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Options Trading: What is Options Trading and How does it Work?

Updated: May 01, 2024
Chinmay Soni
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Opinions expressed by Traders Union Contributors are their own.
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Table of Contents

  • What are Options
  • Options Use Cases
  • Opportunities and Risks
  • Main Types
  • Buying and Selling
  • Hedging vs. Speculation
  • How to Trade
  • Trading Strategies
  • Risk Management
  • Best Brokers
  • Expert Opinion
  • Related Articles
  • FAQs
Editorial Note: While we adhere to strict Editorial Integrity, this post may contain references to products from our partners. Here's an explanation for How We Make Money. None of the data and information on this webpage constitutes investment advice according to our Disclaimer.

The best investment portfolios are typically made up of several asset classes like stocks, bonds, and ETFs. Options are another type of asset class available to investors; however, they offer unique opportunities for speculation and risk management.

In this article, we'll explain what is options trading and teach you how to trade options. From there, you'll be able to unlock the power of this exciting asset class.

What Are Options?

An option — also called a stock option or equity option — is a derivative financial instrument. Options are a contract that is agreed between a buyer and a seller in relation to a particular stock or investment. These contracts give the buyer the right — but not the obligation — to buy or sell a set amount of a specific underlying asset at an agreed price before the contract expires or as it expires.

As demonstrated above, the essential aspect of the contract is that the buyer has the option to exercise the terms of the deal. They are not forced to do so. This dynamic means that buyers will only exercise the contract when it is wise to do so.

For example, a buyer takes out a call option for a particular stock at $100 per share. This value is called the exercise or strike price. If the underlying stock is trading in the market at $80 per share, the buyer won't exercise their option because they would be paying an extra $20 compared to the market price.

If, however, the underlying stocks were trading at $130 in the current market, the option buyer might choose to exercise the contract as they would be buying at a $30 discount compared to the current market price.

Of course, there are several ways that investors can trade options. In the example above, the buyer used a call option. However, investors can also use put options, which give the buyer the right to sell a stock at a particular price. These contracts can protect a buyer from making excessive losses in a specific position.

Additionally, some investors blend various call and put options for complex options strategies that we will discuss later in the article. Finally, some investors can decide to write and sell options too.

American vs. European Options

Within the options markets, there are American and European options. These are different styles of options rather than being named after the geographical regions they are traded in. American and European options have many similarities. However, they also have some crucial differences: for example, buyers of American-style options can exercise their options at any point before the contract expires.

Most equities options are American-style; however, many indices, like the S&P 500, have European-style options.

The most notable difference between American and European options is that European options can only be exercised when the contract expires. American options, however, can be exercised at any point that the holder decides.

Some other key differences between these styles of options are:

  • American option's greater flexibility means that they come with a higher premium.

  • American options are more popular

  • American options are mainly traded via an exchange, while European options are generally traded over-the-counter (OTC)

  • European options can be lower risk because the expiration date is known, meaning profits and losses can be estimated to a greater degree of accuracy.

  • European options lend themselves well to hedging strategies because of the fixed date for expiry.

Stock Options and Other Markets

As mentioned above, stock options are derivatives. This means that their value is derived from an underlying asset. Derivatives are a financial instrument or security that is made from another financial instrument or security.

There are several different types of underlying assets that options are based upon.

  • Stock or equity options are the most common type of options. These options are derived from stocks like Apple. They are traded on the New York Stock Exchange.

  • Index options are options that are derived from various indices, like the S&P 500 or FTSE 100.

  • Exchange-traded product (ETP) options are options that are derived from ETFs and index funds.

Options Use Cases

Options are a popular financial instrument for investors. However, you might be wondering why investors choose options trading over traditional stocks and what exactly are the differences between them.

Stocks represent shares of ownership in an individual company. Options, however, are contracts with other investors that allow you to bet on which direction you think a stock price is going. While these assets are very different, they can be very complementary in a portfolio.

Options allow traders to take a more tactical approach to their investing. Additionally, they often require smaller initial investments. While buying shares in a company is considered a long-term strategy, options trading usually happens over a shorter time scale. Options contracts all come with an expiration date, which can range from as little as a few days to several years.

There are two prominent use cases for options.

1) Speculation

Speculation is a bet on future price movements — either up or down. For example, an investor might do their research using technical analysis or fundamental analysis. From here, they might decide the price of a stock will go up.

