Options Trading Guide With Easy Examples For Beginners

If you are looking to learn basics and advanced concepts of options trading, this post is filed with lots of easy to understand examples of option trading.

In this Options Trading Guide With Easy Examples For Beginners, you will learn things like what an options contract is, different types of options, how options trading works, understanding options greeks, explanation of Black Scholes Model and options trading strategies.

Most beginners make the mistake of buying cheap options contracts and hope to make profits with it. Although it might be profitable sometimes, the professional traders use options as hedging instruments and even opt for options writing as a go-to strategy because of theta factor.

Options trading is not a become rich quick scheme. Understand options trading basics and try to trade options like professionals traders instead of gambling.

If you understand options greeks- Delta, Theta, Gamma, Vega & Rho, you might be able to avoid mistakes made by beginners in options trading. So let’s get started with this post- Options Trading With Examples and learn some better ways of trading options.

What are options contracts

Options are derivatives( financial instruments) that can be bought or sold with the purpose of making profits or can be used for hedging. Options trading involves buying and selling options contracts. Options come in the form of contracts having expiry dates. Options contracts can be of daily expiry, weekly expiry, monthly expiry, and even longer expiration dates.

Options contracts give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

Definition Of Option Contracts

Basics of options trading

Options trading is simply buying or selling options contracts either naked or with an underlying asset. These can be daily options, weekly options & monthly or longer expiry options. A trader or investor can buy or sell options contracts.

To understand options trading, you must understand what is a call option and what is a put option. Understanding call options and put options are the basics and fundamentals of options. So let’s first understand the basics of options.

To understand the basics of options trading, you first need to understand what is a call option, what is a put option, what are strike prices, and what is a premium. Basically there are two types of options

  1. Call option
  2. Put option
Options Trading-Types Of Options

If you understand call options and put options, you can create your own options trading strategies for generating income or hedging any existing positions. First, let’s try to understand whats a call option is and whats a put option is before moving into further advanced topics related to options trading.

What is a call option

A Call Option is an options contract that gives the buyer the right to buy the underlying asset at the purchase strike price at any time up to the expiration date.

What is a put option

A Put Option is an options contract that gives the buyer the right to sell the underlying asset at the purchase strike price at any time up to the expiration date.

Let’s look at the below example to easily understand what are call options & put options.

Let’s assume a stock named ABC Ltd is at $100. So the current market price of ABC Ltd is $100. Option contracts of ABC Ltd with different strike prices wrt the current market price of ABC Ltd will be available for buying and selling.

Strike prices are references to future prices of options contracts. Just for this example let’s assume strike prices of ABC Ltd will be in a range of 5$. So let’s assume different strike prices for ABC Ltd as 80, 85, 90, 95, 105, 110, 115, 120. Now let’s say you buy a call options contract for ABC Ltd with a strike price of 105.

What this means is, you are willing to pay $105 for ABC Ltd during expiry. If the stock price of ABC Ltd increases or decreases, you will pay exactly $105 only for one stock of ABC Ltd. This means your buy rate for an option contract is your buy rate of one stock during expiration.

If you bought a put option instead of a call option with the strike price of 105 in the above-mentioned example, that would mean your selling price for one stock of ABC Ltd will be 105 during the expiration of the contract.

I hope you have understood what a call option is and what is a put option. The above-mentioned examples were to explain to you basic differences between call options contracts and put options contracts. In options trading, Call & Put Options can be further classified into the following three types of options contracts i.e.

  • At The Money Options
  • Out of The Money Options
  • In The Money Options

At The Money Options

An options contract is said to be An The Money Options if the strike price of the options contract is equal to the underlying asset current market price.

At The Money Options Definition

Out Of The Money Options

An options contract is said to be Out Of The Money Options if the strike price of the options contract is yet to surpass the underlying asset current market price.

Out Of The Money Options Definition

In The Money Options

An options contract is said to be In The Money Options if the strike price of the options contract has already been surpassed by the underlying asset current market price.

In The Money Options Definition

Let’s try to understand In The Money(ITM), Out Of The Money(OTM) & At The Money(ATM) options contract with the following example.

