Introduction to Options Trading and why it can be an attractive investment opportunity for investors and traders

Welcome to the my ultimate beginners guide to generating cash flow with options trading. I am quiet sure, you are here, because you are looking to optimise your investment profits with options trading, just as I did when starting options trading.

This beginner’s but comprehensive guide will provide you with all the basics but essential knowledge you need, to get started with selling options and generating cash flow. This guide is almost like a copy of my study notebook when I started out learning about options.

Whether you’re looking to build your investment portfolio or increase your monthly cash flow, this step-by-step beginners guide to selling options strategies has got you covered and will get you started. From understanding the basics of options trading to choosing the right options to sell, I will show you how you can profit from options trading and achieve financial success. Let’s dive into my Options Trading 101!

1. Introduction to Options Trading

Options trading is a type of financial investment method that involves buying and selling contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset (stock) at a predetermined price, known as the strike price, on or before a specific expiration date. Options trading is often used as a way to hedge against potential losses or to generate income from a portfolio of assets.

Options trading can be a complex topic at first, but if understood well, it can be a powerful tool for investors to better manage risk while generating profits. In this guide, I will introduce you to the basics of options trading and why it can be an attractive investment opportunity for all investors and traders.

As I just said, one of the primary advantages of options trading is the ability to manage risk. We will go deeper into the risk management aspect but to give an example, a trader who owns a stock can use options to protect against a decline in the stock’s value by purchasing put options. If the stock price falls, the put option will increase in value, offsetting the losses from the stock. On the other hand, a trader who expects a stock price to rise can purchase call options (which is not my preferred choice – more on this later), which will increase in value as the stock price rises.

Options trading can also be used to generate income. By selling options, traders can receive premiums and profit from the option expiring worthless. However, it’s important to note that selling options also carries certain risks, including the obligation to buy or sell the underlying asset.

Therefor, understanding the basics of options trading is essential for any trader looking to get started with this type of investment. In the next chapters, we will dive deeper into the fundamentals of options trading.

2. Fundamentals of Options Trading

We have introduced options trading, by giving the broad definition of options and mentioning the advantages of using options to manage risk and generate income. But now we will dive deeper into the fundamentals of options trading, including the mechanics of options contracts, the factors that affect the value of options, and how to read options quotes.

a. Option types and option contracts

Let’s start by defining some basic terms in options trading.

An option contract is a legally binding agreement between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, on or before a specific expiration date. Options contracts are standardised and traded on organised exchanges, such as the Chicago Board Options Exchange (CBOE).

Each options contract represents typically 100 shares of the underlying asset. For example, if you buy one call option contract on XYZ stock, you have acquired the right to buy 100 shares of XYZ stock at the strike price on or before the expiration date. If you sell one put option contract on ABC stock, you have the obligation to buy 100 shares of ABC stock at the strike price on or before the expiration date if the option contract is exercised.

Options contracts are composed of five key components : the underlying asset, the number of underlying shares, the strike price, the expiration date, and the option premium. The premium is the price that the buyer pays and the seller receives for the option.

The most basic types of options are calls and puts.

A call option is a contract that gives the holder the right to buy the underlying asset at the strike price on or before the expiration date. A put option is a contract that gives the holder the right to sell the underlying asset at the strike price on or before the expiration date.

Typically, an option contract encompasses 100 shares, and the premium is stated per share. For instance, if the premium for a call option is $1, it signifies that for a contract involving 100 shares, the overall cost of acquiring the options contract is calculated as $1 x 100 = $100.

Being familiar and having a clear understanding of the fundamentals of options trading is essential for any trader looking to get started with this type of investment. Options contracts are a powerful tool for managing risk and generating profits, but they can also be complex and carry significant risks. You should, as a beginning option trader, regularly repeat (out loud or in your mind ) the exact meaning of each type contract and it’s possible outcomes. This will help you to get a quicker and better understanding of options contracts. Next, we will look into some basic options trading strategies for beginners, including buying call options and selling put options.

Let’s take a look at the “option chain” of the stock AAPL on the tastytrade options trading platform, where the option prices are displayed for options with all the different contract parameters:

Let’s find the price of a call option with strike price $190, for the underlying stock AAPL and with expiration date 17/11/23. The ask price for this call option is $1.70 (the premium) – this means that for a contract involving 100 shares, the overall cost of acquiring the option contract is $170

We read this option contract as follows : the buyer of the option pays $170 to the seller of the option contract and he acquires the right to buy 100 shares of the underlying AAPL, from the seller, at the strike price of $190 before or on expiration date fixed at 17 november 2023.

