What is options trading?

What are options?

Options are financial contracts that give holders the right, but not the obligation, to buy or sell an asset at a specified price by a specific date. The underlying asset is usually a stock, but options can also be used for indexes, commodities, funds, and other securities.

Options are a type of derivative – financial contracts that derive their value from the performance of an underlying asset. This means that investors can benefit from price movements without having to buy or sell the asset itself. This flexibility comes at a premium and carries certain risks.

Each option has a fixed expiration date. If it’s not exercised on or by the expiration date, it expires worthless. Options can be traded over-the-counter (OTC) or on public exchanges, and their prices move with the value of the underlying asset.

Key terms to know when trading options

Here are the essential terms to know when trading options:

• Underlying asset: The asset that the option is based on.
• Strike price: The price at which the option can be exercised
• Expiration date: The last day the option can be exercised before it expires worthless.
• Premium: The cost to buy the option. This is quoted per share but options are sold in contracts of 100 shares (e.g. a premium of $1.75 means the total cost of an options contract is $175).

Types of options

There are two main types of options: calls and puts.

Call options

Call options give holders the right, but not the obligation, to buy the underlying security at the strike price before the expiration date. These types of options become more valuable when the asset’s price increases, so traders buy them when they expect an asset to go up.

Here’s an example of a call option:

Imagine a trader buying a call option for Stock XYZ with a strike price of $50 and an expiration in one month. If Stock XYZ rises to $60 before the expiration date, the option increases in value because it gives the right to buy the stock at $50, even though it now trades at $60.

If the stock doesn’t rise above $50, the option can expire worthless and the trader’s loss is limited to the premium paid.

Put options

Put options give holders the right, but not the obligation, to sell the underlying asset at the strike price before the expiration date. Put options gain value when the asset’s price falls, so traders buy them when they expect an asset to go down.

Here’s an example of a put option:

Let’s say a trader buys a put option for Stock XYZ with a strike price of $40. If the stock drops to $30, the option becomes more valuable because it allows the trader to sell Stock XYZ for $40, even though it’s only worth $30 on the market.

If the stock stays above $40, the option can expire worthless with the trader’s loss limited to the premium paid.

How options work

Just like stocks, options can be traded through brokerage accounts on public exchanges. Each option contract gives the right to buy or sell 100 shares of the underlying stock. You can either buy options to speculate on price movements, or sell (‘write’) options to earn income or hedge risk. Selling options involves more risk and requires advanced strategies.

When a trader buys an option, they’re matched with someone selling that same contract. For both call or put options, potential profit or loss depends on how the underlying asset moves relative to the strike price and expiration date.

Real-world example of buying a call option

Imagine a trader believes Stock XYZ, currently trading at $35 per share, is going to rise over the next few months. They buy a call option with a strike price of $35 and three months until expiration at a cost of $2 per share. Since one contract represents 100 shares, the total cost to the trader is $200.

Let’s look at the different outcomes at expiration:

• If Stock XYZ closes at $42, the option is worth $7 per share ($42 - $35), or $700 total. Subtract the $200 cost of the option and total profits are $500.
• If Stock XYZ closes at $38, the option is worth $3 per share, or $300 total. Subtract the $200 cost and the net profit is $100.
• If Stock XYZ stays at $35 or drops below, the option expires worthless and the trader loses the $200 premium paid.

In this example, the stock’s price rose about 20% but the call option returned 250%. This leverage is one of the main appeals of options trading.

How options are priced

An option’s price, or premium, is made up of two parts: intrinsic value and time value:

• Intrinsic value: The amount the option is ‘in the money’. For example, a call option with a $50 strike price and a stock trading at $55 has $5 intrinsic value. If the option isn’t in the money, its intrinsic value is zero.
• Time value: This reflects everything else, including time to expiration, volatility of the underlying asset, and general market conditions. For example, if the same $50 call option is priced at $8 while the stock is at $55, $3 of that premium is time value ($8 total premium - $5 intrinsic value).

Time value declines as the expiration date approaches. This is known as time decay. Even if an option isn’t in the money, it can still have time value – especially if there’s enough time for the underlying asset to move in the right direction.

