How a College Student Learned About Options Trading - Part 1

While options trading might seem complex and overwhelming, breaking down the basics can help make it more approachable. If you're familiar with stock trading or programming, learning about options can feel like a natural next step. 

And while options may increase risk, they also offer flexibility and the potential for enhanced returns. Even as a college student with limited experience in investing and trading, I had a general understanding of options trading!

During the learning process, I faced challenges with understanding several option trading concepts, and I want to save you from the same frustration. This article may help simplify options trading, explaining it in the simplest way possible so that you can see it as an effective addition to your trading strategies. I’ll break down the key terms, eliminate jargon, and guide you through real-world examples, including how to use Alpaca's commission-free Trading API to get started*.

How I Got Started With Options Trading

Before I dive into the details, let me share my story. I’m Satoshi, a college student majoring in statistics. While I haven’t formally studied finance, trading has become a hobby of mine.

I started investing in high school, focusing on long-term strategies like ETFs and mutual funds. This was a good introduction to portfolio management and compound interest. However, I quickly realized that unless you’re investing large sums of money, long-term investing yields slow returns. It’s more of a financial supplement. That’s when I decided to explore options trading for more flexible growth opportunities. 

Around the same time, I was learning the coding language Python, and I wanted to combine my coding skills with trading. After searching online for a way to practice, I discovered Alpaca’s Trading API and started using their paper trading platform, which allowed me to put my skills and understanding of options to the test.

In a relatively short amount of time, I learned the basics of options trading and became familiar with Alpaca’s platform. If I, a student with no formal finance background, could do it, I hope this guide can help you understand the fundamentals of options trading.

How Did I Learn? What Resources Did I Use?

As mentioned earlier, this article will simplify the essential terms of options trading. To get started, here are the key resources I used during my learning journey.

Learning the Basics

Getting a basic education about how options work was a key first step into the world of options trading. I first spent time reading and watching the following resources:

Investopedia: 

• A comprehensive knowledge base covering all types of investments, including options trading. For example, the blog Options Contract: What It Is, How It Works, Types of Contracts was a great starting point.

Financial Wisdom (YouTube): 

• This channel provides concise and straightforward explanations, making complex topics easier to digest. You can explore more here: Financial Wisdom

Alpaca Learn: 

• Alpaca’s official documentation, which offers practical insights into algo trading. You can explore more here: Alpaca Learn

Applying Knowledge and Starting to Trade

I then began trading options while diving deeper into these additional resources:

The Options Industry Council (OIC): 

• This website is incredibly well-organized and easy to understand, offering the most comprehensive guides for options trading. I highly recommend revisiting it frequently as you continue to grow your knowledge. You can explore more here: What is an Option?

The focus of this article is on building a basic understanding of options trading, so I’ve highlighted the resources that were most helpful to me in my first week. While many terms may seem overwhelming, don't worry! I’ll break them down for you step by step in this next part. Let’s begin by understanding from the very beginning… What even is options trading?

What Is Options Trading? Understanding the Basics

At its core, options trading involves a buyer and a seller agreeing on a price (or strike price) for the right to buy or sell an underlying asset or stock within a specific timeframe.

With a call, the buyer gains the right to buy the underlying asset at the agreed upon strike price through the end of the trading day on the expiration date. With a put, the buyer gains the right to sell the underlying asset at the agreed upon price. In order to either buy or sell the underlying asset, the buyer would send a request to exercise the option.

If the option has not been exercised or sold prior to the expiration date, automatic exercise rules come into play after the market closes on expiration: for example, in a long call or put position, options will be automatically exercised if they are at least $0.01 in-the-money. If you have a call option that is exercised, you will receive or buy 100 shares of the underlying stock at the strike price. For a long put position that is in-the-money by $0.01, you will deliver or sell 100 shares of the underlying stock at the strike price. 

Automatic exercise rules may vary by broker depending on whether your account has sufficient long shares available to cover the exercise deliverables of the put contract. You can explore more here: What is Automatic Exercise?

There are two primary types of options: calls and puts. Let’s break down these terms first.

Call Options

A call option (American style) gives you the right to buy a stock at the strike price before the agreed upon expiration date.

Call Option Example:

Let’s say you believe that Stock A, currently priced at $85, will go up. You buy a call option with a strike price of $90, expiring in one month, with a premium of $1. If Stock A rises above $85 before the option expires, you can buy the stock at $85 (even though it’s worth more now). Note: The standard options are bought in multiples of 100. So if you were to buy 5 options, that would be 500 shares (5 x 100). 