When traders buy options, they pay a premium for the right to exercise the option. If they choose not to exercise the option, because it is not profitable to do so, the premium is lost. When traders sell options, they receive the premium and take on the obligation to buy or sell the underlying asset if the option is exercised. If the option is not exercised the seller keeps the premium.

In the example above, you will understand with your fast trader mind, that the execution of the option contract is only profitable when the price of the shares on the stock exchange is higher than the strike price of the contract. If not, the buyer is cheaper off, buying the shares on the exchange.

We will elaborate more on this further in the guide. Let’s build our comprehension of options step by step.

b. Factors affecting the option value

The value of an options contract is determined by several factors. It is no surprise that the different components or parameters of the options contract are part of the determining factors. The value of the options contract, and the value of the option premium is determined by :

• the price of the underlying asset
• the strike price
• the time to expiration
• the level of volatility in the underlying asset
• the level of interest rates.

To get a real in-depth understanding of option pricing, we could start by looking at the fundamental aspects of option pricing models and the factors it uses to calculate the theoretical value of an option. But I can guarantee it is not required to understand all the detailed math behind these option pricing models, we just need to have a good comprehension of a couple of key notions and/or key variables that are frequently used when talking about options. So let me explain them one by one.

Intrinsic value & In-the-money / out-of-the-money

The price of the underlying asset is the most important factor in determining the value of an options contract.

In options trading, the intrinsic value of an option reflects what the option would be worth if exercised immediately. This value is calculated by making the difference between the current market price of the underlying asset and the option’s strike price. The intrinsic value indicates the amount that an option is in-the-money (ITM). In-the-money options have intrinsic value, whereas out-of-the-money (OTM) options, having no value if exercised immediately, have zero intrinsic value.

If the price of the underlying asset is above the strike price of a call option or below the strike price of a put option, the option has intrinsic value and is in the money.

Example: a call option has a strike price of $150 and the share price is $173. The intrinsic value of the option is $23 because if the owner exercises his right to buy the shares at the strike price of $150, with the shares selling on the market for a price at $173, this would mean an instant profit of $23 dollars. The intrinsic value of the option’s contract is $23x 100 shares = $2300

In this example, the option has intrinsic value. If the share price of the underlying asset is below the strike price of a call option or above the strike price of a put option, the option is said to be out of the money. In that case, the option has no intrinsic value and is priced based on its extrinsic value only.

Sometimes the term at the money is used, indicating the strike price is equal to the price of the underlying, and thus there is no intrinsic value.

Let’s take another look at the options chain as displayed on the trading platform:

The ITM and OTM calls and puts have their specific area in the options chain as shown above.

Extrinsic value

As explained above, intrinsic value indicates the immediate value of an option should that option be exercised immediately. But what if an option still has time until its expiration date, then it has time to gain (more) intrinsic value. This potential for an option to become more valuable before it expires is valued as a part of the premium and is called the extrinsic value. It reflects what could happen to the option’s value until it expires.

The time to expiration is also an important factor in determining the value of an options contract. As the expiration date approaches, the time value of the option decreases (there is less and less time to gain (more) intrinsic value, which can cause the price of the option to decrease as well. For this reason, extrinsic value is also known as “time value“.

Volatility in the underlying asset also affects the extrinsic value of an options contract. Options on volatile assets are generally more expensive than options on less volatile assets, because there is a higher probability that the option will gain (more) intrinsic value and get in the money at expiration.

The extrinsic value of any option is comprised of two components : Time till expiration and the Implied volatility of the shares.

The more time there is till expiration the greater the extrinsic value. Options with a greater number of Days till Expiration (DTE) are more expensive because there is more time for the stock to reach or exceed the strike price. Same reasoning for volatility : the more an underlying asset is expected to move, the greater the extrinsic value and thus premium, because there is a higher possibility the stock will reach or exceed the strike price.

The extrinsic value of an option decreases over the duration of the contract, as uncertainty around the underlying price and profit potential decrease. As the position nears expiration, the extrinsic value of the option nears zero, and the price of the option converges towards its intrinsic value.