Example of ITM, ATM & OTM Call Options

Assume share price of ABC Ltd company is $150. For call options, all the options contracts of ABC Ltd above $150 are Out Of The Money i.e. these prices are yet to be surpassed. And all the options contracts below $150 are called In The Money Options Contract. A call option with the strike price of $150 is called At The Money Option.

Example of ITM, ATM & OTM Put Options

Assume share price of ABC Ltd company is $250. For put options, all the options contracts of ABC Ltd above $250 are In The Money i.e. these prices are already surpassed. And all the options contracts below $250 are called Out Of The Money Options Contract for put options. A put option with the strike price of $150 is called At The Money Option.

Option Premium

You need to understand what an option premium is in options trading, before learning how options trading works. Options premium is the total amount paid/ received during the buying and selling of an options contract. Usually, options contracts are in lot sizes.

This means if you are buying one option contract, you are buying one lot which might be equal to 100 stocks. The lot size of the options contract depends on the current market price of the underlying asset.

The lot sizes of options contracts are decided by the trading exchange. In options trading apart from the premium one should also be aware of brokerage charges and taxes to be paid.

How Does Options Trading Work

I hope you got a little understanding of call options and put options and how the strike price is a future reference to the underlying stock price. You don’t have to confuse yourself with how does options trading works.

This post-Options Trading With Examples is written to make you easily understand the basics and advanced concepts of options trading.

Let’s look at different examples of call and put options to understand when profits and losses are made with options trading.

How you make profits with call options

In the earlier mentioned example of ABC Ltd stock, we assumed you purchased a call option of strike price 105. So let’s further assume you purchased call option of strike price 105 at a premium of $1. So if the lot size of ABC Ltd option contract is 100, you invested $100 to buy the 105 strike price option contract of ABC Ltd.

Let’s assume the expiration date for this 105 strike price call option of ABC Ltd is after 20 days of your purchase. Assume good news regarding ABC Ltd comes out that can improve the companies earning further.

Suddenly after the good news, you see a spike in ABC Ltd stock price and the current market price of ABC Ltd reaches $110 and closes at $108 on the expiration date.

So how much did you make in this entire call option trade? The real rate of your option contract will be the current market price of ABC Ltd stock Minus strike price of your call option multiplied by lot size.

Profits in call option trade = (Current Market Price of ABC Ltd(CMP) -Strike price of your purchased option contract)*Lot Size Of Options Contract=($108-$105)*100=$3*100=$300

Your real profits will be your profits from call option trade minus your investment amount.

Real profits in call options trade=Your investment amount-Your profits from call option trade=$300-$100=$200.

So your overall profit on an investment of $100 on ABC Ltd option contract of 105 strike price is $300 on expiry. You can sell your option contract and book $300 profits or you can exercise the call option contract and buy the underlying stocks by paying the entire amount.

You will pay a lot size multiplied by the strike price at which you bought ABC Ltd stock option to posses entire stocks of ABC Ltd. So your total investment will be 100*105=$10500. So you are paying $10500 instead of $10800 which is the current investment for 100 shares of ABC Ltd company. Hope you understood how you will make profits in trading call options.

How you lose money with call options

Let’s continue with the above-explained call option example & look at scenarios that will result in losses instead of the profits as described in the above-mentioned example. We assumed that you purchased a call option of strike price 105 at a premium of 1$. So if the lot size of ABC Ltd option contract is 100, you invested $100 to buy the 105 strike price option contract of ABC Ltd.

Expiration date for the purchased call option is 20 days away. This time no good news comes out and we don’t see a a spike in current market prices of ABC Ltd stock. The ABC Ltd stock trades as normal and it closes at $102 during expiry. So the current market price of ABC Ltd stock is $102 during expiry.

So how much profits or losses did you make this time with the 105 strike price call option when ABC Ltd stock price were $102 during expiry? Any guesses? Actually this time you would have made losses in this call option buying trade. The current market price of the underlying asset i.e. one share of ABC Ltd stock were $102 during expiration.

Losses in call option trade = (Current Market Price of ABC Ltd(CMP) -Strike price of your purchased option contract)*Lot Size Of Options Contract=($102-$105)*100=$3*100=-$300. Now if you are thinking you made a loss of $300 in this trade, wait a second. Remember the definition of options contracts that we discussed earlier in this blog post? Read the definition of option contract again below.

