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Options trading has become a popular activity among retail traders amid the rise of zero-commission brokerage firms like Robinhood.
However, even though these instruments often offer a great reward-to-risk ratio compared to trading the underlying asset directly, many variables could play against traders, including the passage of time, variations in the implied volatility of the instrument, and its liquidity.
In the following article, I will attempt to explain the most basic concepts about options, including what they are, how they work, which are the most popular strategies used when trading these instruments, and how you can get started in options trading.
What Are Options?
An option is a contract between a seller (often known as the writer) and a buyer (commonly known as the holder). An options contract is designed to track the price of an underlying instrument, whether that is a stock, a commodity, or a cryptocurrency.
These contracts give the holder the right, not the obligation, to buy (call) or sell (put) a certain number of units — typically 100 units per contract — of the underlying asset they track once the contract expires. In the United States, the Options Clearing Corporation (OCC) is the entity in charge of issuing, standardizing, and guaranteeing the execution of these contracts.
There are two types of options contracts. The American-style contract can be exercised at any given point during its lifetime while European-style contracts can only be exercised on the expiration date.
Multiple variables can affect the price of options including the following:
- Price of the underlying asset
- Strike price
- Expiration date
- Greeks (delta, gamma, vega, theta, rho), which describe an options risk parameters
- Implied volatility
Pro Tip: Options are contracts that give the buyer the right — but not the obligation — to buy (for calls) or sell (for puts) the underlying asset at a specific price on or before a specific date.
Call Options
A call option gives the holder the right, not the obligation, to buy a certain number of units of the underlying asset — typically 100 for stocks.
For example, the holder of a 09/17 AAPL $170 call option has the right to buy 100 stocks of Apple Inc. once the contract reaches its maturity date or before for American-style options.
However, if the price of the underlying asset is lower than the sum of the price plus the premium paid for the stock, the contract will typically be worthless and, therefore, the buyer would not have an incentive to exercise his or her right.
Put Options
A put option gives the holder the right, not the obligation, to sell a certain number of units of the underlying asset — typically 100 for stocks.
For example, the holder of a 09/17 AAPL $170 put option has the right to sell 100 stocks of Apple Inc. once the contract reaches its maturity date or before for American-style options.
However, if the price of the underlying asset is lower than the price minus the premium paid for the option then the holder would not have an incentive to exercise his or her right.
| Call Options | Put Options |
|---|---|
| Call options ensure that the buyer has the right to purchase the asset at a pre-defined price | Put options ensure that the buyer has the right to sell the asset at a pre-defined price |
| Call options will exercise when the market price of the underlying asset increases | Put options will exercise when the market price of the underlying asset decreases |
| The seller has the asset or required amount of investment to buy the asset | The buyer has the asset or required amount of investment to buy the asset prior to the exercise of the option |
| Profit = market price - strike price - premium | Profit = strike price - market price - premium |
How to Trade Options
Options are typically considered too sophisticated for traders who are getting started in the investing world due to the large number of variables that can affect their price and the high risk of losing money if adequate strategies are not adopted.
However, if you believe you are prepared to take your first steps into the fascinating world of options trading, here’s a step-by-step guide on how you can get started.
Step 1: Open an Options Trading Account
Most brokerage firms in the United States nowadays offer access to the options markets. These providers have been progressively slashing the commissions they charge for trading these instruments due to increased competition.
Notably, Robinhood is the cheapest platform on which options can be traded as they don’t charge any fees or commissions for trading these instruments. Meanwhile, other providers typically charge a fixed fee per contract per trade.
Traders will typically have access to simple options trading strategies — commonly known as Level 1 Options — right after they open an account with a US-based brokerage firm. For more sophisticated strategies like vertical puts, straddles, and strangles — often known as Level 2 Options — most providers will ask for further information about the trader’s background, knowledge about how options work, and prior trading experience.
Moreover, a minimum account balance will often be required when executing Level 2 options strategies.
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| Best For | Intermediate traders | Beginner traders | Advanced traders |
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Step 2: Pick the Options You Intend to Trade
Once you have opened an account with a brokerage firm, you will now be able to trade any options available using Level 1 or Level 2 strategies.
You can easily check which options are available for each of the instruments listed on your broker’s platform by accessing the security’s options chain. These chains typically list all the options available by expiration and each expiration date also features a list of every strike price available for both calls and puts.
The following are some of the most common options trading strategies:
Long Call
A long call option strategy involves buying a call option contract with a given strike price and expiration date. These contracts generate a profit if the price of the underlying asset is higher than the sum of the strike price plus the premium paid once the expiration date is reached.
The maximum profit that can be realized with a long call option is unlimited while the maximum loss is limited to the premium paid to purchase the contract. A long call strategy is appropriate if the trader believes that the price of the underlying asset will rise.
