Understanding the Basics
A long option is a contract that gives the buyer the right to buy or sell the underlying security or commodity at a specific date and price. There is no obligation to buy or sell in the contract, but simply the right to “exercise” the contract, if the buyer decides to do so. An option that gives you the right to buy is called a “call,” whereas a contract that gives you the right to sell is called a "put." Conversely, a short option is a contract that obligates the seller to either buy or sell the underlying security at a specific price, through a specific date. When the buyer of a long option exercises the contract, the seller of a short option is "assigned", and is obligated to act.
To make this clearer, let’s use a real world analogy… Let’s say you’re shopping for an antique grandfather clock and find the perfect one at the right price: $3,000. But you won’t have the cash for another three months. You talk to the owner and he agrees to sell it at that price in three months with a specific expiration date, but you have to pay $100 for him to agree to the contract. After three months, you have the money and buy the clock at that price.
But maybe it’s discovered that the clock was owned by Theodore Roosevelt, which makes it worth $10,000. You have the right to exercise your option and buy it for $3,000, netting you a profit of $6,900 (minus transaction costs). On the other hand, let’s say it’s discovered that’s it’s not an antique at all, but a knock-off worth only $500. You’re under no obligation to exercise your option and buy it at $3,000, so you can opt not to buy it at all and simply let the contract expire. Although you’re still out the $100, at least you’re not stuck with a clock worth a fraction of what you paid for it. From the option seller's perspective, in the first scenario he gets the $100, but is later forced to sell the clock at less than true market value. In the second scenario, he keeps the clock, and the $100 you paid in premium.
If you understand this concept as it applies to securities and commodities, you can see how advantageous it might be to trade options. For a relatively small amount of capital, you can enter into options contracts that give you the right to buy or sell investments at a set price at a future date, no matter what the price of the underlying security is today.
Some things to consider before trading options:
Leverage: Control a large investment with a relatively small amount of money. This allows for strong potential returns, but you should be aware that it can also result in significant losses.
Flexibility: Options allow you to speculate in the market in a variety of ways, and use a number of creative strategies. There are a wide variety of option contracts available to trade for many underlying securities, such as stocks, indexes, and even futures contracts.
Hedging: If you have an existing position in a commodity or stock, you can use option contracts to lock in unrealized gains or minimize a loss with less initial capital.
Setting Up an Account
You can trade and invest in options at TD Ameritrade with several account types. You will also need to apply for, and be approved for, margin and option privileges in your account.
Choosing a Trading Platform
With a TD Ameritrade account, you’ll have access to options trading on our web platform, as well as on our two more comprehensive platforms: Trade Architect, and thinkorswim. Trade Architect is ideal for those traders first starting with options. It features fundamental tools, such as P&L charts, option strategy chain filters, and other tools that can give you ideas and the ability to test your strategy.
The thinkorswim platform is for more advanced options traders. It features elite tools and lets you monitor the options market, plan your strategy, and implement it in one convenient, easy-to-use, integrated place. Also, if you plan on participating in complex options trades that feature three or four “legs,” or sides of a trade, thinkorswim may be right for you.
Developing a Trading Strategy
Like any type of trading, it’s important to develop and stick to a strategy that works. Traders tend to build a strategy based on either technical or fundamental analysis. Technical analysis is focused on statistics generated by market activity, such as past prices, volume, and many other variables. Charting and other similar technologies are used. Fundamental analysis focuses on measuring an investment’s value based on economic, financial, and Federal Reserve data. Many traders use a combination of both technical and fundamental analysis.
Whether you use technical or fundamental analysis, or a hybrid of both, there are three core variables that drive options pricing to keep in mind as you develop a strategy:
Price of the underlying security or commodity
Time to expiration
Implied volatility based on market influences and future outlook
With both Trade Architect and thinkorswim, you’ll have tools to help you analyze these variables and more. You’ll also find plenty of third-party fundamental research and commentary, as well as many idea generation tools. You can even “paper trade” and practice your strategy without risking capital. In addition, you can explore a variety of tools to help you formulate an options trading strategy that works for you. You can also contact a TD Ameritrade Options Specialist anytime via chat, by phone 866-839-1100 or by email 24/7.
Building Your Skills
Whether you’re new to investing, or an experienced trader exploring options, the skills you need to profit from options trading should be continually developed. You’ll find Trade Architect, is a great way to start. For veteran traders, thinkorswim, has a nearly endless amount of features and capabilities that will help build your knowledge and options trading skills.