Trading options. Sounds risky. And it can be.
However, just because you generally hold options contracts for relatively short periods doesn’t mean you’re a day-trader. Options can work for all types of investors, but it’s best to understand the basics before you start using them in your portfolio.
The basics of options
An option is a contract that gives the owner the right, but not the obligation, to buy or sell a financial asset at a fixed price for a set period of time. In this guide, we discuss options where the underlying asset is a stock, though it can be something else, such as an exchange-traded fund, currency or commodity.
Different types of options
The two main types of options are call and put options.
- A call option gives the buyer the right, but not the obligation, to buy the underlying stock at a fixed price until a certain date.
- A put option gives the buyer the right, but not the obligation, to sell the underlying stock at a fixed price until a certain date.
While you can use call and put options in a variety of ways, buying call options generally reflects bullishness in a stock (you expect the stock price to rise), whereas buying put options typically indicates bearishness (you expect the stock price to fall).
When you buy a call or put, you’re considered “long” the options contract; however, when you own an option, you don’t own the underlying stock.
Key terms and concepts in options trading
To understand how basic options trading works, you need to know a few key terms:
- Underlying stock: The stock that your call or put option gives you the right to buy or sell
- Strike price: The price at which you can buy or sell the underlying stock
- Premium: The price of an options contract
- Expiration: The date the option expires
How to trade options
- Open a brokerage account: Before you can start trading options, you’ll need a brokerage account and options approval. Most brokerage accounts offer options among their tradable securities, but you may need to fill out some forms before you’re approved to trade options.
- Determine your goals: Decide whether you want to trade the option’s premium or hold the option through expiration to exercise it.
- Identify a specific option to trade: Your goals will help determine the specific option to buy or sell. If you expect a stock’s price will rise, you may decide to buy a call option. If you expect a stock’s price will fall, you might want to buy a put option. There are also options-selling strategies, including selling covered calls, that allow traders to capitalize on movement in an underlying stock.
- Place your options trade: When you’ve decided which option to trade, you can begin to place the order to buy or sell. Select the quantity of options contracts, choose your order type, which will be either “buy to open” or “sell to open” depending on the options strategy you want to use, and determine whether you want to send it to your broker as a market or limit order.
- Monitor your position: As time goes by and the price of the underlying stock changes, the value of your options contract will also change. Keep an eye on your position and be prepared to close it when the time comes.
- Close the trade: At this point, you can either close the options contract before expiration or exercise the option at its strike price. If you’re ready to conclude the trade, you will either send a “sell to close” or “buy to close” order to your broker. You can also roll the position, meaning you close one options contract and open a new one, or allow the option contract to expire. At expiration, out-of-the-money options expire worthless, while in-the-money options will be exercised at the strike price.
For more detailed information on trading options, check out our full guide.
How options trading works
Let’s look at two examples to illustrate how options trading works for calls and puts on a hypothetical company’s stock, XYZ Corp., that’s trading at $45 per share.
You calculate the cost of an options contract by multiplying the premium by 100 because an option contract represents 100 shares of the underlying stock. An options contract with a premium of $1.00 costs $100. When you purchase an options contract, you pay this non-refundable premium to the seller of the options contract.
A call option example
For our first example, consider a hypothetical call options contract: XYZ December 15th, 45 Call $1.00.
XYZ represents the ticker symbol of the underlying stock. December 15th is the expiration date. $45 is the strike price. $1.00 is the cost of the premium, meaning it will cost you $100 to purchase one options contract.
Purchasing 100 shares of a $45 stock would cost $4,500. However, one call options contract that gives you the right to buy 100 shares of this stock for $45 by the expiration date costs $100.
In this example, our options contract is “at the money,” meaning the strike price and underlying stock price are close or identical. An in-the-money call option is one with a strike price below the underlying stock price. An out-of-the-money call option is one with a strike price higher than the underlying stock price.
Relatively complicated factors determine the value of options premiums. We cover some of them elsewhere. To best illustrate how options work, we’ll keep this explanation straightforward.
You will tend to pay a higher premium for an in-the-money call option and a lower premium for an out-of-the-money call option.
Why is that? Imagine that, a week into owning this call option, the underlying stock increases to $46. All else equal, this should increase the value of your options premium.
Let’s say the premium increased to $1.50. You could sell this now in-the-money options premium for $1.50, closing your position. You would profit to the tune of the difference between what you paid for the contract ($100) and its new value ($150), less trading costs. You never directly messed with the underlying stock. You merely traded the options contract and benefited — profited — from an upside move in the underlying stock.