Options contracts give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

Definition Of Option Contracts

What this means is you don’t have the obligation to square off your call option buy position when you are in loss. Only & only if you have a strong reason to buy the underlying stock by exercising the call option contract, you should limit your losses by letting the option contract expire worthless.

So when you allow your option to expire worthless in the above-mentioned example, your total losses will be your investment or the premium amount you made to buy the call option contract i.e. $100. A loss of $300 will be only for those who want to exercise the call option contract to buy the underlying asset.

I hope you understood how profits and losses occur in trading call options with the help of an above-mentioned example. Now let’s look at how profits and losses occur while trading put options contracts.

How you make profits in put options

Now in this example, you are going to assume that you purchased a 95 strike price put option contract of ABC Ltd for $1. As the lot size is 100 shares, your total investment to buy a put option of ABC Ltd company will be $100.

Assume that bad news for the ABC Ltd company comes out and creates panic and few investors sell their positions at ABC Ltd company. The current market price of ABC Ltd company drops to $90 per share. On expiry, the ABC Ltd stock closes at $92.

When you buy a put option, you are actually selling the underlying asset at the purchased strike price. You make profits when current market prices of underlying assets go below your purchased strike price when buying a put option.

Profits from put option buy trade = (Strike price of your purchased put option contract-Current Market Price of ABC Ltd(CMP))*Lot Size Of Options Contract=($95-$92)*100=$3*100=-$300.

Your initial investment was $100. So the net profits will be your total profit from the trade minus your initial investment=$300-$100=$200. I hope you understand now how you will make profits when you buy a put option contract. Now let’s look at an example of how a loss will occur when you buy a put option contract.

When does a loss occur in put option trading

So if you buy a put option contract and the current market prices of the underlying stock go above the purchased strike price of the put option contract, you will make losses.

From the above-mentioned example of put option buy trade setup, let’s assume you purchased put option contract of strike price 95 at $1, and your investment will be $100.

Instead of current market price going below the strike price, this time assume the current market prices of ABC Ltd strike price went up due to some good news or any event catalyst.

During expiry the current market price of ABC Ltd stock closed at $98(this is an assumption for this options trading example).

Your losses in this put option buy trade will be lot size multiplied by strike price of purchased put option contract minus current market price of ABC Ltd stock.

Losses in put option buy trade = (Strike price of your purchased option contract-Current Market Price of ABC Ltd(CMP))*Lot Size Of Options Contract=($95-$98)*100=$3*100=-$300.

But as we discussed earlier, as a buyer of put option contract you don’t have an obligation to exercise the option. So you can allow this option to expire worthless with exercising. Your total loss when you don’t exercise the put option you purchased w.r.t this example will be your investment or premium you paid to buy the option contract i.e. $100.

I hope you understood how losses occur when buying put options contracts. We have discussed how profits and losses occur with options trading. Combine options trading with institutional buying and selling tips for higher accuracy in options trading. Now let’s move on to some advanced topics related to options trading such as Black Scholes Model, options Greeks and options trading strategies.

Identify fair price of a options contract using Black Scholes Model

The Black-Scholes Model was first discovered in 1973 by Fischer Black and Myron Scholes, and then further developed by Robert Merton.

A Black-Scholes Model also called as Black-Scholes-Merton is a mathematical pricing model used to determine the real value or fair price or theoretical value in options trading for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate.

We are not going to discuss the formula of the Black Scholes Model in this post. As a trader, I feel you just need to understand how to use Black Scholes Model calculator to choose profitable options contract.

Most of the trading brokers have in-built black scholes model options calculator inside of trading terminal.

Or simply find out free online options trading Black Scholes Model Calculator like following ones

Below you can see the asked fields which you have to fill when you use the Black Scholes Model Calculator. I have shared images of the Black Scholes Model calculator from two different websites.

Zerodha Black Scholes Calculator

Options Trading Black Scholes Model Calculator-Zerodha

GoodCalculators.com-Black Scholes Calculator

Options Trading Black Scholes Model Calculator-good calculator

To use the Black Scholes Model calculator as shown in the above example images, simply enter the asked fields to get the approximate theoretical value of an option contract.