What affects options pricing?

The main factors that influence how much an option is worth are:

• Underlying asset price: The premium of a call tends to rise as the asset rises, and vice versa for puts
• Strike price: The gap between the strike price and the asset price directly affects intrinsic value
• Time to expiration: The more time to expiration, the more opportunity for the asset to move favorably – and the higher the premium
• Volatility: Higher volatility means more price swings and more potential for profit, resulting in higher premiums.

Even though all these factors play a role, time and volatility are generally the most important when it comes to options pricing.

The Black-Scholes model

The Black-Scholes model is one of the most widely-used models for pricing options. It calculates a theoretical value based on several inputs:

• Current asset price
• Strike price
• Time to expiration
• Volatility
• Interest rate.

Most broker platforms automatically calculate this value behind the scenes and display it as the option’s ‘implied volatility’. This reflects how much the market expects an asset’s price to move.

Benefits of trading options

Leverage and potential for higher returns

Options give exposure to an asset’s price movements for less than buying the asset itself, and small moves in the underlying asset can translate to much larger percentage gains for the option. This leverage can amplify returns if the trade moves in the right direction. However the seller of an option may have unlimited risk and buyers can lose the full premium for the option.

Flexibility in investment strategies

Options can be used to speculate on price moves, generate income, or reduce risk. Different strategies allow traders to customize their exposure depending on their market views and risk tolerance.

Hedging against other investments

Options can be used to hedge against other investments, providing a sort of insurance. For example, buying a put option on a stock you already own could protect against downside risk if the stock drops in value.

Liquidity and accessibility

Most popular stocks have actively-traded options, so it’s relatively easy to enter or exit trades. Many brokers also offer low or no commissions on options trades.

Risks of trading options

Potential for significant losses

If the underlying asset doesn’t move as expected before expiration, the option can expire worthless and you’d lose the entire premium paid. Additionally, certain strategies – especially those that involve selling options – can expose you to losses larger than the initial investment. The seller of an option may have unlimited risk if they do not own the underlying asset, and if they own the underlying assets may be obligated to sell well below current market value.

Complexity

Options involve more variables than stocks. Things like strike price, volatility, and time decay all add extra complexity and a steeper learning curve.

Market volatility

Options prices can swing sharply from day to day, especially with volatile stocks. Some traders specifically seek out this movement, but it can also lead to losses if not managed carefully.

Options by underlying asset

Options can be based on a wide range of underlying assets, including:

• Stocks: Based on individual stocks or ETFs.
• Indices: Based on the value of a stock market index, like the S&P 500 or Volatility Index (VIX).

Although less common for retail trades, options can also be based on commodities, currencies, or interest rates.

Options by expiration

Common types of options expirations include:

• Daily (0DTE): Expire on the same day they’re traded
• Weekly: Short-term contracts that expire on Fridays
• Monthly: Traditional options contracts that expire on the third Friday of each month
• LEAPS® (Long-Term Equity Anticipation Securities®): Long-dated options that can last up to 2 years and 8 months.

If an option is in the money at expiration, it will be automatically exercised by most brokers unless the trader chooses otherwise.

Other options

More complex options contracts are known as ‘exotic options’. These include:

• Binary options: These pay either a fixed amount or nothing at all. The outcome depends on whether the underlying asset hits a certain price at a specific time. Binary options carry significant risk and are heavily regulated in many countries as they have potential for fraud.
• Barrier options: These include options that activate or expire automatically when prices reach a certain level. They’re less common amongst retail investors as they involve complex rules.

Risks to purchasers

Some specific risks of buying options include:

• Expiration risk: If an asset doesn’t move in the expected direction before expiration, the option can expire worthless. This means you could lose the entire premium paid.
• Exercising requires funds: If you exercise a call option, you must be ready to purchase 100 shares of the underlying stock per contract. If you don’t have the funds, you need to sell the option before expiration.

Strategies used to mitigate these risks include:

• Avoid holding options through expiration, unless you intend to exercise
• Use limit orders to control entry and exit prices
• Never invest more than you’re comfortable losing.