Example :

In this example of a call option: the values show as follows : $10.60 (the premium) – $6.58 (intrinsic value $131.58 – $125) = $4.02 (extrinsic value)

Essentially, the market is aware the price may change over the 44 days still left to expiration, so the added premium (extrinsic value) is included to compensate for the changes in time value and volatility.

3. Why Selling Options Can Be a Better Strategy than Buying Options

In this chapter we will explore why selling options can be a better strategy than buying options, and provide examples of selling both put and call options.

Options trading can be approached from two main perspectives: buying options and selling options. Buying options is often seen as a way to speculate on the direction of the underlying asset, with the potential for large profits if the trade goes well. However, buying options can also be risky, with the potential for significant losses if the trade does not go as planned (and who really knows what direction the market will go…).

On the other hand, selling options can be a more conservative strategy, with the potential for steady income and limited risk. When you sell an option, you are taking on the obligation to buy (short put) or sell (short call) the underlying asset at the strike price if the option is exercised. In exchange for taking on this obligation, you receive a premium from the buyer of the option.

One of the key benefits of selling options is that you can profit from the passage of time (and time never stops). As time passes, the time value of the option decreases, which can cause the price of the option to decrease as well. This means that if you sell an option and the price of the underlying asset remains relatively stable, you can earn a profit as the time value of the option decreases.

Another benefit of selling options is that you can use options to generate cash flow from assets that you already own. For example, if you own a stock, that generates income through its dividend, you can also sell call options on the stock to generate additional income. If the price of the stock remains below the strike price of the call option, the option will expire worthless and you can keep the premium that you received for selling the option.

Now, let’s explore some practical examples of when and why you might choose to sell put and call options.

Example of Selling Put Options

Selling put options is a popular strategy for beginning and experienced option traders for generating income from a portfolio of stocks or other assets. When you sell a put option, you are taking on the obligation to buy the underlying asset at the strike price if the option is exercised. In exchange for taking on this obligation, you receive a premium from the buyer of the option.

Selling put options can be a practical strategy if you are bullish on a particular stock or asset, but do not want to purchase it outright at the current market price. For example, let’s say you believe that XYZ stock is undervalued at its current market price of $50 per share, but you do not want to spend $5,000 to purchase 100 shares.

Instead, you could sell a put option with a strike price of $45 and receive a premium of $1 per share or $100 for one options contract representing 100 shares. If the price of the stock remains above $45 at expiration, the option will expire worthless and you can keep the premium that you received for selling the option. If the price falls below $45 at expiration, the option will be exercised and you will be obligated to buy 100 shares of XYZ stock at $45 per share, but since you received a premium of $1 per share, your effective purchase price for the stock will be $44 per share.

If you have the cash ready to buy the shares, this strategy is called the cash-secured put strategy. It is a very popular options selling strategy used by investors who want to purchase a particular stock at a lower price.

Example of Selling Call Options

Selling call options is another popular strategy for generating income from a portfolio of stocks or other assets. When you sell a call option, you are taking on the obligation to sell the underlying asset at the strike price if the option is exercised. In exchange for taking on this obligation, you receive a premium from the buyer of the option.

It can be a practical strategy if you own a stock and want to generate additional income from it while you wait for the price to increase. You can sell call options on the stock and receive a premium. If the price of the stock remains below the strike price of the call option, the option will expire worthless and you can keep the premium. If the price rises above the strike price, you will be obligated to sell the stock at the strike price, but since you received a premium, your effective selling price for the stock will be higher.

For example, let’s say you own 100 shares of ABC stock, which is currently trading at $60 per share. You could sell a call option with a strike price of $65 and an expiration date of one month from now for a premium of $1 per share, or $100 for one options contract representing 100 shares. If the price of the stock remains below $65 at expiration, the option will expire worthless and you can keep the premium. If the price rises above $65 at expiration, you will be obligated to sell the stock at $65 per share, but since you received a premium of $1 per share, your effective selling price for the stock will be $66 per share.

This strategy is called the covered call strategy, because your contract is covered by shares you own. It is a popular options selling strategy used by investors who own shares of a particular stock and want to generate additional income.

In summary, selling put and call options can be a practical and beneficial strategy for generating income and managing risk in your portfolio. When you sell options, you take on the obligation to buy or sell the underlying asset at the strike price if the option is exercised, but in exchange, you receive a premium from the buyer of the option.

By choosing the right strike price and expiration date, you can create a strategy that aligns with your investment goals and risk tolerance.

