

Iron Condor: The short iron condor is a neutral strategy that profits in a low-volatility environment. It consists of:

• Short an out of the money call and put.
• Purchasing another out-of-the-money call and put.

This short iron condor strategy generates profit when the underlying asset remains within a defined price range, allowing the trader to collect the net premium received.

Advanced options trading strategies

  Hedging and risk management strategies are advanced techniques used by experienced traders to manage risk and optimise their positions.

Delta-Neutral Trading: Delta indicates how much an option’s price will be affected by movement in the underlying asset. A delta-neutral trading strategy aims to maintain a portfolio with a net delta of approximately zero.

Example:

• The simplest delta hedge example is to buy one call with a +0.50 delta, then sell two call options with a -0.25 delta to create a neutral position.

Gamma Scalping: Gamma is the rate at which delta changes. Gamma scalpers adjust their positions based on market movements.

Example:

• Traders seeking to hedge against price swings adjust their delta exposure if implied volatility increases.

Latest trends in options trading

 Options trading has evolved over time, with new trends shaping its future.

Growth of short-dated options

Zero-day options (0DTE) have become more popular than ever. These options have the same expiration date as the day they are traded, making them appealing to high-frequency traders.

The evolution of algorithmic trading

AI and algorithmic models are increasingly being used by institutional investors to conduct large-scale options trades in a more streamlined way. Retail traders can also benefit from algorithmic trading by utilizing an easy-to-learn programming language like Python for options trading.

Conclusion

Options are a growing market for income, speculation and hedging. However, a lack of education can lead to poor risk management.