Money is not a client of any investment adviser featured on this page. The information provided on this page is for educational purposes only and is not intended as investment advice. Money does not offer advisory services.
As an investor, you’ve probably heard about options trading. But to many, the jargon associated with options is intimidating enough to dampen any interest in learning how they work. From options pricing (also known as options premiums) and expiration dates to understanding the role played by underlying assets and option holders, the process can entail a considerable amount of education.
Read on to learn about these financial derivatives, their pros and cons, the different types available, and whether or not trading them is a good fit for your investment goals.
What is options trading?
Options trading is a dynamic approach to financial markets that allows traders to potentially profit not only from the rise and fall of the underlying stock but from the broad stock market and its perpetual market volatility. Options are a type of derivative, or financial instruments that derive value from an underlying asset price.
In its simplest terms, options allow you to buy and sell contracts that grant the right — but not the obligation — to buy or sell an underlying asset at a predetermined price, known as the strike price, before a specific date, known as the expiration.
Options contracts are valued based on how likely an event is to happen. If the price of a stock rises, so does the value of the options contract that allows an investor to buy that stock at an initial set price. The worth of a contract is also determined by time value: The more time there is for price movement, the greater the chance of an options contract allowing an investor to benefit from that stock move. For example, a four-month contract would hold more time value than a one-month contract.
When a contract hits the strike price, an option can be exercised, meaning the underlying asset can be bought or sold. One of the most popular applications of trading options is to generate income, but it can also be used to hedge against risk or speculate on the future direction of an underlying stock. Importantly, derivative markets aren’t for beginners. Understanding the types of options, how they work, their pros and cons, and some common options trading strategies is critical to success.
Types of options and how they work
The two most common option contracts are call options and put options. The following section details both, including examples of how they work, so you can better understand if they’re a good fit for your investment goals.
A put option is a contract that gives the option holder the right, but not the obligation, to sell an underlying asset at a predetermined price during a certain period of time. Think of put options as “putting” the asset away from you at a fixed price. A put has an expiration date before which time they can be exercised.
Put options are typically used either to hedge against risk or to place bets against the price of an underlying asset, the latter of which makes a put a bearish bet. For example, if someone believes a stock price will fall and takes a contract for a put stock option, they would make money if shares of the stock decrease.
How put options work
Let’s say you believe shares of a particular stock are going to fall based on a poor earnings outlook. They are currently trading at $50 per share. You purchase a put option for 100 shares at a specified price of $50 per share with a premium of $1 per share, costing you $100. Then, prior to the option’s expiration, shares fall by half to $25.
If you exercise your put option, you could sell the 100 shares at the higher $50 per share price, and you would profit by $25 per share, less the $1 premium, meaning you would net $2,400. However, if the underlying stock’s price rises and the options contract expires, you would lose your $100 premium.
A call option is the opposite of a put option in that it gives the option holder the right, but not the obligation, to buy an underlying asset for the strike price during a certain period of time. Like put options, calls also have expiration dates.
As opposed to puts, which are bearish in nature, call options are bullish bets that the price of an underlying asset will increase. For example, if someone believes a stock price will rise and takes a contract for a call stock option, they would make money if shares of the stock increase.
How call options work
Now, rather than expecting shares of a particular stock to fall, let’s say you believe they will rise. In this case, you purchase a call option for 100 shares with a set price of $50 per share and a premium of $1 per share. Once again, this will cost you $100 in premiums. Then, prior to the option’s expiration date, shares gain $25, to a price per share of $75.
If you exercise your call option, any appreciation above the strike price represents your payout. So if you buy the 100 shares at the strike price of $50 per share, and the underlying stock is now trading for $75 per share, you would profit $25 per share for 100 shares, or $2,500, less the $1 per share premium paid to the option seller, meaning you would net $2,400. However, if the underlying stock’s price falls and the options contract expires, you would lose your $100 premium.