Long Put
A long put option strategy involves buying a put option contract with a given strike price and expiration date. These contracts generate a profit if the price of the underlying asset is lower than the result of deducting the premium paid from the strike price once the expiration date is reached.
The maximum profit that can be realized with a long put option is unlimited while the maximum loss is limited to the premium paid to purchase the contract. A long put strategy is appropriate if the trader believes that the price of the underlying asset will decline.
Covered Call
A covered call involves writing (selling) an options contract by using an open position the trader has on a given asset. A trader must hold a minimum of 100 shares to write a covered call on a given stock. This strategy can generate passive income for the stockholder as long as the price of the underlying asset expires below the option’s strike price.
However, if the price of the underlying asset rises above that level, the holder of the contract can exercise his contract and the writer will be forced to hand over his collateral while missing out on the extra gains. The maximum profit is limited to the premium received for writing the covered call while the maximum loss is unlimited although not necessarily material as the options seller will only miss out on the gains he would have realized if he held the underlying asset.
Pro Tip: Investors use options to generate capital gains, speculate, reduce market risk and produce income.
Long-Term Equity Anticipation Securities (LEAPS)
LEAPS options are contracts that have an expiration date that exceeds nine months or so, although the exact minimum length required for a contract to be considered a LEAPS may vary from one author to the other.
In essence, a LEAPS is the options version of a buy-and-hold strategy. Since their expiration date is far from the present, they give the underlying asset more time to rise (call) or decline (put) as expected.
However, since the future is highly uncertain, LEAPS tend to trade at high premiums due to the elevated implied volatility that is assigned to the contract. As a result, the price typically has to rise or decline dramatically for a LEAPS strategy to be profitable.
The benefit of LEAPS is that, if the trader’s directional price forecast is correct, they can deliver higher gains compared to buying and holding the underlying asset directly.
The maximum profit that can be realized with a LEAPS is unlimited while the maximum loss is the premium paid for the contract.
Step 3: Pick a Strike Price and Expiration Date
Now that you know the most common strategies for trading options, it is time to pick which contracts you will be dealing with. For this, you have to pick a strike price and an expiration date.
Most traders will pick out-of-the-money (OTM) options due to their lower prices. OTM options are those with strike prices above the market price (calls) or below the market price (puts).
However, since the price of the underlying asset must fluctuate dramatically for these options to be in-the-money (ITM), the risk of the contract expiring worthless is elevated. Moreover, when the price of the underlying asset is experiencing significant volatility, the price of the option will be affected by this abnormal price action and sellers will charge a higher premium that could reduce the likelihood of generating a profit.
Finally, a trader must pick the expiration date of the options contract. The concept of time decay is important at this point as out-of-the-money options will see their price decrease as the expiration date approaches. Therefore, traders should pick an expiration date that gives the underlying asset enough time to perform as expected.
In most cases, an expiration date that is 45 to 60 days away from the time that the option is bought can be flexible enough to give the underlying asset enough time to fluctuate in line with the trader’s forecast.
Step 4: Establish a Trading Plan
Options are very volatile instruments by nature. Changes in the different variables that affect their price such as the instrument’s implied volatility, Greeks, and time decay can hurt a position.
Therefore, options traders must have a plan before entering a position that should include the maximum loss they are willing to take, an exit price for the underlying asset at which they will close their position, and a maximum holding period. This will prevent them from facing the losses resulting from accelerated time decay.
Pro Tip: A few key differences between stocks and options is that options come with an expiration date and an exercise price; options don’t come with shareholder rights and don’t pay dividends. Also, options in general terms cost only a fraction of the cost of the underlying asset.
Important Options Trading Terminology
You might have read some terms that you are not familiar with as they may only be mentioned in a conversation regarding options trading. If you plan on navigating the complex world of derivatives, here’s a glossary of the most relevant concepts you should know.
In-the-Money
The phrase “in-the-money” or ITM refers to call options whose strike price is below the market price or put options whose strike price is above the market price. As their expiration date approaches, the value of ITM options should get closer to the contract’s intrinsic value, this being the difference between the strike price and the market price of the underlying asset.
Imagine that you have bought a call option on Zoom Video Communications (NASDAQ: ZM) with a strike price of $280 and the market price currently stands at $282. This option contract is in-the-money and, as its expiration date approaches, its intrinsic value should get closer to $2 ($282 – $280).
Also, the deeper the option is in-the-money, meaning that the strike price is way lower than the market price, the closer its price will get to the intrinsic value.
Out-of-the-Money
The phrase “out-the-money” or OTM refers to call options whose strike price is above the market price or put options whose strike price is below the market price. As their expiration date approaches, the value of OTM options should get closer to zero.