Risks to sellers

Risks associated with selling options include:

• Assignment risk: When you sell an option, there’s always a chance the buyer will exercise the contract (known as assignment) and you’ll need to fulfil the terms. If you’re selling calls, you’ll need to deliver the asset, and if you’re selling puts, you’ll need to purchase the asset.
• Dividend risk: Risk of assignment increases the day before a stock’s ex-dividend as calls buyers exercise early to receive the dividend.
• Margin risk: Some short options require margin, which means the broker may require more funds to keep the position open. If you can’t meet the margin call, the broker may close out your positions – potentially at a loss.

To mitigate these risks:

• Monitor ex-dividend dates and corporate news for stocks in your portfolio
• Maintain a cash or margin buffer
• Understand the full risk exposure before entering a trade

How to trade options in 5 steps

Here is a step-by-step guide on trading options, including how to open an options trading account, choose a strike price, and pick an expiration date.

1. Open an options trading account

Start by choosing a broker that offers options trading. Look for one with low fees, an easy-to-use platform, and good research tools. Popular beginner-friendly brokers include Robinhood, Webull, Fidelity, and Charles Schwab.

Opening an options trading account can require approval. Brokers might ask you for:

• Investment objectives: E.g. growth, speculation, or income
• Trading experience: How long you’ve been trading or how many trades you make each year
• Financial details: Your liquid or total net worth, annual income, or employment information
• Options you want to trade: E.g. calls, puts, spreads, covered or naked.

Based on your answers, you’ll be assigned a trading level that determines what kinds of options strategies you’re allowed to use. Once your account is approved, you can deposit funds.

2. Pick your options strategy

Next, decide how you want to trade based on your view of the stock. If you expect the stock to:

• Rise, buy a call or sell a put
• Fall, buy a put or sell a call
• Stay the same, sell a call or put.

Many broker platforms have built-in research tools, screeners, or simulators to help you plan your strategy. If you’re a beginner, start by learning basic strategies like buying calls or puts.

3. Predict the option strike price

Options only become profitable if the stock moves beyond the strike price (plus or minus the premium). You’ll need to choose a strike price close to where you expect the stock to trade by expiration. Available strike prices are listed in option quotes, or option chains, and spaced in standardized increments (e.g. $1, $2.50, $5, $10).

4. Determine the option time frame

Options expire on a specific date. The longer the time to expiration, the more expensive the option – but also the more time for the stock to move in your favor.

Short-term daily or weekly options carry higher risk and are best for advanced options traders. Monthly or yearly expiration dates give stocks more time to move in a favorable direction and are more suitable for long-term investors.

There are also two styles of options:

• American-style options can be exercised anytime before expiration
• European-style options can only be exercised on the expiration date

Since American-style options carry more flexibility, they tend to cost more than European-style options.

5. Place your trade

Finally, you can enter the trade. It’s best to use a limit order instead of a market order as it gives you more control over the price you pay.

After placing the trade, monitor the position regularly and stay aware of time decay and volatility shifts. You might also want to set up alerts or stop-loss orders.

Examples of trading options

To understand how options work in real life, let’s take a look at the two most common options strategies: buying a call and buying a put.

An example of buying a call

Imagine a company called ABC Co. with shares currently trading at $200. You believe the stock will rise to $240 in the next few months. Here’s how you might execute a call trade:

1. You buy a call option with a $210 strike price, expiring in one month
2. The option costs $6 per share or $600 total (remember, one contract = 100 shares)
3. This option gives you the right to buy 100 shares of ABC Co. at $210, regardless of its market price.

If the stock rises to $240:

• The option is now worth $30 per share ($240 - $210)
• Your total option value is $3,000
• After subtracting the $600 premium, your net profit is $2,400.

If the stock stays below $210, the option expires worthless and you lose the $600 premium.

An example of buying a put

This time, let’s imagine you believe ABC Co. will drop from $200 to $160 in the next month. Here’s how you might execute a put trade:

1. You buy a put option with a $190 strike price, expiring in one month
2. The option costs $8 per share or $800 total
3. This option gives you the right to sell 100 shares of ABC Co. at $190, even if the stock falls.