As a result, the investors may choose to buy the stock outright or buy a call option on the stock. Some investors will choose to buy the call option because it allows them a degree of leverage. For example, if a stock price is $100, the call option could cost as little as a few dollars.

2) Hedging

The original purpose of options is because they allow investors to hedge their bets. Hedging by using options will enable investors to reduce their risks without paying excessive amounts. You can use options to insure investments against that move against you.

For example, you want to buy a specific type of stock. However, you'd like to limit your potential losses. By using put options, you can limit your risks by only exercising the contract if the stocks make gains. If they don't, you are only down the cost of the contract.

Options Trading Opportunities and Risks

Like all financial instruments, options come with advantages and disadvantages.

Advantages of Options Trading

Lower Upfront Costs

When compared to stock trading, options trading requires lower upfront financial commitments. The costs of buying an option are a) the premium and b) the trading commission.

These outgoings are significantly less than what investors would pay to purchase shares outright.

Options investors have to pay a lot less to get involved in a trade, but if the market moves in their direction, they can benefit just as much as an investor who purchased the stock outright.

Lower Exposure to Losses

Options buyers limit their downside because of the nature of options. If you buy a put or call option, you aren't bound to follow through on the trade. Let's say you do your analysis and believe that a stock will be worth a specific amount on a particular date. Should it turn out that your assumptions were incorrect, all you've lost are the costs of the contract and your trading fees.

Flexibility

Options give a trader a lot of flexibility. Depending on their particular strategy or the outcome of the contract, traders can (before the contract expires) choose to:

1) Exercise the option and purchase the shares. From here, they can add them to their portfolio

2) Exercise the option, and either sell some or even all of the shares

3) If an options contract is in profit, the investor can trade that contract with another investor

4) If an options contract loses money, investors can claw back some of their losses by selling the contract to another investor.

Lock in a Stock Price

A significant advantage of options is that they allow an investor to lock in a stock price. By agreeing on an options contract, investors can freeze the stock price at a specific price (i.e., the strike price) for some time. Depending on which type of option they use, this can guarantee an investor can buy or sell at the strike price before the options contract expires.

Disadvantages of Options Trading

Increased Risks for Options Sellers

As detailed above, for options buyers, the risks are only the cost of the contract. However, for options sellers — or, as they are also known, options writers, the risks can become amplified. If an investor writes a put or a call, they are committed to buying or selling shares at a specific price within the time frame designated by the contract. In some situations, this obligates the seller to purchase a stock at a deeply unfavorable price. Because there is no limit on how high a stock could rise, this could leave an options writer with an astronomical bill.

Time Limitations

Options trading tends to be a better option in the short term. Because the contracts have fixed periods, you have less time for your investment ideas to bear fruit. Long-term investments — for example, betting on a specific type of tech — can take time to realize their potential. If you buy stock in these types of companies, you have the luxury of giving them time to grow.

However, options contracts typically take place in a short time frame. Sellers and buyers are looking at near-term price movements when they set these contracts. The disadvantage here is that with options contracts, you need to be right about two things: the direction the stock takes and the time frame these price rises will happen. Many investors have been right about the price movement but missed out on profits because their contract expired.

Trader Requirements

If you want to trade options, you need to meet specific qualifying criteria. So, before you start options trading, you need to apply to your broker for approval. The qualifying process requires answering questions about your finances, your investing experience, and your understanding of the risks of options trading.

Once satisfied with your answers, the broker assigns a trading level that dictates the options trades you can place. Additionally, If you want to trade options, you'll need to keep a minimum of $2,000 in your brokerage account. This deposit is a strictly enforced industry requirement. Traders need to consider this $2,000 as an opportunity cost and calculate what else they could do with this money.

Additional Costs

Some additional costs may apply to options trading. When calculated against potential profits, these costs could affect your bottom line. For example, some options trading strategies involve selling call options on securities that you don't already own. To do this, you will need to set up a margin account, which is, in essence, a line of credit that is used as collateral if the trade moves against the investor.

Each broker has different minimum requirements for opening a margin account. As a result, they will base the amount of margin and interest rates on how much securities and cash are in the account. Margin loan rates can be anywhere from a few percent to 10% or more.

If an investor can't repay this loan, or if their brokerage account drops below a certain percentage during the course of daily price changes, the lender can then issue a margin call. A margin call can liquidate an investor's account if they don't add more collateral (cash, stocks, etc.).

