Options Trading for Beginners: A Guide to Getting Started and Managing Risks

Options Trading for Beginners

For those looking to diversify their investment strategies, options trading can be a powerful tool to generate income, hedge risks, or even accelerate financial independence. Recently, the Forget About Money podcast brought together two experienced options traders, Karsten Jeske, also known as Big ERN, and Brad Finn, to discuss options trading for beginners in straightforward terms. Their conversation highlighted essential definitions, strategies, and practical considerations for those new to options.

In this guide, we’ll break down the fundamentals of options trading, explore how it can fit into a financial independence journey, and share insights on key strategies, risks, and more.

Trading Options for Beginners

What Are Options?

In simple terms, options are financial contracts that grant the holder the right (but not the obligation) to buy or sell an asset at a specific price within a set timeframe. Options allow investors to leverage positions without fully committing to buying or selling the underlying asset. Call options allow you to buy an asset at a specified price, while put options give you the right to sell an asset at a specified price.

Call Options vs. Put Options

Karsten and Brad highlighted the concept that call options are like lottery tickets—they provide high potential gains if the stock price rises above the strike price. Put options, on the other hand, act like insurance, giving the holder the right to sell an asset if it falls below a certain price.

Options buyers are often willing to overpay for the benefit of such lottery tickets and portfolio insurance. Thus, Karsten and Brad emphasize that most successful options traders sell options.

Why Options Trading? Who Should Consider It?

Options trading is not suitable for everyone. Unlike traditional investments, options are more complex and involve more risk. Karsten Jeske and Brad Finn both noted that options trading can fit well for individuals who are comfortable with stock market basics and have a solid understanding of risk management.

Brad shared, “Options trading isn’t one-size-fits-all—it’s about finding the right strategy for your risk profile.” Options trading can be beneficial for those seeking additional income streams, those who want to hedge their portfolio, or investors looking for opportunities to grow their wealth strategically. However, it’s important to approach options trading with caution and to start small.

Recommended Portfolio Allocation for Options

As a general rule of thumb, Brad recommends allocating no more than 5-10% of your total net worth to options trading. This approach limits potential losses while still allowing you to benefit from options strategies. Brad stated, “Starting small and increasing your allocation only as you gain experience is key.”

Karsten trades options in a much larger account but cautions that it’s best to start small and go through at least one bear market to test the waters before running an options strategy in a sizable account.

Understanding Covered Calls and Cash-Secured Puts

To help beginners navigate options trading, Karsten and Brad shared insights into two foundational strategies: covered calls and cash-secured puts.

Covered Calls

A covered call involves holding shares of a stock and then selling call options on that stock. This strategy allows investors to generate income by collecting premiums from the options they sell. It’s a conservative approach, best suited for those who own stocks and are open to selling them if the stock price rises above the strike price.

Cash-Secured Puts

A cash-secured put is a strategy where the investor sells a put option on a stock they’re willing to buy. By holding cash in the account to cover the potential purchase, this strategy minimizes risk and allows the investor to buy the stock at a discount if the price falls below the strike price. This approach can be particularly effective for investors looking to add to their stock portfolio at a lower cost.

Options Trading vs. Day Trading: Key Differences

Options trading and day trading are often confused, but they are very different investment approaches. While day trading involves buying and selling stocks within the same day, options trading is generally more strategic and can play out over days, weeks, or even months. Day trading requires constant attention to market movements and a tolerance for high risk, while options trading allows for more flexibility and targeted risk management.

Three Popular Options Strategies for Beginners

Karsten and Brad introduced three options strategies that can benefit beginners.

All strategies have in common that we act as (net) options sellers:

  1. Covered Calls: Generate income on stocks you already own by selling call options.
  2. Cash-Secured Puts: Buy stocks at a discount by selling put options on stocks you’re willing to own.
  3. Bull Call Spreads: Buy a call option at a lower strike price and sell a call option at a higher strike price to create a defined risk/reward setup.

The Risks of Trading Options and How to Mitigate Them

Options trading comes with inherent risks, including volatility, and market swings. Karsten and Brad emphasized that risk management is essential for anyone considering options trading.

Common Risks and How to Mitigate Them

  • Volatility: Stick to low-volatility stocks or indexes to minimize exposure to sudden market swings.
  • Leverage: Avoid high leverage unless you’re experienced with options and prepared for potential losses.

Brad shared, “Options aren’t just for speculators; they can be powerful tools for risk management.” By starting with conservative strategies like covered calls and cash-secured puts, beginners can ease into options trading while managing risk.

Step-by-Step Guide to Starting Options Trading

If you’re new to options trading, here’s a simple step-by-step guide to get you started:

  1. Open a Brokerage Account: Choose a brokerage platform that supports options trading and get approved for options trading.
  2. Learn the Basics: Familiarize yourself with call options, put options, covered calls, and cash-secured puts.
  3. Set a Budget: Limit your options trading to 5-10% of your total portfolio.
  4. Start Small: Begin with one or two simple trades, such as covered calls or cash-secured puts.
  5. Monitor and Adjust: Keep track of your trades, expiration dates, and adjust your strategies as needed.

Karsten shared this advice for newcomers, “Options trading is a journey—take it slow, learn as you go, and be prepared for both wins and losses.”

How Options Trading Fits Into a Financial Independence Journey

For those pursuing financial independence, options trading can serve as a valuable tool for generating passive income. However, both Karsten and Brad caution that options trading should be approached carefully within an FI plan.

Brad stated, “Options trading can play a role in achieving FI, but it’s important to see it as part of a larger investment strategy.” By focusing on lower-risk strategies like covered calls and cash-secured puts, options trading can supplement traditional retirement income streams without taking on excessive risk.

Is Options Trading Worth It?

For many, the appeal of options trading lies in its potential for both income generation and risk management. However, options trading is not a shortcut to financial independence, nor is it suited for every investor.

Karsten emphasized, “Options trading isn’t for everyone, but for those willing to learn and manage risk, it can be a powerful addition to a financial independence plan – If you add just a percentage point of return
every year it would make a tremendous difference both during accumulation and in (early) retirement.”

Conclusion

Options trading offers a range of strategies for investors looking to diversify their portfolios, generate income, or protect their assets. However, as with any investment strategy, it’s essential to approach options trading with a clear understanding of the risks and mechanics involved.

For beginners, starting small with covered calls and cash-secured puts can provide a safe entry point. With insights from experts like Karsten Jeske and Brad Finn, you can explore the benefits of options trading while keeping your financial independence goals in focus.

Whether you decide to pursue options trading or stick with traditional investing, always remember to manage risk, stay informed, and align your investments with your long-term financial objectives.

Links to Options Trading resources by Karsten and Brad:

Karsten Jeske’s Options Trading: The Strategy in a Nutshell

Brad Finn’s Options Trading YouTube Channel

David Baughier

My passion for helping others led to the curation Fiology. Help me spread the message of Financial Independence by clicking a colorful link above and sharing this post on your favorite social platform. Thank you!

Leave a Comment