4. Most Used and Important Options Selling Strategies

In the previous chapters, we discussed the basics of options trading and the practical and beneficial situations for selling put and call options. In this chapter, we will delve into some of the most used and important options selling strategies, including some basic combinations of puts and calls, and provide examples for each strategy.

Short Strangle Strategy

The strangle strategy is an options trading strategy that involves selling both a call option and a put option with the same expiration date but different strike prices. This strategy is used when the trader expects the underlying stock to experience a price movement in either direction, but is unsure about the direction of the movement.

To implement a short strangle strategy, the trader could sell a call option with a strike price above the current market price of the stock and sell a put option with a strike price below the current market price of the stock. This strategy is used when a trader expects the price of the underlying asset to remain within a specific price range until the expiration date.

The goal of the short strangle strategy is to generate income from the premiums received by selling the call and put options. The trader will profit if the price of the underlying asset remains between the two strike prices at expiration. The maximum profit is limited to the total premium received when selling the options, while the maximum loss can be unlimited if the price of the underlying asset moves beyond the strike prices.

To execute a short strangle strategy, a trader would first identify an underlying asset and determine the desired price range in which they expect the asset to trade. They would then sell a call option with a strike price above the expected price range and sell a put option with a strike price below the expected price range.

For example, let’s say a trader wants to use the short strangle strategy on Microsoft (MSFT), which is currently trading at $275 per share. They believe that MSFT will remain within a range of $250 to $300 until the expiration date. The trader could sell a call option with a strike price of $300 and sell a put option with a strike price of $250 both with the same expiration date.

If MSFT remains within the expected price range until expiration, the trader will profit from the premiums received from selling the options. However, if MSFT moves beyond the strike prices, the trader could potentially face unlimited losses.

To manage risk, traders using the short strangle strategy may adjust the strike prices or expiration date of the options to better match their market outlook. Overall, the short strangle strategy is a popular options trading strategy used by traders to generate income in a specific price range. However, it requires careful risk management and an understanding of the potential downside risks involved.

Short Spread Strategy

The short spread strategy, also known as a credit spread, is an options trading strategy that allows traders to profit from the market’s neutral or directional price movements. This strategy involves simultaneously selling one option and buying another option with the same expiration date, but different strike prices. The premium collected from selling the option is higher than the premium paid to buy the option, resulting in a net credit to the trader’s account.

There are two types of short spreads: the bear call spread and the bull put spread. The bear call spread involves selling a call option with a higher strike price and buying a call option with a lower strike price. The maximum profit for the bear call spread is limited to the net credit received, while the maximum loss is limited to the difference between the strike prices minus the net credit received.

On the other hand, the bull put spread involves selling a put option with a lower strike price and buying a put option with a higher strike price. The maximum profit for the bull put spread is also limited to the net credit received, while the maximum loss is limited to the difference between the strike prices minus the net credit received.

One of the advantages of using the short spread strategy is that it limits the trader’s maximum loss while still allowing for potential profits. Additionally, the strategy allows traders to benefit from a neutral or directional market, which can be useful during times of uncertainty or volatility.

Let’s say that MSFT is currently trading at $275 per share, and a trader believes that the stock will either stay at the current price or decrease slightly in the near future. The trader could implement a bear credit spread by selling a call option with a strike price of $310 and simultaneously buying a call option with a strike price of $320.

Assuming that the trader receives a credit of $2.50 per share for selling the $310 call option and pays a debit of $1.35 per share for buying the $320 call option, the net credit received would be $1.15 per share ($2.50 credit – $1.35 debit).

If MSFT stays below the $310 strike price at expiration, both options will expire worthless and the trader will get to keep the full credit received as profit. However, if MSFT rises above the $310 strike price, the trader may have to buy back the short call option at a higher price to avoid a large loss.

To limit the potential loss, the trader could buy back the short call option and sell the long call option at a higher price if MSFT approaches the $310 strike price. This would reduce the overall profit, but also limit the potential loss.

Overall, a bear credit spread is a limited risk strategy that allows traders to profit from a moderate decline in the underlying stock’s price, while also capping the potential loss.

5. Choosing the Right Options to Sell

One of the keys to successful options trading is choosing the right options to sell. This means selecting options that align with your risk tolerance, investment goals, and market outlook.

First and foremost, it’s important to consider your risk tolerance. If you’re a conservative investor, you may want to focus on selling options that are (far) out-of-the-money or have a low probability (delta) of expiring in-the-money. This can help minimize your risk, but may also limit your potential profits.

