- An option is a contract giving you the right but not the obligation to buy or sell an asset at a specific price before a specific date.
- If the asset doesn't perform as hoped, the option just expires; you're only out the small premium you paid for it.
- Options are generally more complex than traditional investing and often require careful timing and market-watching.
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When it comes to investing, you're not limited to just buying and selling assets like stocks and bonds directly. More complex securities known as options also exist, which give investors the right — but not an obligation — to trade an underlying asset at a specified price by a specified timeframe. Doing so can give you exposure to assets like stocks or exchange-traded funds (ETFs) at a fraction of the upfront cost, which can be helpful for several reasons such as hedging against risk or trying to generate substantial returns using leverage.
However, an option is not actually an investment in an underlying asset. Instead, it's what's called a derivative: a contract between two or more parties whose value is based on, or derives, from an underlying financial asset. Options can gain or lose value based on the performance of the underlying asset.
Stock options defined
There are two main types of options: calls and puts.
A call option gives you the right to buy an underlying asset within a certain period, while a put option gives you the right to sell an asset within a period.
Either way, you have to pay for this right; the cost of the option is known as its premium. It's a per-share fee (option contracts are typically for 100 shares of the underlying security). The exact amount of the premium also depends on:
- The price at which the option-holder might buy or sell the asset, known as the strike price
- How far into the future the option's expiration date is: the more distant the date, the higher the premium typically
In general, the more likely the security is to reach the strike price based on market expectations, the higher the premium. Yet premiums constantly fluctuate based on what's happening with the underlying asset, and investors can trade options contracts prior to expiration for whatever the premium might be at that time.
If you don't trade the option prior to maturity, however, you lose the entire premium. In some cases, investors can exercise options for a higher value than what the premium originally cost them, thereby turning a profit, but many options end up expiring worthless.
Options can be applied to a variety of securities such as bonds, commodities, and currencies, but equities are the investment of choice. "Most traders focus on stock options trading," says Edward Moya, senior market analyst at AlphaSense.
If all this sounds confusing, that's because options are inherently more complex than investing directly in their underlying assets, and these generally aren't meant for beginners. However, if you want to gain a better understanding of options, we'll break down the essentials in this guide.
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Understanding options contracts
Options contracts may be more complicated than traditional stocks and bonds, but if you can understand their core components, then it's not too difficult to get a feel for how they work overall.
Some of the key terms to know include:
Call options
If you buy a call option, you gain the right to buy the underlying asset at an agreed-upon price, known as the strike price, by a certain date, known as the expiration date. Ideally, the underlying asset like a stock rises in value so that you can either sell the call prior to expiration for more than you paid for the premium, or if it rises above the strike price, you can potentially exercise the option for a profit.
Let's say you buy a call option for Big Tech Company with a strike price of $500 and an expiration date of a month from now.
Let's say your premium is $10 per share, and the options contract is for the standard 100 shares. This means you'll have to pay a total premium of $1,000 for the option.
However, if shares in the Big Tech Company rise to, say, $600 before the expiration date, you'll make a profit of $100 per share, or $10,000 in total (minus the $1,000 premium).
Put options
In contrast to calls that give you the right to buy an underlying asset at a given price by a given date, put options allow you to do the opposite by selling an asset. Even though you don't actually own the underlying asset, you're still gaining the right to sell it at a certain price, which means that if the stock price falls below that amount, you're essentially profiting from the difference between the lower stock price and your strike price (minus the premium).
For example, suppose you bought a put option for Big Tech Company that has a strike price of $500, yet shares in the Big Tech Company fall to $400. Since you could sell 100 shares for $500 ($50,000 total) and buy them back at $400 per share ($40,000), you'll make a profit of $10,000 (minus your premium).