You need to enter the spot price i.e. current market prices of the underlying assets and the strike price which you are considering to buy for options trading.

In time to expiration, you should enter the total number of days left for the expiration of the options contract. Volatility percentage should be entered for each individual underlying asset. The volatility percentage should be available on your trading exchange website.

For the risk-free interest rate, the risk-free annualized Treasury interest rate is used. The dividend yield for options trading, can be considered zero for Black Scholes Model.

When you fill all the required fields inside the Black Scholes Model Calculator and click on calculate, the Black Scholes Model Calculator will display useful options contract values like options premium, delta, gamma, rho, vega, and theta.

These additional values are also known as Options Greeks. I hope you have a fair understanding of the Black Scholes Model now.

Black Scholes Model is used in options trading by professionals. Now let’s learn what are options Greeks and how to use Options Greeks in options trading.

Options Greeks

Option Greeks are mathematically calculated metrics that can impact the pricing of an options contract. The Options Greeks are Delta, Gamma, Theta, Vega, and Rho. Each Option Greek value indicates useful metrics related to the option contract.

Delta

Have you ever wondered how much will an options contract price change when the underlying asset value changes ? Well this is what Options Greeks Delta all about.

Delta value of an options contract gives us an fair idea of how much will an options price move when the underlying asset moves by $1.

What is Delta in Options Greeks

Gamma

Gamma value along with delta and theta plays a important role in understanding options pricing. Options contracts that has higher number of Gamma attracts option traders.

Gamma value in options Greeks provides an approximate value of how much Delta will change with 1$ change in underlying asset price.

What is Gamma in Options Greeks

Theta

Theta value in Options Greeks also knows as time decay indicates how much value of Options Contract i.e. the price will decrease with the end of each day until expiry. Option sellers closely watch out Theta value and pick up options selling trade that has high Theta value.

Vega

Vega in options Greeks indicates how much change in the value options contracts will happen with a one-point change in implied volatility.

Rho

Rho in options Greeks indicates how much change in the value options contracts will happen with one percent the change in interest rate.

Till now in this blog post, I have covered Options Definition, types of options i.e. call options & put options, and options Greeks. I have also explained how profits and losses occur during options trading. Now lets learn few options strategies used by professional traders.

Trading Strategies Of Options

There are lots of options trading strategies out there if you start searching for it. We are going to cover four famous options trading strategies used by options traders i.e.

  • Collar Options Strategy
  • Straddle Option Strategy
  • Strangle Options Strategy
  • Iron Condor Option Strategy

Collar Options Strategy

A collar options strategy is used when you want to protect your existing long position in an underlying asset like stocks.

Collar Options Strategy= Long In Underlying Asset+Long In Put Option+Short In Call Option

Collar Options Strategy Explained

A collar position limits the upside potential and also limits the downside risk at the same time.

Let’s assume the same example Of ABC Ltd stock. Assume that the current market prices of ABC Ltd are $100. For this example, assume that you already purchased one share of ABC Ltd stock which is worth $100. You sell 110 strike price call options for $5 and you buy 90 strike price put option for $5. Now let’s look at three different possible scenarios i.e.

Underlying asset i.e. the stock price of ABC Ltd remains $100 on expiry

Profit from underlying asset long position =0

Profit from call short position=$5

Loss from put long position=-$5

Net profits=0+$5-$5=0

So if the underlying asset prices are unchanged, the collar options strategy will produce zero profits and zero losses.

Underlying asset i.e. the stock price of ABC Ltd closes at $120 on expiry

Profit from underlying asset long position =$20

Loss from call short position=-$5

Loss from put long position=-$5

Net profits=20-$5-$5=10

So if the underlying asset prices close at $120 on expiry, the collar options strategy will limit the profits to $10.

Underlying asset i.e. the stock price of ABC Ltd closes at $80 on expiry

Loss from underlying asset long position =-$20

Profit from call short position=$5

Profit from put long position=$5

Net profits=-20+$5+$5=-10

So if the underlying asset prices close at $80 on expiry, the collar options strategy will limit the losses to -$10.