How to trade options
The process of trading options begins just the way it would if you were trading stock: opening an account. However, for options trading, there are certain requirements, such as margin accounts, and once the trade is executed, the contract’s expiration date dictates the forthcoming conditions. Conversely, when purchasing stocks, you are able to decide if and when to sell them without limitations.
The following section provides details about the process for trading options.
Open a trading account
Before opening a brokerage account or downloading an investing app, determine whether options trading is offered as one of the investment products. Brokerage accounts are ideal if you are seeking investment advice from a financial advisor, but they can involve commissions.
Additionally, most brokerages require you to have a margin account to trade options. A margin account is a type of brokerage account in which your broker lends you cash upfront, using your account as collateral, to purchase securities. Margin increases your purchasing power, but it also exposes you to great risk and potentially larger losses.
Decide on the options contract
There are innumerable options contracts available, each with varying strike prices and expiration dates. Before deciding which you’d like to trade, you must first understand your objectives. Are you comfortable with high-risk options? Does your strategy require a longer timeline? Is the stock market currently experiencing high volatility? Once you determine these answers, you can use them to help you formulate a strategy that’ll help you identify which particular options contract — or contracts — to target.
Choose a strike price
Once you have identified which options contract(s) you’d like to focus on, decide on the strike price — the fixed price at which you can buy or sell the underlying security. “In the money” options are those which can generate a positive return if exercised based on the strike price relative to the price of the underlying stock. Therefore, in-the-money options contracts are those which possess profit opportunities.
Calls are in the money when the stock’s price is above the strike price, and out of the money when the security’s price is below the strike price. Put options are in the money when the stock’s price is below the strike price, and out of the money when the security’s price is above the strike price.
When choosing a strike price, it’s critical to factor in the expiration date and the likelihood of the underlying asset reaching that price before expiry.
Execute the trade
At this juncture, you will pay the options contract premium and, if required, a commission to your brokerage. After the contracts are purchased, if you want to exercise the option, you can contact your broker informing them of your decision. However, some brokers will automatically exercise an option for you at an expiration date if it’s in the money.
Pros and cons of options trading
- Smaller commitment than buying stocks
- Significant upside potential
- Numerous strategies can be used
- Complex for new investors
- Margin requirements
- Elevated risk
No investment is without its advantages and disadvantages, and options trading is no different. It involves numerous potential benefits and potential drawbacks. The following section surveys some of those pros and cons.
Pros of options trading
Smaller commitment than buying stocks
Option premiums are typically low-cost and allow you to benefit from movement in underlying stock prices without having to spend a tremendous amount of money upfront for the shares. Therefore, your potential returns could be much higher than your initial entry costs.
Significant upside potential
The biggest advantage of trading options is that it provides you with significant upside potential. Losses can be limited to the option’s premium when the contract is out of the money, and as long as you don’t spend money you don’t have (e..g, buying on margin), purchase illiquid contracts or write uncovered options contracts. The upside potential for options can be vast.
Numerous strategies can be used
Compared to investing in stocks, trading options has more strategies that can be employed. Some popular options trading strategies include covered calls, protective puts, long calls and long puts, spreads, straddles and strangles, among others. Depending on your goals, numerous strategies can accommodate your options trading approach.
Cons of ETFs
Complex for new investors
Trading options can come with some complexities, including understanding technical language as well as how the financial derivatives work. As a beginner, it’s important to familiarize yourself with the jargon, process and potential outcomes before starting to trade options. For this reason, options trading is often reserved for experienced retail traders or professional traders.
You cannot simply open a brokerage account and immediately begin trading options. You’ll need to satisfy an initial margin requirement — the amount of money you must deposit in your account in order to purchase an options contract. That amount varies depending on the brokerage and the options.
According to the U.S. Securities and Exchange Commission, before trading on margin, regulatory authorities like FINRA require you to deposit a minimum of $2,000 or 100% of the purchase price of the margin securities, whichever is less. This is known as the “minimum margin.” Some brokerages may require you to deposit more than $2,000.