None-standard options are options where the deliverables of the contract have been adjusted based on a corporate action of the underlying stock. For example, a stock split can impact the deliverable of the contract. Brokers generally don’t allow opening orders on non-standard options due to the complexity of the deliverables.

Let’s go over an example of standard options.

• If Stock A rises to $90, you can buy it at $85 (with a premium of $1 per share), potentially making a profit of $5 (minus the $1 premium) per share. In this example, you would make a profit of (100 shares x ((Stock A New Price - Stock A Old Price - Premium)). So you would make $400! (100 x ($90 - $85 - $1))
• If Stock A stays below $85, you don’t have to buy it, and the only money you lose is the premium you paid for the option. So, in this case, you’d lose $100. (100 x $1).

Put Options

While call options allow you to buy a stock at a strike price, a put option (American style) is a contractual agreement that allows you to sell a stock at the strike price up to and including the expiration date.

Put Option Example:

Suppose you think Stock B, currently priced at $95, will drop. You buy a put option with a strike price of $90, expiring in one month. If Stock B falls below $90, you can sell it at $90, even if it’s worth less.

• If Stock B drops to $85, you can sell it at $90 (with a premium of $1 per share), potentially making a profit of $5 (minus the $1 premium) per share. In this example, you would make a profit of (100 shares x (Stock B Old Price - Stock B New Price - Premium)). So you would make $400! (100 x ($90 - $85 - $1))
• If Stock B stays above $90, you don't have to sell it, and the only money you lose is the premium you paid for the option. So, in this case, you'd lose $100 (100 x $1).

In Short:

• Call options are trades that are made with the view that the stock price will go up, potentially making you a profit.
• Put options are trades that are made with the view that the stock price will go down, potentially making you a profit.

Option Trading Vs Stock Trading: How They Differ

If you’re reading this, I assume you’re familiar with stock trading or have some experience with it. So, you might be wondering: how exactly are options trading and stock trading different?

The best way to understand the contrast between stock trading and options trading is by running through the same example of Stock A.

Regular Stock Trading Example:

• You decide to buy 100 shares of Corp A at $85 per share.
• Total investment: 100 x $85 = $8,500.
• If Corp A's stock rises to $90 per share, your profit would be (100 x $5) = $500.
• If the stock falls to $80 per share, your loss would be (100 x $5) = $500.

Options Trading Example:

• Instead of buying the stock, you purchase a call option on Corp A with a strike price of $90, paying a premium of $2 per share for the option contract.
• Total cost: 100 x $2 = $200.
• If Corp A's stock rises to $100 per share before the option expires, you can exercise your right to buy 100 shares at $90. Your profit would be (100 shares x (Stock A New Price - Stock A Old Price - Premium). So, in this case, (100 x ($100 - $90 - $2)) = $800.

If the stock price stays below $90, you lose only the premium paid, which is $200, rather than losing as much as in regular stock trading.

The Risks of Options Trading

Like other investments, options have no guarantees, and there is a chance you could lose all of your initial investment or even more. For instance:

• Option buyers risk losing the entire premium they paid. If the option expires "out-of-the-money," they will lose the entire amount.
• Option sellers (writers) may face higher risks, as some contracts can lead to unlimited potential losses.

Other risks include:

• Market Risk: High market volatility near the expiration date can cause sudden price changes, leading to options expiring worthless.
• Underlying Asset Risk: Options depend on an underlying asset (like a stock or index). So, any factors that affect the asset’s price will also affect the option’s value.

Next: Dive into Chapter 2

In this article, I shared my learning journey and the resources that helped me the most. We also covered the core concepts of options trading and compared them to stock trading using the imaginary stock A.

If you’re comfortable with the terms discussed here and ready to dive deeper into the world of options trading, proceed to the next article: How A College Student Learned About Options Trading Part 2.

*Commission-free trading means that there are no commission charges for Alpaca self-directed individual cash brokerage accounts that trade U.S.-listed securities and options through an API. Relevant regulatory fees may apply. Commission-free trading is available to Alpaca's retail customers. Alpaca reserves the right to charge additional fees if it is determined that order flow is non-retail in nature.

Options trading is not suitable for all investors due to its inherent high risk, which can potentially result in significant losses. Please read Characteristics and Risks of Standardized Options before investing in options.

Please note that the content is for informational purposes and is believed to be accurate as of the posting date but may be subject to change. The examples and images above are for illustrative purposes only.

All investments involve risk and the past performance of a security, or financial product does not guarantee future results or returns. There is no guarantee that any investment strategy will achieve its objectives. Please note that diversification does not assure a profit, or protect against loss. There is always the potential of losing money when you invest in securities, or other financial products. Investors should consider their investment objectives and risks carefully before investing.

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