A collar option strategy is ideal when you already have a long position and want to hold the position. If you feel there could be a potential downside move in the underlying asset, a collar strategy can help you limit the potential downside loss.

Straddle Options Strategy

Straddle in options strategy aims for profits irrespective of which direction underlying asset prices move.

A straddle options strategy is used when you expect a highly volatile price movement/change in the underlying asset like stocks.

Straddle Options Strategy= Long in Call option+Long In Put Option(should meet conditions mentioned below)

Straddle Options Strategy Explained

Straddle Options Strategy Mandatory Conditions:

  • Call & put options should be of same strike price
  • Call & put options should have same expiration dates

A Straddle Options Strategy position limits the downside risk and provides an unlimited profit potential opportunity. If the underlying asset moves big in a single direction, one of the purchased options contracts will have a higher premium value.

The underlying asset move should be big enough to overcome the loss that occurred from the counter position. Let’s look at the below example to understand how a straddle options strategy works.

Let’s assume the same example Of ABC Ltd stock. Assume that the current market prices of ABC Ltd are $300. You buy 300 strike price call options for $5 and you buy 300 strike price put option for $5. Now let’s look at three different possible scenarios i.e.

Underlying asset i.e. the stock price of ABC Ltd remains $300 on expiry

If the underlying asset price remains at $300, both of the purchased options will have zero value and will expire worthlessly. So your total loss in this scenario will be the total premium paid to purchase the options contracts.

Loss from call long position=-$5

Loss from put long position=-$5

Net loss=-$5-$5=-10

So if the underlying asset prices are unchanged, the straddle options strategy will produce zero profits and total premium paid will be your overall loss. You will not lose more than your premium value. So your downside risk is limited in an Options Straddle Strategy.

Underlying asset i.e. the stock price of ABC Ltd closes at $340 on expiry

Profits from call long position=$40-$5=$35

Loss from put long position=-$5

Net profits=$35-$5=$30

So if the underlying asset i.e. ABC Ltd stock prices close at $340 on expiry, the straddle options strategy will make a profit of $30.

Underlying asset i.e. the stock price of ABC Ltd closes at $260 on expiry

Loss from call long position=-$5

Profit from put long position=$40-$5=$35

Net profits=-$5+$35=$30

So if the underlying asset prices close at $260 on expiry, the straddle options strategy will make a profit of $30.

A straddle options trading strategy is ideal when you expect a big movement in any underlying asset. If you find an underlying stock which is in a range for quite some time, and potentially can give out a breakout trade but you are unsure of which direction, you can definitely try straddle options strategy.

Strangle Options Strategy

Strangle in options trading is similar to a straddle but has one different condition i.e. buying a call and put options contracts with the same expiration date but with different strike prices. Unlike straddle, a strangle options trading strategy will have different strike prices of the call option and the put option.

A strangle options strategy is used when you expect a big movement in the underlying asset and are unsure of the direction. Downside risk in a strangle options trading strategy is limited to the amount paid for buying a call and put options i.e. the total premium paid.

Strangle Options Strategy= Long In Call Option+Long In PutOption(both options will have different strike prices but the same expiration date)

Strangle Options Strategy Explained

Strangle Options Strategy Mandatory Conditions:

  • Call & put options should be of the different strike price
  • Call & put options should have the same expiration dates

A strangle options position limits the downside risk and provides unlimited profit potential if the underlying asset makes a huge move in one direction.

Let’s assume the same example Of ABC Ltd stock. Assume that the current market prices of ABC Ltd are $200. You buy 220 strike price call options for $5 and you buy 180 strike price put option for $5. Now let’s look at three different possible scenarios i.e.

Underlying asset i.e. the stock price of ABC Ltd remains $200 on expiry

If the underlying asset price remains at $200, both of the purchased options will have zero value and will expire worthless. So your total loss in this scenario will be the total premium paid to purchase the options contracts.

Loss from call long position=-$5

Loss from put long position=-$5

Net loss=-$5-$5=-10

So if the underlying asset prices are unchanged, the strangle options strategy will produce zero profits and total premium paid will be your overall loss. You will not lose more than your premium value. So your downside risk is limited in an Options Strangle Strategy.