Main Types of Options

To learn about options trading, you'll need to understand the main types of options you can trade. The two most fundamental categories to choose from are calls and puts.

Put Option

Put options are the opposite of call options. Instead of paying for the right to buy the underlying security, a put option is a contract to sell the option at a decided upon strike price.

Put options also have expiration dates and work within the same framework.

Put options are bought if you expect the price of the underlying asset to go down within a specific time frame.

Call options can work as hedges by limiting losses and maximizing gains. For example, you purchase 100 shares of an airline because — after performing your analysis — you believe the price will rise to $40 per share. The current price is $20 per share, so your total investment is $2000.

Of course, not all investments go the way we plan. So, to protect your investment, you decide to hedge against the risk that the price will drop. As a result, you purchase 100 put options worth $4 each.

In the scenario where the stock price goes up to $40, your put option expires worthless. However, your losses are the $400 premium you paid, which are offset against the $2000 profit you've made. However, it's worth remembering that if the price drops, your gains are also limited.

Call Options

A call option gives you the right to buy the underlying security at a determined price and time. As detailed above, the price that you agree to pay is called the strike price, and the date for exercising the call option is called the expiration date.

Call options are bought if you expect the price of the underlying asset to go up within a specific time frame.

In our example of buying airline stock above, you bet on the price going up. However, in specific scenarios, you can bet on the price dropping. For example, the current share price is $20, but you believe it will decline to $10. To hedge against this position, you can purchase a call option, betting the stock price will rise to $40.

If the stock drops to $5, your call options expire as worthless, and you lose $400. In this scenario, your gains are uncapped because there are no limits to each share price.

Long vs. Short Options

Options trading is generally considered a "long" — i.e., you are buying the option in the hope that the price goes up. As detailed above, you agree to purchase a stock at a specific price in the future.

However, even buying a put option — i.e., the right to sell a security at a specific price and time in the future — means you are still, in effect, buying a long option.

Shorting an option is still selling the option. However, the profits of the sale are capped at the premium of the option, but the risk is unlimited. With call and put options, the longer the amount of time that is left on the contract, the higher the premium.

What is Buying and Selling Options

Now that you understand the basics let's look at how you can buy and sell options. Options trading is the process of buying and trading options. It's generally done with securities on stock, bond, and ETF markets, and so on. To buy and sell options, you'll need to go through a broker.

As mentioned above, buying and selling options are dramatically different.

Options Trading – Hedging vs. Speculation

There are two primary approaches that investors can make when options trading. These are either speculation or hedging.

1) Speculation

Call options allow investors to gain profits from price rises in underlying stocks (or other assets) while only paying a small fraction of the costs of buying stocks. This scenario is possible with options because they are leveraged instruments.

Many traders favor these instruments because they allow unlimited profits, but losses are limited to the price paid for the option. Considering the high levels of leverage involved when buying call options, they are thought of as a high-risk investment.

2) Hedging

Many investment banks and other financial institutions use call options to hedge against other positions. In many ways, hedges are like insurance that pays out when an unforeseen event occurs. Call options can be used to hedge against short stock portfolios. Inversely, you can sell them to hedge against pullbacks in long stock portfolios.

How To Trade Options? A Beginners Guide

Trading stock options is a bit more complicated for beginners than traditional stock trading. Putting aside the technical or fundamental analysis that is involved with buying either instrument for a moment, buying stock is relatively simple. You decide how many shares you want, and then your broker fills your order at either the market price or a limit price that you can set.

On the other hand, options trading is more nuanced. For starters, you need to understand a few advanced strategies. You can also use alerts and signals. Secondly, opening an options trading account requires a few more steps than a regular investment account.

But don't be intimidated; our beginner's guide to trading options will steer you onto the right path.

STEP 1: Open an Options Trading Account

Before you start trading options, you need to assure your broker you know what you are doing. Brokers screen options trading applicants to evaluate their trading experience, financial preparedness, and understanding of the risks involved.

Additionally, options trading accounts require more significant amounts of starting capital.

To pass your assessment, you'll need to provide your broker with:

  • Your investment objectives

  • Your trading experience

  • Personal financial information, including assets, net worth, income, and employment information, etc.

  • The types of options that you'd like to trade, i.e., calls, puts, etc.