Yet if the underlying stock doesn't fall as much as you hoped or ends up gaining value, your option could expire worthless. Still, you're only losing the premium in this scenario, rather than holding onto a stock that's losing value or engaging in short selling which has theoretically unlimited potential losses. Remember, the option didn't obligate you to buy or sell anything, it just gave you the chance to. The only thing you will have lost would be the money you paid for the option.
Strike price
The strike price, as mentioned above, is the predetermined price that the underlying asset can be bought or sold at.
Regardless of what actually happens to the asset's price, the option holder always retains the right to exercise at the strike price up until the expiration date (for American options, whereas European options can only be exercised at expiration).
You can even buy call options with a strike price below the current trading price or put options above the current trading price, which is known as an in-the-money option. However, the cost of these premiums generally means that the underlying asset price still needs to move in your favor in order for these options to become profitable.
Expiration date
The expiration date is when the options contract expires, typically at the end of regular market hours (4 p.m. ET in the U.S.). Generally, the farther out the expiration date, the more expensive the contract, as there's more time for the underlying asset to move toward the strike price. As it gets closer to the expiration date, the value of the contract generally falls in what's known as time decay unless the underlying price changes enough in favor of the option holder.
Prior to the expiration date, an option holder can trade the contract for whatever the premium is at that point. Even if you're in the money, many people end up closing out options prior to the expiration date, as doing so often results in a similar gain compared to exercising the option, yet you don't have to put up so much cash to exercise the option (e.g., buying 100 shares) or actually take possession of the underlying asset.
Premium
The premium is simply the cost of an options contract. The party selling the option collects the premium and the party buying the contract (whether that's a put or sell) pays the premium. The premium changes based on what the market expects in terms of the option reaching the strike price. The more likely the option is to hit the strike price, based on time and price, the higher the premium generally is.
Why trade options?
There are several reasons an investor might trade options, rather than just buying the underlying asset. Some of the top reasons include:
Leverage
Trading options grant investors buying/selling rights over particular shares, but without as much cost that comes with actually buying those shares outright. For a fraction of the cost, you effectively control 100 shares (or whatever the contract stipulates). In other words, you gain the power of leverage, in exchange for the premium.
Speculation
If you want to bet on the direction of an asset, an option gives you the opportunity to do so without having to actually buy the underlying asset. So, in some ways, there's less risk, in the sense that you don't have to, say, buy 100 shares of stock and be stuck with them if they tumble. However, there's a risk of losing the money spent on option premiums.
Hedging
If you own a big stake in a stock outright, you can use an options contract in order to reduce the risk of potential losses.
"A conservative investor may use options to hedge a large position," says Robert Ross, a senior equity analyst at Mauldin Economics.
For example, if an investor owns 100 shares of Company ABC and doesn't want to sell, they can reduce risk by buying a put option. While there's the cost of the premium, doing this still can still possibly defray some of their losses if Company ABC falls in price, since that could mean the put option gains value. In other words, you're essentially setting a floor for your losses.
Income generation
Investing in options can lead to potential gains, but some investors instead sell (also known as write) options to earn income from the premiums. Selling options means you're taking the opposite position as buyers, i.e., you're generally betting against the asset reaching the strike price.
To sell call options, many brokers require you to own at least 100 shares of the company you're writing the call for (since one option contract typically equals 100 shares). In this case, you're selling what's known as a covered call, because the potential losses are offset by owning the underlying stock.
For example, if you own a stock priced at $100 and sell a covered call option at $110, let's say you earn a $100 premium that's yours to keep. If the stock moves to $109 by the expiration date, the call likely expires, so you get to hold onto both your stock and the premium. However, the call buyer can technically exercise their right to buy your 100 shares at any time (for American options at least)— typically after crossing the strike price. So, if the stock goes up to, say, $120, the buyer could still exercise their option at $110.
If you didn't own the underlying stock, you'd essentially have to buy 100 shares at $120 and sell them to the call buyer at $110, which would be a $1,000 loss. However, with a covered call, you simply transfer the shares you already own — so you're still missing out on a $1,000 potential gain in this scenario (by selling your shares at $110 instead of $120), but you're not losing money either.
