How To Trade Options Like the Pros

A good options trade can bank 100% in profit from a 10% gain in stock price. But it can be tricky getting started.

So we wanted to share our guide with you, "Options Trading for Beginners: How to Get Started and Make Money with Options."

But there's also one small piece of advice we want to share, something even experts forget often. It can make or break an investor, so stay tuned…

While some stocks do provide market-beating gains, options can produce massive returns in just a few days or even hours.

Trading options can be intimidating for some, and we want to dispel some of these fears with a few tricks. Once you've mastered the basics of trading options and executed a few of your own trades, you'll find it's simpler than you thought.

That's why we've created a guide to options, or options trading 101, if you will.

When you purchase options, you're not buying shares of a stock. Instead, it's the right to buy or sell shares of a particular stock at your specified price and by a certain deadline. You usually pay much less than you would buying the stock.

If the share price moves as predicted, your gains are much larger than if you had owned the shares themselves.

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Take Yelp Inc. (NYSE: YELP) as an example. Between April 18 and May 9 last year, the share price jumped from $44.83 to $47.92.

That would give you a 6.9% gain if you owned the stock.

But Tom Gentile, options trading specialist for Money Morning, provided readers with a tip just before the Yelp earnings release. He said that share prices generally rise in the weeks leading up to this date and then fall soon after.

Investors that purchased options based on Tom's recommendation were able to produce a 64% gain in just three weeks.

This might sound confusing on the surface, but it will make more sense once you understand the basics of options, and then we'll tell you more on how to get started with options trading.

How Options Trading Works

Options are aptly named. They provide you with the "option" to buy or sell a specified number of shares at a certain price on a certain date.

The trick is knowing what price and dates are the right ones to produce the gains you want.

Your specified buy or sell price is referred to as the "strike" price.

Let's say you bought an option to buy stock on Sept. 1 for $25 per share – that's your strike price. The options contract was $1 per share (that's called the premium), representing 100 shares of a company. Your initial investment, then, is $100.

Now you wait and see what the stock does.

Let's assume the date arrives, and the stock is trading at $50 per share. If you choose to exercise the option, or buy the stock, you'll have $25 in profit for every option exercised. For 100 shares, exercising the option would cost you $2,500.

But you might not have $2,500 to spare, or you might just not want the stock, for whatever reason.

That's fine, because you also have an options contract that's gone up in value, since the underlying share price doubled. A doubling share price can cause the options contract to soar. For the purpose of this explanation, let's say the contract has jump 500% in value. That means you could have turned your $100 investment into $600.

But it really depends on the situation, whether exercising or selling the option is more profitable.

In this case, exercising the option would mean 100% profit. Buying 100 shares for $2,500, then turning around and selling them for $5,000.

But if the options contract went up 500%, turning $100 to $600 might be more profitable for those interested in big percentage gains. You might sell the contract. The cash you'd receive would be less, but the percentage gain would be higher.

In fact, Options Clearing Corp. reports that only about 12% of options contractsare ever exercised, meaning the owner rarely buys or sells the shares listed in the contract.

Key Options Trading Terms

Before we outline how to get started trading options, here are a few key terms you should know:

  • The strike price is the price listed on the option, at which you can buy or sell the shares by the expiration date.

  • If you are "in the money," this means that the current price of the stock is favorable relative to your option contract. In the above example, if you have an option to buy shares at $25 and the price hits $30, you're in the money.

  • If you are "at the money," this means that the current stock price is at or near your strike price. "Out of the money" means that it's below your strike price or unfavorable to you.

  • The price you'll pay for the option is the premium. This will get higher as the position on the option improves.

Remember, an option gives you the right to either buy or sell a stock at a specified price. For every option sold, there is someone on the other end that could lose out if the contract is exercised, which brings up the issue of puts and calls.

The two most basic types of options are put options and call options.

Put and Call Options

A put option gives you the right to sell a specified number of shares at the strike price. This is something you would buy if you're anticipating that the share price is going to fall. Your option will increase in value as the share drops below the strike price.

A call option gives you the right to buy a specified number of shares at the strike price. You would generally want this when you expect that the share price will go up by your expiration date.

Those two concepts seem simple enough, but even with all of this knowledge under your belt, there's one all-important thing to consider. In fact, you don't want to touch options trades until you have this down…

The Most Important Thing to Remember in Options Trading

If there is one thing you should avoid with options trading, it's getting emotional about your trades.

This means that you want to set calculated exit points from the start and stick to them. If the share price hits your target, you buy or sell your option.

Relying on emotions might work in your favor a few times, but it won't be successful long-term.

Beyond this, target options on stocks that are ready to make a move. This isn't much different than traditional investing. There might be catalysts for moves with a company, such as rumors of an acquisition, an upcoming earnings report, or other industry or product news.

You can also reduce your risk by having both put and call options on the same stock, which is referred to as a straddle. This technique is a bit more complex, but you'll get the hang of it quickly.

If you really want to dive deep into options trading, Tom Gentile offers a seven-day crash course that covers everything you need to know to get started.

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This article is supplied courtesy of Money Morning.

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