Once the broker has your answers to these questions, they will assign you a trading level that is based on a level of risk, typically 1 to 5, with 5 representing the highest level of risk. This rating will determine which types of options you can trade.

STEP 2: Decide Which Options to Buy or Sell

Once your account is set up, you'll need to decide which options you should buy or sell.

The direction that you believe the underlying stocks will move will determine which options contracts you should buy.

As a general rule:

  • Buy a call option or sell a put option if you believe the stock price will rise.

  • Sell a call option or sell a put option if you believe the price will be stable.

  • Buy a put option or sell a call option if you believe the stock price will decrease.

STEP 3: Determine the Option Strike Price

If you buy an option, it only keeps its value if the stock price closes the expiration period "in the money." That means the price needs to be either above or below the strike price.

For call options, you'll want it to be above the strike; for put options, below the strike. So, you'll want to buy the option with a strike price that is where you believe the stock price will be during the time of the contract.

For example, an energy company is trading at $200. You believe the price will rise to $250 by a specific date. So, you buy a call option with a strike price of less than $250. In an ideal scenario, this strike price will be $250 minus the cost of the option. If the stock price hits $250, you are, as they say in the industry, in the money.

Likewise, if you believe the same energy company's stock price will drop to $150, you can buy a put option with a strike price above $150 plus the cost of the option. Again, if the price drops below the strike price, your option is in the money.

Of course, you can't just choose an arbitrary strike price. Options quotes offer several different strike price increments based on the stock price. These increments can be something like $1, $2.5, $5, $10, and so on.

The price you pay for options comprises two parts: the intrinsic value and the time value. The intrinsic value is made up of the difference between the share price and the strike price. In our example above, that is $50. Time value is made up of several factors, including stock volatility, how long is left on the contract, interest rates, and so on.

STEP 4: Define the Option Time Frame

Finally, all option contracts have a time frame within which you can exercise the option. Again, you can't choose these arbitrarily. As mentioned above, there are two main types of options, American or European. American can be exercised at any point during the contract; European can be exercised on the date they expire.

Expiration dates can range from days, weeks, months, or years. Shorter options are best for experienced traders.

Basic Options Trading Strategies

While options trading is more complex than stock trading, there are several simple strategies that investors can employ. Instead of diving right in, investors should learn a few strategies first. Here are six strategies for options trading beginners.

1) Buying Calls

Buying calls is a very straightforward options strategy. If you believe a stock, index, or ETF will rise, you can buy a call and sell it before the option expires. This is an excellent strategy with lower overall risks because the only potential losses are the price of purchasing the contract, whereas the profits are unlimited.

2) Buying Puts

Buying puts are similar to buying calls, but instead, they rely on the underlying asset dropping in value. This strategy is an excellent alternative to short-selling because it has less risk. Again, if investors buy puts, they are only risking the cost of the premium.

3) Short Put

Short puts are a strategy for investors who are selling options. To make money with this method, you charge the premium on the options contract. Selling short puts to other investors can be profitable, but it carries a high degree of risk if the option is exercised in the money.

4) Covered Call

A covered call is a strategy that uses two parts. Unlike other strategies on this list, the investor needs to own the underlying stock in the company already. Then, they sell a call on this stock and receive a premium.

To make money with this method, you'll want the stock price to either decrease or stay the same. Therefore, the buyer of the option will let their option expire, allowing you to pocket the premium. This strategy is often used by investors who are looking to generate some income from stocks they own during periods of low market volatility.

5) Married Put

This strategy takes its name because it marries two investment strategies: stocks and options. Purchases are made at the same time, with investors buying a put option for every 100 shares of stock.

Because puts rely on a share price decreasing, married puts are a hedge against share prices dropping.

6) Protective Put

Protective puts are a strategy employed by investors to protect themselves from losses. For example, investors will buy a long put against an asset they own, which gives them some insurance if the asset drops in value. This strategy is similar to a married put but differs in that it protects against losses of an asset that is already in your portfolio.

How To Trade Options Successfully? Always Manage Your Risks

Perhaps the most important aspect of options trading is learning to manage risk. Some losses are inevitable in investing and trading, so keeping them minimized can be the difference between success and failure. Here are a few tips to help you manage your risks.

1. Position Sizing

When opening any trades, keep position sizing in mind. If you buy a call option, the most money that you can lose is the premium. Try to keep this amount as no more than 1-2% of your total capital. For example, if you have $10,000 in your options trading account, don't buy calls that will cost more than $100 or $200.

