If you’ve ever accepted a new job or signed up for a new cell phone service, you’ve likely signed a contract. But a contract to buy and sell stocks? That’s something a lot of people, even avid investors, haven’t experienced.
With options trading, you have a contract to do just that. But while there are lots of ways to invest in options, many popular strategies are risky, with the potential to reap big gains or lose your entire investment (and, sometimes, more).
Options received a lot of attention earlier this year when an army of everyday investors teamed up on Reddit to send GameStop’s stock soaring. Members of the subreddit r/WallStreetBets weren’t buying stocks of the actual companies; they were buying options.
Options traders speculate about volatility and, if they’re right, may make a lot of money. But the margin for error can be razor thin. Here’s everything to know about trading options.
What is options trading?
Options traders can buy contracts that give them the option to buy or sell an underlying asset for a certain price — called a strike prices — at a certain time.
Say you buy an options contract giving you the right to buy a stock for $10 for the next 30 days. Even if the actual price of the stock has jumped to $30 on that 29th day, you can still buy that stock for $10.
Options traders are speculating that an underlying asset’s price will move one way or another. Stock option contracts tend to represent 100 shares of the underlying stock. But stocks aren’t the only option; investors can also buy and sell options on other assets, like bonds, commodities and exchange-traded funds (ETFs).
There are two main types of options: calls and puts.
What are call options?
Buying a call option gives you the right, but not the obligation, to buy an underlying asset for the strike price price during a certain period of time. You’re calling it away from another investor at a fixed price.
If the share prices skyrocket, you can see a much greater return by owning an option than you would owning just the shares. And if you buy this type of option, you can only lose the money you spent on it. But when selling one (shorting the call), your potential loss is unlimited unless you also own the underlying stock.
What are put options?
A put option gives you the right, but not obligation, to sell an underlying asset for the strike price during a certain period of time. You’re putting the asset away from you at a fixed price.
Some investors use this strategy to hedge against risk while others use it as a way to bet against the price of a particular stock.
If you buy this type of option, you can only lose the money you spend on the option. But again, if you sell the option, you’re putting yourself at risk for a much bigger loss.
How does options trading work?
Options contracts are valued based on how likely an event is to happen. If a stock price goes up, so does the value of an options contract that allows an investor to buy that stock at an initial set price. The value is also determined by timing: the more time there is for a price to move, the more valuable the options contract that allows an investor to benefit from that stock move. (A four-month contract would be more valuable than a one-month contract, for example).
Volatility also makes an options contract more valuable. Big swings in the price of an underlying security means there is more of a chance the price will swing high enough or low enough for an options trader to make money from trading according to their contract. Professional investors use complicated mathematic formulas to capture all these dynamics and assign a single value to options. It's so complicated that the economists who designed one popular options pricing model won the Nobel Prize for their work.
Here’s an example of how options trading works from James Angel, a finance professor at Georgetown University: say you are looking at options for a stock that is $100. Now say you get a six-month call option with a strike price of $100. The call could cost approximately $10. With $100, you could buy a call on 10 shares. If the stock went up to $110, the value of the call could jump from $10 to $16. Your total profit would be around $60 (a 60% return on that initial $100).
However, if you bought an option with an expiration date in a week, the option might only cost $2. You could buy an option on 50 shares with your $100 and — if the stock went to $110, the option could go up to $10 and your position would go to $500 for a 400% return.
Meanwhile, if you just bought the stock and not the option, you would only make a 10% return. But if you had bought the option and it never went "in the money" (you couldn't exercise it), you would lose your $100. A stock owner, however, would still have the stock, which could be selling for a lot less than $100.
How do you trade options?
Nowadays, investors can trade options via typical brokerages like Vanguard and Fidelity, as well as commission-free platforms like Robinhood and Stash. However, investors need to be approved to trade options by the brokerage, and have enough capital to do so.
Applications to trade options tend to ask about your financial situation and investing experience. Investors can apply to various levels of options trading, and each level involves more rigorous disclosure of financials and trading knowledge as the strategies get more complex. For example, at Fidelity, a level-one investor can sell covered calls, but it’s not until level two that they can buy call and put options. (A "covered" call means the seller owns the asset against which the call is sold. For stock investors, it can be a way to use your portfolio to generate extra cash in flat markets. But if stock prices rise, you risk having to hand your portfolio to the buyer of the calls.)
Some brokers will automatically exercise an option at an expiration date if it’s in-the-money. A call option is in-the-money if the trader can buy a security below its current market value, while a put is in-the-money if the trader can sell the security above its current market value.
When buying or selling options, you need to choose which type of option to trade, the strike price and the time frame. There are various options trading strategies. You should buy a call option or sell a put option if you predict the stock price will go up. You should buy a put or sell a call option if you think the stock price will go down. For a stock whose price you think will remain stable, sell a call or put option. Remember: the longer the time frame of an options contract, the less risk for the buyer.
What do investors think are the benefits of trading options?
When you buy an option, you pay for the premium — the option's current market price — plus the trading commission, and that total cost can be a lot less than the cost of buying an underlying asset, like a stock. This means buying or selling options on an underlying asset instead of just buying or selling the underlying asset itself could give you bigger gains — if you’re right about how the price of the asset will move.
Buying options can also help hedge risk, since you don’t have to follow through on the trade outlined in the contract. If you’re wrong about the direction a price moves, you only lose what you paid for the options contract.
Is options trading risky?
Anytime you are speculating about what the market will do, there’s risk. And while sophisticated investors will use options as a way to hedge against risk, everyday investors who aren’t as in tune to the everyday ups and downs of the market aren’t advised to do so.
To make money off of trading options, you really need to be right about whether a stock’s price will move up or down.
“Options can allow you to make really precise bets,” Angel says. “But unless you have reason to think you know more than everybody else, on average you’re going to lose.”
There’s also a set time frame in which you have to be right, which adds risk. If you think a stock’s price will go up and have a six-month contract but the price goes up in eight months, you’re out of luck. At the expiration date, the contract is worthless and you’ve lost all the money you spent on it.
Selling options is a lot riskier than buying options because sellers don’t have the choice to act — they’re obligated to buy or sell the security at a certain price within a certain time frame, even if it means they’ll lose money. Since there’s no ceiling for a stock’s price, the potential losses are unlimited.
Should I trade options?
For many investors, options trading doesn’t make sense and should not be included in a portfolio at all.
But for those who want to try trading options, carve out just a small portion of “play money” that you would be okay losing all of, says Beth Agnello, a financial planner with Fair Winds Financial Advice. (Don’t use your emergency or retirement savings.)
Experts recommend using no more than 5% of your wealth when making riskier investments, like trading options or Bitcoin, or picking stocks.