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How to Trade Options Effectively

Learning to trade options can seem daunting, but fortunately there are some smart and easy ways to learn the ropes.

For many traders, options are a foreign concept. For new traders, they typically appear as either an object of terror, or a gold mine ready to be harvested.

The truth lies somewhere in between.

Like all financial products, options have a time and a place. The fear part stems from a lack of education, understanding or risk management. When used properly, options can help an investor define their risk, protect their investments and enhance their income or returns. When used improperly or with a high level of risk, however, they can quickly and completely decimate an entire portfolio.

Read More: What Is Options Trading?

When approaching options for the first time, it's important to start small, start simple and start studying.

1. Start Small

It's easy to get overwhelmed by options. Often the percentage move on an option contract will exceed the percentage move of the underlying stock or index by a significant amount. For instance, a stock rises 5% and your option position tied to the stock rises 20%. Other times, your option position movement may be detached from a stock's price action. For instance, a stock rises 5% but your bullish option falls 20%. That's because there are more factors influencing an option's price beyond the underlying stock price. Until you understand these factors, starting small will help you avoid frustration while learning.

Emotions play a huge factor in trading, and not understanding why you are making or losing money can have a huge impact on you. Greed or fear will be more likely to appear, so starting with less risk will help manage this. Additionally, maintaining a small number of different option positions will help you avoid feeling overwhelmed or suffering from paralysis by analysis when you first get started. It's actually a pretty good approach for most traders in general.

2. Start Simple

Kicking off your options trading experience with an unbalanced skip-strike call butterfly probably isn't the best way to go. And, yes, that really exists.

Combination trades, or those using multiple options at once, are best left to professionals and experienced traders. The easiest way to protect yourself and your portfolio is keeping things simple.

First and foremost, do not sell naked options. What this means is do not create a short position by selling a call or put without an offsetting position. As you advance your knowledge, strategies around selling puts (a bullish strategy) often make sense; however, probably not a day one trade.

Your goal when first starting should be a basic strategy like buying a call (bullish) or selling a put (bearish or protection).

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A call is a contract allowing its owner to buy a specific number of shares (usually 100) at a set price (known as the strike price) for a set period of time (the contract's expiration date). The cost of the contract is called a premium.

For a trader, this premium, which is the cost of buying the contract, is the maximum amount of money they can lose. I refer to it as their defined risk; we are defining exactly how much money is at risk in the trade. And owning a call comes with unlimited upside until the expiration date.

Buying a put has the same characteristics as a call except the holder has the right to sell at a set price rather than the right to buy. It also has defined risk. This approach can be used if you think a stock's price will decline or if you want to buy insurance against an existing long position. For the cost of the put, an investor can create a floor under the position.

It's important not to confuse defined risk or "safe" strategies with profitability. When discussing buying a call or a put, we're talking about a trade that shouldn't get out of hand or ruin your portfolio, since you know your risk. For instance, if you buy a call for $100 on a stock trading at $100 and the stock falls to $20, the most you can lose is $100. Owning that stock could have hurt a lot.

On the flip side, suppose you bought a put for $200 on Gamestop (GME) when the stock was $25 and shares spiked to $400 -- your loss is limited to $200. If you were short shares at $25, however, a stock running to $400 could wipe out your entire portfolio.

Once you have a basic understanding of these concepts, then you can move into a concept like a covered call where you sell a call against an existing long position. In exchange for getting paid for selling the call, you agree to sell your stock at a set price. Remember, the premium is yours to keep no matter what happens with the stock. Your downside risk remains similar, only reduced by the premium received, while your upside is called at the strike price of the call option sold until the expiration date.

Never sell a call option unless you have the minimum number of shares to cover the sale of shares in case the short call is exercised. In most cases you'll need to own 100 shares per call sold.

3. Start Studying

By starting simple and starting small, it will help you begin studying through a natural course of observation and doing. Now, you can read all the books you want, but there is no education that matches watching a call or put in action. Seeing how the values change in relation to a stock's changing price and volatility along with the passage of time gives you a first-hand look at things such as delta and implied volatility and time decay without you even realizing it.

In no way does it hurt to read books, watch videos or read articles on options, but there is nothing that can more accurately show how they function than a live market and a real trade.

Start small. Smart simple. And start studying the safer, defined risk methods to basic risk management and option trading. Work on a basic understanding following these basic steps, and before you know it you can be trading options from a position of comfort and a growing knowledge base.

Tim Collins is a regular contributor to Real Money, TheStreet’s premium site, and provides options trade ideas each day on Real Money Pro, our sister site for active traders. Click here to learn more and get great columns, commentary and trade ideas from Jim Cramer, Helene Meisler, Mark Sebastian, Paul Price, Doug Kass and others.