On the other hand, if you’re willing to take on more risk, you may want to consider selling options that are closer to the current stock price. These options have a higher probability of expiring in-the-money (which is negative for option sellers), but also offer greater potential rewards.

Your investment goals are another important consideration. Are you looking to generate income on a regular basis, or are you willing to take on more risk in the hopes of achieving larger gains? If you’re focused on income generation, you may want to consider selling options that are closer to expiration or have a higher premium. If you’re willing to take on more risk for the potential of larger gains, you may want to consider selling options with longer expiration dates or higher strike prices.

Finally, it’s important to consider your market outlook. If you’re bullish on the market, you may want to focus on selling put options, which allow you to profit if the stock price rises. If you’re bearish on the market, you may want to focus on selling call options, which allow you to profit if the stock price falls.

When selecting options to sell, it’s also important to consider the underlying stock’s volatility. Options on highly volatile stocks will generally have higher premiums, but also carry greater risk. Options on less volatile stocks may have lower premiums, but offer more stability.

In addition to considering these factors, it’s important to stay up-to-date on market news and trends. This can help you make informed decisions about which options to sell and when to sell them.

Overall, selecting the right options to sell requires careful consideration of your risk tolerance, investment goals, and market outlook. By taking these factors into account and staying informed about market trends, you can make more confident and profitable options trades. It is a wise idea to stay small and with high probability.

6. Managing Risk in Options Trading

Options trading can be an exciting and potentially profitable venture, but it comes with its fair share of risks. That’s why managing risk should be a top priority for any trader, especially when it comes to position sizing.

Position sizing refers to the amount of money a trader allocates to a single trade. It’s a crucial aspect of risk management because it helps limit downside risk and prevents traders from overexposing themselves to a single trade. As a general rule, traders should never risk more than a specific % of their portfolio on a single trade (for example 2 to 5 %).

Let’s take an example to illustrate the importance of position sizing in risk management. Suppose a trader has a $100,000 portfolio and wants to sell a put option on a stock that’s trading at $50. The option has a strike price of $45 and a premium of $2. The trader is bullish on the stock and believes it will remain above the strike price by the expiration date.

If the trader sells one put option contract, they’ll receive a premium of $200 ($2 x 100 shares). However, if the stock drops below the strike price by expiration, the trader will be obligated to buy 100 shares at $45 each, resulting in a “loss” of $4,500.

To manage their risk, the trader should determine the maximum amount they’re willing to lose on the trade and adjust their position size accordingly. If they’re only willing to risk 1% of their portfolio, they should sell one contract, since the maximum loss would be $1,500 ($45 x 100 shares – $200 premium). If they’re willing to risk 2%, they could sell two contracts.

Another important risk management tool is the use of stop-loss orders. A stop-loss order is an order to close a position when it reaches a certain price, which helps limit losses. We will not go into detail about this here.

In conclusion, managing risk is crucial for options traders, and position sizing is one of the most important tools for doing so. By limiting the amount of money they allocate to each trade and using stop-loss orders, traders can protect themselves from significant losses and improve their chances of long-term success in the options market.

7. Conclusion

If all this was new to you : Congratulations! You’ve reached the end of our beginner’s introduction to selling options. In this article, we covered a lot of ground, from the basics of options trading to more advanced strategies for selling options. Here are some key takeaways:

• Selling options can be a profitable strategy for traders looking to generate cash flow and limit their risk.
• Choosing the right options to sell is crucial and depends on your risk tolerance, investment goals, and market outlook.
• Risk management is essential when trading options, and strategies like stop-loss orders and position sizing can help limit downside risk.
• There are several popular options trading strategies that involve selling puts and calls, including the covered call, cash-secured put, and iron condor.

Now that you have a better understanding of options trading and selling options, it’s time to take the next step. If you’re interested in learning more about options trading and how to get started with selling options, check out our website at tradingoptionscashflow.com. We offer a range of educational articles and resources to help beginners get started, just like I did, with learning more about options trading.

In addition, we also offer a range of tools to help traders track their options trading strategies and results with specific spreadsheets for option trading.

Remember, options trading involves risk and may not be suitable for all investors. It’s important to do your own research and consult with a financial advisor before making any investment decisions.

Thank you for reading, and we wish you the best of luck on your options trading journey!