If the stock drops to $160:

• The option is worth $30 per share ($190 - $160)
• Total value = $3,000
• After the $800 premium, your net profit is $2,200.

If the stock stays above $190, the option expires worthless and you lose the $800 premium.

Why trade options?

Options have unique features that can be used to manage risk, generate income, or amplify returns through leverage. Their original purpose was to hedge risk and limit downside losses, acting as a kind of insurance for a portfolio.

Options also offer leverage, allowing traders to control large positions with a relatively small investment. For example, buying a call option often costs much less than buying 100 shares of the same stock outright – while still giving you a chance to benefit from increasing prices.

Traders also use options to generate income, even if the markets aren’t moving much. One of the most popular strategies for this is the covered call, where an investor who owns a stock sells a call option on it – more on that in the next section!

5 options trading strategies for beginners

Getting started with options trading can be intimidating. To help you out, we’ve outlined five options trading strategies for beginners:

1. Long call

A long call involves buying a call option in anticipation of a stock rising above the strike price before expiration. The potential profit on this trade is theoretically unlimited and the loss is limited to the premium paid for the option.

Long call example: A trader buys a call on Stock X, currently trading at $20. The strike price is also $20 and the option costs $1, or $100 for a contract. If the stock price rises above $21, the trader starts to profit. If the stock soars to $30, the option could be worth $1,000. But if the stock finishes below $20, the option expires worthless and the trader loses the $100 premium.

When to use it: When expecting a stock’s price to rise significantly before the option’s expiration.

2. Covered call

A covered call involves a trader owning 100 shares of stock and selling a call option against it. The goal is to earn income from the premium if the stock stays flat or rises slightly.

Covered call example: Stock X is trading at $20. A trader owns 100 shares and sells a call with a $20 strike price collecting $100 in premium. If the stock stays below $20, the option expires worthless and the trader keeps both the shares and the premium. If it rises above $20, the shares will be sold at the strike price, limiting upside but still capturing a profit.

When to use it: When holding stock you don’t expect to rise significantly.

3. Long put

A long put involves buying a put option to profit from a stock’s decline. Like a long call, the risk is limited to the premium paid while the potential reward is unlimited.

Long put example: Stock X costs $20, and a put with a $20 strike is purchased for $1. If the stock drops to $15, the put is worth $500. If it stays above $20, the put expires worthless and the trader loses $100.

When to use it: When you expect a significant drop in a stock’s price and want to limit downside risk.

4. Short put

A short put involves collecting a premium upfront and hoping the option expires worthless. This can be a way to generate income, especially if you’re willing to buy the stock at a lower price.

Short put example: Stock X is at $20 and the trader sells a put with a $20 strike price for $1, collecting $100 for the premium. If the stock stays above $20, the trader keeps the premium. If it drops below $20, the trader might have to buy the stock at the strike price.

When to use it: When you’re neutral or bullish on a stock and willing to buy it at a lower price.

5. Married put

A married put works like insurance – if a stock’s price drops, the put increases in value and cushions the losses.

Married put example: A trader buys 100 shares of Stock X at $20 and also buys a $20 strike put for $1. If the stock drops to $15, the stock loses $500 but the put gains $500, limiting the total loss to the $100 premium paid for the option.

When to use it: When you own a stock you expect to rise but want protection in case it drops.

What does exercising an option mean?

Exercising an option means using the right to buy or sell the underlying asset at the same strike price. Most traders don’t exercise their options but choose to sell them before expiration to capture profits.

Is trading options better than stocks?

There’s no clear answer for this – options trading offers more flexibility than stocks, but it also comes with increased complexity and risk. Stocks can be simpler and better for long-term investing, while options are more suitable for traders interested in hedging or speculation.

What is the difference between American options and European options?

The difference between American and European options is when the option can be exercised:

• American options: Can be exercised anytime before or on expiration
• European options: Can only be exercised on the expiration date.

How is risk measured with options?

Risk in options trading is primarily measured using the ‘Greeks’:

• Delta: Measures sensitivity to the stock price
• Gamma: Measures how delta changes over time
• Theta: Measures time decay
• Vega: Measures sensitivity to volatility
• Rho: Measures sensitivity to interest rates.