Imagine that you have bought a call option on Ford (NYSE: F) with a strike price of $14 and the market price currently stands at $12. This option contract is out-the-money and, as its expiration date approaches, its intrinsic value should get closer to zero.
Also, the deeper the option is out-the-money, meaning that the strike price is farther than the market price, the closer its price will get to zero as well.
At-the-Money
The phrase “at-the-money” or ATM refers to call or put options whose strike price is exactly the same as the market price. As their expiration date approaches, the value of ATM options should get closer to zero.
Imagine that you have bought a call option on Uber Technologies (NYSE: UBER) with a strike price of $39 and the market price currently stands at $39. This contract is at-the-money and, as its expiration date approaches, its intrinsic value should get closer to zero.
It is important to note that at-the-money options are not profitable for buyers as they will be worthless at expiration and the buyers will lose the premium paid on the contract. Meanwhile, for sellers, ATM options are still profitable as they will get to keep the premium they received from writing the contract.
Premiums
A premium is the price paid to buy an options contract. Premiums are listed on a per-contract basis and the minimum number of options contracts that can be bought per trade is 100. Therefore, if the premium for a certain option is $0.05, the buyer will have to spend $5 to enter a position ($0.05 * 100 contracts).
Options premiums are typically calculated using a formula known as the Black-Scholes Model. This formula uses multiple variables – including the implied volatility of the option, the market price of the underlying asset, the strike price of the option, the time until the expiration date occurs, and the risk-free interest rate — to price different contracts.
Spreads
Similar to stocks, options also have bid/ask spreads depending on their liquidity. The most liquid options have tight spreads while less liquid contracts have wider spreads.
Low liquidity is not good for options traders as it could result in losses if a holder is unable to close her position at her desired asking price due to a lack of buyers.
The Greeks
In options, “the Greeks” are letters of the Greek alphabet that are used to illustrate how different variables can affect the price of an options contract. Here are the most commonly used ones:
- Delta: Reflects how much the price of the contract will change for every $1 change in the price of the underlying asset
- Gamma: Reflects how much Delta will change for every $1 fluctuation in the price of the underlying asset
- Theta: Reflects how much the price of the contract will decline or increase (depending on whether the option is ITM or OTM) for every day that passes
- Vega: Reflects how the price of the option will react to a single-point variation in the implied volatility of the contract
Expiration Date
The expiration date of an options contract is the date on which the buyer will be able to exercise his or her right to buy (call) or sell (put) the underlying asset at the strike price.
Strike Price
The strike price of an option is the price at which the buyer will be able to buy (call) or sell (put) the underlying asset at the expiration date or before that for American-style options.
Benefits of Options Trading (Pros)
- Gains are higher compared to trading the underlying asset directly if the option expires in-the-money.
- Options are typically cheaper than buying the underlying asset directly.
- Options can generate fixed income for a stockholder via the sale of covered calls.
- Options can be used for hedging purposes. This means that an investor can purchase put options to protect himself from the losses he would experience if the price of the underlying asset declines.
- Traders with a small account balance can use options to place leveraged bets without directly borrowing funds.
- The maximum loss of an options trade is typically limited to the premium paid.
Downsides of Options Trading (Cons)
- Options are complex financial instruments. They are priced using a complicated formula that is affected by changes in multiple factors and traders may not realize the extent of the risk they are assuming unless they fully understand how options work.
- Options prices can fluctuate wildly during short periods.
- Certain options strategies like the sale of naked puts can result in unlimited losses.
Frequently Asked Questions (FAQs) on How to Trade Options
The following are some of the most frequently asked questions we get on the topic of how to trade options.
Why Do Investors Trade Options?
Options can be used for speculating about the direction that the price of a given underlying asset will take in a short period and they can enlarge the gains produced by the operation compared to holding the asset directly.
On the other hand, they can also be used for hedging purposes (buying put options) or for generating passive income (covered calls).
How Do You Make Money with Options Trading?
Most of the strategies implemented to make money with options require in-depth knowledge about how they are priced while technical analysis skills will typically be required as well.
On the other hand, stockholders can easily make money on options by selling covered calls. However, there is the risk that they may have to give up their holdings if the contracts they sold expire in-the-money.
Can You Trade Options on ETFs?
Yes. There are options for exchange-traded funds (ETFs) although not for all of them.
What Is Binary Options Trading?
A binary option is a different type of option that involves predicting the direction that the price of the underlying asset will take in a very short period. Even though these options are legal and available for US-based traders, they are considered riskier than traditional options and are more similar to placing a casino bet.
Final Thoughts
Now that you know what options are, how they work, and how you can trade them, do you think you are ready to get started with options trading?
If you are, make sure you only trade with money you can afford to lose and you should also learn more about the intricacies of these complex financial instruments before getting started to increase your odds of being successful at it.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.
