Basics of Options Trading

This guide is essentially an extension of our introduction to options trading. While our introduction section has been written specifically to provide a general overview of what options are and what trading them is all about, this guide to the basics focuses on some of the more precise details that you will need to know about before you should be thinking about getting involved in options trading.

We would suggest that if you are a complete beginner then you should start with our introductory section. However, if you already have a good general understanding of the fundamentals of options trading and what is involved, then this guide to the basics is the next logical step.

Here we cover the main types of options contracts that you can trade along with the types of orders you need to place to trade them. We also provide details of the various categories of spreads that are applied in trading, along with the different trading styles that can be used. You will also find comparisons between options and some of the other commonly used financial instruments.

  • Types of Options
  • Types of Orders
  • Types of Spreads
  • Types of Trader & Trading Styles
  • Comparing Options to Other Financial Instruments

Types of Options

Options can be categorized in a number of ways and there are actually several different types: calls and puts. Calls are contracts that give the holder the right to buy the underlying security while puts are contracts that give the holder the right to sell the underlying security. Obviously this is a very significant distinction and these are essentially the two main types of contracts. However there are many different ways in which options can be classified too.

For example, they can be classified based on the underlying asset involved, the way in which they can be exercised, how they are settled or the length of the contract. There are also a wide variety of exotic contracts, which are usually more complex and contain specific provisions. For a complete guide to the various different forms and full details on some of the more commonly used ones, please visit Types of Options.

Types of Orders

When you buy and sell options contracts you have to place orders with a broker, in a similar way to how you would buy and sell stocks, and there are several different types of order that can be used. There are four main types, two of which are the most commonly used. These are the buy to open order, which is used to enter a new position through buying contracts, and the sell to close open order which is used to exit an existing position by selling contracts you have previously bought.

The other two main orders are the sell to open order and the buy to close order. These are used for opening a position by writing contracts and closing a position by buying back previously written contracts respectively.

In addition to these four main types, orders can also contain other parameters relating to how the order is filled, the timing of the order, and automatic exit points. There are also combination orders that can be used to coordinate multiple positions. For an in-depth guide to the range of orders that can be used, please visit Types of Orders.

Types of Spreads

One of the biggest advantages of trading options is found in the creation of spreads. Creating options spreads is slightly more complicated than the straightforward buying and selling of contracts, but the concept itself is simple enough to understand.

An options spread is basically when you buy and/or sell two or more options contracts relating to the same underlying security. A simple spread would be buying calls on a specific security and then writing calls on the same security. Spreads are very widely used in options trading, usually for limiting the risk of entering a particular position or reducing the initial cost of entering a particular position.

There is a huge range of different spreads that can be used and essentially every options trading strategy involves the use of at least one spread. At some point you will want to learn all about the different spreads and how they are used, but to start with you just need to understand the main categories. These include call spreads, put spreads, debit spreads, and credit spreads. To read more on this particular subject, please visit Types of Spreads.

Types of Trader &Trading Styles

Most options traders employ a specific trading style when buying and selling contracts. It's useful to understand the different trading styles and what is involved, as at some point you will want to decide which trading style is best for you. A lot will depend on what your investment objectives are, how much time you have to commit to trading, and what kind of skills you have.

For example, if you are planning on trading full time and are particularly good at making fast decisions under pressure then day trading may be a good style for you. Alternatively, you may want to start out using a style that doesn’t have to be so time consuming – swing trading.

You can visit Types of Trader & Trading Styles for more detailed information on the different trading styles that you can use.

Comparing Options to Other Financial Instruments

If you are trying to decide whether options trading is right for you, then it would be useful to compare options to other financial instruments that can be traded; such as stocks, bonds, futures and foreign currencies.

Even if you determine that options contracts are the right financial instrument for you to trade, it cannot hurt to have at least a basic understanding of these other instruments – you may even decide to trade a selection of different instruments.

It's also worth bearing in mind that options contracts are derivatives that are based on the value of other financial instruments so knowing a little about how those instruments work is likely to benefit you whatever you decide to do.

Please visit Comparing Options to Other Financial Instruments for an in-depth look at the differences between options contracts and other forms of investment.