Instead of selling the options contract to close the trade, you could exercise it and buy the underlying stock for $45 per share (you’ll need the $4,500 to make the purchase) even though the stock now trades for $46. The party on the other side of the trade — who you bought the option from — agreed to sell you 100 shares of stock for $45, regardless of its market price, when they sold you the call contract. You never know who this person is, and it really doesn’t matter. Your profit at exercise is the difference between the strike price and market price of the underlying stock, minus the premium paid for the call option, less trading costs.
If the stock drops below the strike price prior to expiration, there’s a good chance the premium will also decrease in value. You can sell the contract for the remaining premium — and possibly take a loss — to exit your position. If you hold onto the contract in this scenario, the now out-of-the-money option expires worthless at expiration, meaning you lose all the premium you paid for the call.
In summary, these are the three most likely outcomes of being long a call:
- You trade the option based on premium price movement
- The option goes in the money, you exercise the option and buy the underlying stock
- The option goes out of the money, expires worthless and you lose the premium
A put option example
For our second example, consider a hypothetical put options contract: XYZ December 15th, 45 Put $2.00.
XYZ represents the ticker symbol of the underlying stock. December 15th is the expiration date. $45 is the strike price. $2.00 is the cost of the premium, meaning it will cost you $200 to purchase one options contract.
Recall that buying a put option reflects bearish sentiment. You could sell the stock short, which, in this case, would require sufficient account equity. Short selling is an advanced and potentially risky strategy. While not without risk, buying a put option is usually a less expensive way to place your bet that a stock will decline.
A week into owning this put option, the underlying stock decreases to $43. All else equal, this should increase the premium of your now in-the-money put option. Put options are in the money when the strike price is above the underlying stock price and out of the money when the strike price is below the underlying stock price. Put options are at the money when the strike price and underlying stock price are close or equal.
Like with the call, you can sell the put, profiting on the difference between what you paid for the contract and its presumably increased value. Or you could exercise the option.
If you do this, you will sell 100 shares of the underlying stock for $45 per share. You’ll sell it to the mystery party on the other side of the trade, who sold the put and agreed to buy the stock from you for $45, regardless of its market price. Obviously, selling a stock for $45 when it trades for $43 on the open market means you’re on the winning side of the trade and makes you money. You’re selling the shares for $4,500 even though they have a market value of $4,300.
One key point to remember: If you exercise a put option, you must deliver the shares, selling them to the other party at the strike price. If you already hold enough shares of the stock in your account, you’ll sell them for, in this case, $45 per share. If you don’t own the shares, your broker will borrow them for you, resulting in a temporary short position in your account until you add enough funds to purchase the shares. To be able to hold a short position, you need a margin account, short selling approval and sufficient equity to cover the position.
Say you were wrong and the stock rises to $50. You now own an out-of-the-money put. If the market price of the underlying stock remains higher than the strike price of your put at expiration, your put option expires worthless, meaning you lose the $200 premium you paid.
With some differences, the main outcomes of a long put position are the same as they are with a long call.
The risks and rewards of options trading
There are all kinds of risks and rewards associated with options trading. Our introductory guide covers the basics of being long calls and puts.
With these two basic strategies, the main reward is that you need less money to buy an option than to purchase or short-sell a stock. Tying the lingo together, you pay a premium for this reward. As indicated in our earlier example, you must consider the premium paid when calculating profits on an exercised option.
The main risk associated with long calls and puts is the option may expire worthless, resulting in a loss of the premium you paid.
You assume considerably more risk when you short-sell calls and puts. We cover this in our guide that looks at more advanced options strategies.
Benefits and risks of using options as a hedge
When you hedge with options, you’re attempting to mitigate risk in an existing individual investment or your entire portfolio. But just because the objective is safety doesn’t mean hedging strategies come without risk.
Benefits
- Decreased short-term risk: When everything goes well with an options hedge, you might break even or make some money. For example, if you think the broad stock market will go down temporarily, you can buy puts on an index ETF to reflect that downside sentiment. If the market does drop, your put should turn into a profitable trade, offsetting the losses you’re probably experiencing in your bullish core portfolio.
- A less expensive option: Many options strategies give investors leverage, meaning it’s generally less expensive to hedge using options than to make moves directly with stocks. Specifically, buying a put requires a fraction of the capital required to short a stock.
- Targeted strategies: Typically, you have three options with stocks: buy, sell or sell short. With options, you can tailor strategies to better align with how long you think specific market conditions will exist and respond to other factors, such as general and event-driven volatility.
