Since the release of ChatGPT, AI technology has been applied and used in all imaginable ways, including for trading and investing. I asked ChatGPT to generate the 15 most popular questions that beginner and advanced options traders ask. These questions cover the important concepts that all traders need to know.
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These are the top 15 questions from ChatGPT with my response to each topic.
1. What are options and how do they work?
An options contract is a derivative trading instrument that derives its value from the underlying asset. Options allow you to make a 'side agreement' in a secondary market.
There are four components to every options contract:
- The underlying asset
- The strike price
- The expiration date
- The cost (also known as the premium)
Options give you the right to buy and sell stocks at a specific strike price on or before the expiration date. The process of buying and selling is an exchange of risk, and the strike price is the point at which you can 'strike' a deal.
2. How much money do I need to get started in options trading?
This may be less than you think, but it is often nota good idea to start trading with too little. Sure, it is possible to make your first trade with %50 dollars of risk, but our suggestion is to have a minimum of $5,000 when starting out.
If you have a small account, check out this Monthly Iron Condor bot template that was built specifically for small portfolios around $3k.
3. How do I select the best options trading strategy?
This depends completely on your own needs and tendencies, and you need to find what works for you and your risk profile specifically. In general, credit spread strategies are some of the best to consider. Getting started with some trades is the best way to clarify this answer.
4. What are the key components of an options contract?
- Underlying security
- Strike price
- Expiration date
5. What is the difference between a call option and a put option?
There are only two types of options, calls and puts.
A call option gives you the right, but not the obligation, to buy an asset at the strike price on or before expiration. A put option gives you the right, but not the obligation, to buy an asset at the strike price on or before expiration.
6. What is the difference between buying and selling an option?
There always needs to be two parties involved in any trade, and these trades are always a one-to-one exchange of risk. The buyer acquires risk while the seller acquires an obligation.
It's important to note that most trades never get to the expiration date and are merely the trading of contracts back and forth before that time. For example, you can sell your long call option prior to expiration if the underlying stock goes up and you want to exit the trade and realize a profit.
7. How do I determine the strike price for an options contract?
Strike prices are determined by how much risk you accept and how much money you are willing to pay or receive. This comes back to the idea of the transfer of risk.
Intrinsic value is an option’s value if it were exercised immediately. You can determine an option’s intrinsic value by comparing its strike price with the underlying security's current market price.Options contracts become less valuable as they get out-of-the-money, or further from where the security is trading.
8. What is implied volatility and how does it impact options trading?
The expected movement, or implied volatility, is a huge component of the strike price. Implied volatility is forward-looking and represents future volatility expectations.
Assessing how volatile an option is determines its price. Ticker symbols with higher volatility have higher option premiums because there is a larger range of potential outcomes.
9. What are the risks involved in options trading?
There are numerous risks involved with options trading, and you should not trade options until you understand how they work.
The key risks I notice most often are:
- Not understanding what an options contract is
- The leveraged nature of options contracts as a derivative product
- Overexposure to a single ticker or sector, due to a lack of diversification
- Emotional risk and human error, which can be mitigated through automation
10. What are the different options trading strategies I can use?
Options strategies range from simple single-leg calls and puts, to more complex multi-leg combinations of calls, puts, or both. Option strategies can be risk-defined with limited or unlimited profit potential, or more risky with no defined max loss. Your options approval level will determine what your broker will allow you to trade; but just as question 8 states, you should only trade strategies that you understand completely and feel confident with.
Learn about 36 popular options strategies like iron condors, iron butterflies, credit spreads, and more with our Options Strategy Guides.
11. How do I calculate profit and loss for an options trade?
Option payoff diagrams show you how much money a position will gain or lose based on different prices for the underlying security.
The key component is understanding strike prices and premiums. For example, if you collect a $2.00 credit opening a $5 wide iron condor, you will make $200 per contract if the stock expires between the short strikes, and you'll lose $300 if the stock price closes beyond the long options.
Watch this video to see how to calculate an iron condor's profit, loss, and break-even prices.
12. How do I manage risk in my options trading portfolio?
Here are the 4 key concepts for portfolio risk management:
- Trade smaller position sizes
- Choosing net option selling strategies over buying options
- Diversify into uncorrelated asset classes
- Use a tool to stay consistent
Don't miss this workshop on Crafting Bot Portfolios for Safer Trading.
13. Should I use technical analysis to inform my options trading decisions?
You can certainly use technical analysis, as it can be helpful, but it's not necessary. More important is to understand how to use technical analysis and technical indicators. Rather than thinking about it as a basis for decisions, use it to help tilt, skew, or confirm your ideas.
Have you seen the RSI Signals Research? We tested 700+ combinations of trend, signal, and lookback period to deliver to you a comprehensive RSI signal database. Grab your free copy here!
14. Can you use charts and graphs to trades options?
Charts and graphs can be useful and informative, but are also not necessary. It can be difficult to make this method work, as it is very subjective.
At Option Alpha, we believe options traders should focus on objective data and leveraging math and probabilities to eliminate emotions and reduce mistakes when making decisions. That's why we calculate Alpha and Expected Value for every potential trading opportunity.
15. What are some common mistakes to avoid when trading options?
This last question summarizes a lot of the topics above, including position sizing, risk management, and diversification. Here is a list of the most common mistakes I see amongst all options traders:
- Position sizing that is too large
- Trading this is too concentrated
- Not having enough cash on hand to weather storms and volatility
- Not sticking to a plan and executing on it
- Short term mindsets
The great news is you can work on these issues to improve your options trading. Whether you're new to options or an experienced trader, there is always room to learn!