Options strategies that involve selling options contracts may lead to significant losses, and the use of margin may amplify those losses. Some of these strategies may expose you to losses that exceed your initial investment amount. Therefore, you will owe money to your broker in addition to the investment loss.
Like any investment, higher risk is correlated with higher potential returns. That’s no different with options. However, you should consider that those potential losses can be severe. Investors should ensure that they completely understand the implications of options trading before beginning, because failing to do so can result in disastrous losses.
Those losses are typically magnified for options writers. As an options holder, your losses are limited to the entire amount of the premium you pay — no more, no less. But for options writers, in the case of uncovered calls for example, there is unlimited potential loss since the price of the underlying stock can conceivably rise indefinitely.
What are options trading levels?
After you open your options trading account with a brokerage, most brokers will assign you an options trading level based on two determining factors: your experience and your financial position. These levels range from one to five, with one being the lowest in both experience and fund requirements, and five being the highest.
These levels will dictate which types of options contracts and strategies you can use. For instance, at Level 1, a trader is typically restricted to trading covered calls and protective puts — options strategies that entail existing ownership of the underlying asset.
- Level 1: Covered calls and protective puts
- Level 2: Long calls and long puts
- Level 3: Options spreads, the buying of multiple options of the same type (calls or puts) with the same underlying asset, but with different strike prices, expirations or both
- Level 4: Credit spreads, which involve purchasing one option and selling another in the same class and expiration but with different strike prices
- Level 5: Selling naked options, for which the trader doesn’t own the underlying asset
Options trading strategies
Options traders are often drawn to trading derivatives because of the manifold options trading strategies available to them, which can be used to increase the odds of success. The following section discusses some of the most popular options trading strategies and how they work.
One of the most common investment strategies for options is using covered calls. A covered call gives someone else the right to purchase shares of a stock you already own — hence “covered” — at a specific price (i.e., the strike price) at any time on or before the option’s expiration. Using covered calls is a great way for investors to earn income on shares of stock they already own.
Protective puts and married puts
Protective puts and married puts are identical with the sole exception of the time when the stock is acquired. If shares are purchased at the same time as the put option, it’s referred to as a married put. If you already own the shares and then purchase the put, it’s a protective put. In either case, the idea is that you can use put options to hedge a stock already in your portfolio, thereby providing yourself with downside protection by being able to sell at the strike price.
Bull call spread
Option spreads are another popular strategy. They can be bullish, as with bull call spreads, or bearish, as with bear put spreads. In the case of the former, an investor simultaneously buys calls at a specific strike price while selling the same amount of calls at a higher strike price. Both call options will have the same underlying asset as well as the same expiration.
This is referred to as a vertical spread strategy, and one benefit of this tactic is that the trade encompasses two “legs.” Both legs don’t need to be closed at the same time, thereby allowing you to “leg out” just part of the spread while leaving the rest in place to maximize earning potential. However, because there are two legs to a spread, it limits both losses and gains.
Bear put spread
Bear put spreads are similar to bull call spreads, but with the expectation that the underlying asset will fall in price rather than appreciate. This version of the vertical spread strategy entails simultaneously buying puts at a specific strike price while selling the same amount of puts at a lower strike price. Both put options will have the same underlying asset as well as the same expiration.
Just like the bull call spread, the bear put spread strategy involves two legs. This limits potential gains and losses on the trade.
Options trading FAQs
Can you trade options in a retirement account?
Do options pay dividends?
How much money should I have in a margin account?
Summary of Money's What Is Options Trading?
Options trading is a way for experienced traders to use financial derivatives to generate income, hedge their existing positions or to speculate about short- or long-term changes in asset prices. There are varying levels of complexity involved, and because options trading entails higher risk than other investments, it can also result in higher returns. However, if you are a beginner, it’s recommended that you acquaint yourself with the jargon associated with options trading, the advantages, disadvantages and the numerous strategies available to you before you begin.