Risks
- You can lose money: You buy a put as a hedge. The market goes up. Your put expires worthless. You lose the premium you paid. Think of options like insurance. You’re paying a premium for some sort of protection you might not wind up needing. Some options strategies, such as selling uncovered calls, can lead to significantly larger losses.
- Paying too much to hedge: Charles Schwab explains that “if you strongly believe the stock market will fall 5% to 8% over the next three months, an effective hedging strategy that costs less than 5% of your total portfolio’s value may be worth consideration.” However, if your proposed hedge exceeds the subsequent downside you experience, you effectively paid too much for your insurance.
What are options Greeks?
The options “Greeks” are an often complicated set of terms that define and help quantify how option prices react to various influencing factors.
The most commonly used Greeks include:
- Delta: An option’s Delta quantifies how much an option premium changes for every $1 change in the underlying stock. A Delta of 0.75, for example, indicates an anticipated $0.75 move in an option premium for every $1 move in the underlying stock.
- Gamma: This Greek shows how much the Delta might change for every $1 move in the underlying stock.
- Theta: Theta measures time decay, or how much you can expect — holding all other factors constant — an option premium to decline as time passes. A Theta of 0.10 suggests an option premium will lose $0.10 per day, all else equal.
- Vega: This Greek measures how sensitive an option premium is in response to changes in the option’s implied volatility.
- Rho: Rho considers an option premium’s sensitivity to changes in interest rates. Longer-dated options tend to be more sensitive to interest rates than shorter-dated options.
One reason why the Greeks are sometimes complicated is because all else typically isn’t equal. As one variable changes, it can impact other variables, causing the Greeks not to work as tidy in the real world as they do in theory and on paper.
Most traded stock options
Bret Kenwell, US investment and options analyst at eToro, said that, as of April 2024, the most traded stock options are those on big technology stocks, specifically Tesla (TSLA) and Nvidia (NVDA). Additionally, Kenwell noted that S&P 500 and Nasdaq 100 index options tend to see the highest volume on most days. He said this is because they’re among the “most popular with both retail and institutional investors,” with “the latter group deploying a number of complex strategies, particularly with the indices, adding to the volume totals.”
Relationship between options prices, volatility and news
As a beginner — and most definitely if you intend to get into advanced options trades — you need to know how options prices act and react alongside relatively complicated, often event-driven factors, particularly implied volatility.
As Kenwell explained: “When an event is in play, the options market accounts for that through higher volatility. In the options world, this is measured through ‘implied volatility,’ which is a component of options pricing. When implied volatility becomes elevated — either ahead of a known event or after an unexpected development — options prices tend to be elevated, too.”
While not without risk, this can be a good thing for options sellers looking to collect a hefty premium. However, it’s a double-edged sword on the other side of the trade. Kenwell said, “The good thing about buying options ahead of known events is that an investor’s risk is limited to the premium paid for the option. The flip side is those options prices will likely be inflated versus other options in the same stock with a different expiration date.”
Along these lines, ho-hum earnings results sometimes trigger what traders call “IV collapse,” leading options prices to drop due to a decline in implied volatility, regardless of the move in the underlying stock.
Frequently asked questions (FAQs)
Investors buy and sell options for myriad reasons. The most popular reasons include:
- Income generation: Often, when an investor sells an option, such as a covered call, they’re hoping the contract they sold expires worthless. If so, they not only keep the premium they collected but don’t have to worry about buying or selling shares of the underlying security if an option goes in the money and gets exercised.
- Speculation: Like in our hypothetical example, some investors trade options premiums, which tend to go up and down in association with movement in the underlying security. It generally costs less money to speculate on stocks using options because options premiums trade for a fraction of the cost of 100 shares of stock.
- Downside protection: Numerous options strategies, from basic put buying to complicated multi-leg trades that include buying and selling options contracts, give investors the chance to make money if a stock they own or their entire portfolio drops in value. Known as a hedge, using options to offset on-paper (or realized) losses is a major reason why people buy and sell options.
It depends on the bank or brokerage. However, to trade options, you’ll likely need a margin account. Financial Industry Regulatory Authority (FINRA) regulations require at least $2,000 in account equity to make margin trades.
Yes. With advanced strategies that typically involve selling calls and puts, you can lose more money than you invest. In our call and put buying strategies, however, you only risk losing the premium you paid for the options contract, plus trading costs.
The strategies discussed in this guide are not considered high-risk investments because you know exactly how much you stand to lose when you make these trades. However, intermediate to advanced options strategies can carry meaningfully more risk.