Underlying asset i.e. the stock price of ABC Ltd closes at $250 on expiry

Profits from call long position=$30-$5=$25

Loss from put long position=-$5

Net profits=$25-$5=20

So if the underlying asset i.e. ABC Ltd stock prices close at $220 on expiry, the strangle options strategy will make a profit of $20.

Underlying asset i.e. the stock price of ABC Ltd closes at $150 on expiry

Loss from call long position=-$5

Profit from put long position=$30-$5=$25

Net profits=-$5+$25=$20

So if the underlying asset prices close at $150 on expiry, the strangle options strategy will make a profit of $25.

A strangle option strategy is ideal when you expect a huge movement in underlying stock but are unsure of direction. But be sure that if significant movement in one direction of the underlying asset doesn’t happen, your entire premium paid will be your losses.

Iron Condor Options Trading Strategy

An Iron Condor options strategy is used when you expect low volatility. Strike prices between which underlying asset prices can close during expiration are considered as favorable.

Long in one call options contract and short in another call options contract combined with long in one put option contract and short in one put options contract will create an iron condor options strategy.

All options contracts used in the Iron Condor options trading strategy will have the same expiration date.

Iron Condor Options Strategy= Long in ATM or OTM Call Option+Short In OTM Call+ Long In OTM Put Option+Short In ATM or OTM Put Option

Iron Condor Options Strategy Explained

An Iron Condor position limits the potential profits to net credits received using all for open positions.

Let’s assume the same example Of ABC Ltd stock. Assume that the current market prices of ABC Ltd are $250. You sell 250 strike price call options for $8 and you buy 270 strike price call options for $3. And simultaneously you sell 250 strike price put option for $7 and buy 230 strike price put option for $4. Now let’s look at three different possible scenarios i.e.

Underlying asset i.e. the stock price of ABC Ltd remains $250 on expiry

Profit from call short position=$8

Loss from call long position=-$3

Profit from put short position=$7

Loss from put long position=-$4

Net profits=$8+$7-$3-$4=$8

So if the underlying asset prices are unchanged, the Iron Condor Options Strategy will produce Maximum profits i.e. the total credit received minus premium paid to buy options i.e. $8.

Underlying asset i.e. the stock price of ABC Ltd closes at $290 on expiry

Loss from call short position=-$40+$8=-$32

Profit from call long position=$20-$3=$17

Profit from put short position=$7

Loss from put long position=-$4

Net loss=-$32+$17+$7-$4=-$12

So if the underlying asset prices close at $290 on expiry, the Iron Condor Options strategy will be in $12 loss. The higher the underlying asset price from the shorted call option strike during expiry, the greater the losses.

Underlying asset i.e. the stock price of ABC Ltd closes at $210 on expiry

Let’s assume the same example Of ABC Ltd stock. Assume that the current market prices of ABC Ltd are $250. You sell 250 strike price call options for $8 and you buy 270 strike price call options for $3. And simultaneously you sell 250 strike price put option for $7 and buy 230 strike price put option for $4. Now let’s look at three different possible scenarios i.e.

Profit from call short position=$8

Loss from call long position=-$3

Loss from put short position=-$40+$7=-$33

Profit from put long position=$20-$4=$16

Net profits=$8-$3-$33+$16=-$12

So if the underlying asset prices close at $210 on expiry, the Iron Condor Options strategy will make a net loss of $12. The lower the underlying asset price from the shorted put option strike during expiry, the greater the losses.

An Iron Condor options strategy is ideal when you are expecting low volatility in the overall market or a specific stock. Always remember that an iron condor options strategy can be very risky if an underlying asset makes a significant move in one direction.

Conclusion:

Options Trading needs a good understanding of overall markets.

If you understand the basics of factors that affects price fluctuations of underlying assets, it can further help you in trading options contracts like professionals.

We have covered the definition of an options contract, different types of options contracts, options pricing, options premium, strike price, spot price, Black Scholes Model, options greeks, four different options trading strategies, etc in this post.

I hope this options trading post helps you in understanding the basics and few advanced concepts of options. Please use the comment section below and let us know what else would you like us to explain in this options trading post.

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