2. Selling Options

Losses from selling options can, in theory, be unlimited. If you open positions like this, consider using a hedge as a stop-loss option.

3. Avoid Undefined Risks

Opening options with undefined risk is a recipe for disaster. This type of exposure will eventually catch up with you and wipe all or most of your account. The best investors always have a defined exit strategy. Consider using option hedges to manage your risk for the times when the market moves against you.

Best Options Trading Brokers

Opening a brokerage account for options investing involves some additional considerations. Here are a few tips for what to look for in an options trading broker.

1. Free Education

Options trading involves constant education and evolution. If you are a beginner trader, look for trading platforms that offer educational materials, courses, webinars, and access to experts.

2. Easy of Use

Each trading platform is different. Some are easy to use and have mobile app options, while others are a little tricky. Always try a demo version if possible.

3. Analytic Tools

Many options trading platforms come with analytic tools. Some are free, others are paid. These tools are a must for anyone who is using more advanced or complex strategies. Charting, screening tools, and live quote feeds are a few of the data and research tools to look out for.

Here is a look at some of the best platforms for trading options.

Broker Trading Fees Account Minimum Types of options

Webull

$0

$2000

Stocks and ETFs

Study review

Interactive Brokers

Between $0.25 - $0.70 per contract

$10,000

Stocks and ETFs

Study review

Robinhood

$0

$0

Stocks and ETFs

Study review

Fidelity

$0.65 per contract

$5000

Stocks and ETFs

Study review

TD Ameritrade

$0.65 per contract

$2000

Stocks and ETFs

Study review

Expert Opinion

Options are contracts that give the buyer the option to buy or sell an underlying asset during a fixed time period. The advantage of these financial instruments is that the buyer has no obligation to buy or sell, which means they can only choose to exercise a contract when it is advantageous to them.

For beginners, buying call options is a great way to manage risk, as the only capital they stand to lose is the premium they pay for the right to buy the call. Options are an excellent way for investors to hedge against a market that can move against them. Selling options, on the other hand, can be a high-risk strategy that new traders should approach with caution.

Antony Robertson

Antony Robertson,

Traders Union Financial Analyst

FAQs

If I buy an option, do I own the asset?

No. An option is a derivative of any underlying asset.

What are the two types of options?

The two types of options are calls and puts.

Are options risky?

All investments carry risks. Options can be very risky if managed incorrectly.

What are options used for?

Investors use options to speculate on assets or to hedge against risk.

Glossary for novice traders

  • 1 Trading

    Trading involves the act of buying and selling financial assets like stocks, currencies, or commodities with the intention of profiting from market price fluctuations. Traders employ various strategies, analysis techniques, and risk management practices to make informed decisions and optimize their chances of success in the financial markets.

  • 2 Investor

    An investor is an individual, who invests money in an asset with the expectation that its value would appreciate in the future. The asset can be anything, including a bond, debenture, mutual fund, equity, gold, silver, exchange-traded funds (ETFs), and real-estate property.

  • 3 Options trading

    Options trading is a financial derivative strategy that involves the buying and selling of options contracts, which give traders the right (but not the obligation) to buy or sell an underlying asset at a specified price, known as the strike price, before or on a predetermined expiration date. There are two main types of options: call options, which allow the holder to buy the underlying asset, and put options, which allow the holder to sell the underlying asset.

  • 4 Broker

    A broker is a legal entity or individual that performs as an intermediary when making trades in the financial markets. Private investors cannot trade without a broker, since only brokers can execute trades on the exchanges.

  • 5 Leverage

    Forex leverage is a tool enabling traders to control larger positions with a relatively small amount of capital, amplifying potential profits and losses based on the chosen leverage ratio.

Team that worked on the article

Chinmay Soni
Chinmay Soni
Contributor

Chinmay Soni is a financial analyst with more than 5 years of experience in working with stocks, Forex, derivatives, and other assets. As a founder of a boutique research firm and an active researcher, he covers various industries and fields, providing insights backed by statistical data. He is also an educator in the field of finance and technology.

As an author for Traders Union, he contributes his deep analytical insights on various topics, taking into account various aspects.

Read more
Dr. BJ Johnson
Dr. BJ Johnson
Developmental English Editor

Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.

Read more
Mirjan Hipolito
Mirjan Hipolito
Cryptocurrency and stock expert

Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO).

Read more