Conversely, selling a put means that you would have to buy the shares if the asset moves below the strike price. For example, if you sell a put for a stock with a strike price of $90, and it's currently priced at $100, you might earn a $100 premium that's yours to keep. But if the stock falls to $80, you'd have to buy the 100 shares at $90, so you'd show a $1,000 paper loss on that stock and would have to either hold onto those shares in the hopes it recovers past $90 or risk more losses by owning the stock. Many brokers require you to have enough cash in your account to buy the shares in the event the put you're selling moves below the strike price. This is known as a cash-secured put.
Selling options is often used by more conservative investors compared to buying options, which is generally more aggressive. Still, there's still risk involved with selling options, as it could cause you to miss out on potential gains (with covered calls) or buy an asset you don't want to hold (with cash-secured puts), and the overall risk depends on the situation.
Basic options trading strategies
There are many complex option trading strategies, but some basic strategies include trading the following:
Covered call
A covered call involves selling a call option against a position you already own. If you want to hold the underlying stock but don't think it will rise much over a given period, a covered call could help you generate more income from that asset. Or you might use a covered call as an exit strategy, meaning you're comfortable moving on from your asset if it hits the strike price.
Long call
Buying a long call means you're betting on the underlying asset price rising. Some investors buy long calls but sell them prior to expiration, perhaps even before crossing the strike price, if the premium has increased, thereby enabling them to turn a profit. Others hold on as long as possible to see if they can potentially gain substantial profit by the asset zooming past the strike price by the time the expiration date hits.
Long put
A long put is like short selling but without the upfront commitment. You're buying the option with the hope that the underlying asset will fall. If a stock moves below the strike price, for example, you could sell the security for more than it costs to buy, meaning you can profit from the difference (less fees, taxes, etc.).
Protective put
A protective put is still technically a long put, but the motivation for buying one is to hedge against potential losses. For example, if you own 100 shares of ABC Company and it's gone up a lot recently, say, from $50 to $100, you might want to lock in those gains as best you can. However, if you don't want to sell the stock, you could buy a protective put with a strike price of $100. While you'd lose the premium spent on this, if the stock falls below $100 then those losses would be offset by the gains from your put. So, the cost of the premium is essentially the cost of setting your maximum loss.
Cash-secured put
A cash-secured put involves selling a put option, meaning that you're betting that it won't fall below the strike price, otherwise you'd have to purchase the underlying asset for whatever the strike price is. Cash-secured means you have enough in your brokerage account to purchase the underlying asset if necessary.
Risks of options trading
Options trading can be appealing to many investors, but it's far from easy money. Several risks include:
Potential for loss
For the buyer of an option, the most obvious danger is that the underlying asset doesn't move in the desired direction, forcing them to let the contract expire worthless. So, they paid the premium for nothing. Have this happen often enough, and it can add up to big losses — perhaps more than if you just bought and held the underlying assets.
Time decay
Options trading doesn't simply necessitate an accurate prediction of whether a stock will go up or down, but also an accurate prediction of when it will make its move. You may be correct in thinking that ABC Company is going up, but if your option expires before it surges, you won't be compensated for your premium with a profit. With time decay, your option loses value the closer it gets to the expiration date, unless the underlying asset price moves enough in your favor.
In some ways, "options trading is a lot harder than normal stock investing because you not only have to get the direction right, but also the timing," says Moya.
Volatility
Options trading isn't for the faint of heart. Prices can be volatile, especially if there's a lot of speculation and activity around events like earnings announcements.
Costs
As with any kind of trading, options trading incurs costs. Not only are you obliged to pay a premium when buying options, but you may also have to pay a commission to your broker and small regulatory fees. Because of this, it always makes sense to weigh likely costs against potential profits and losses, before purchasing an option contract. Otherwise your profit may end up being less than you imagined, or your loss greater than imagined.
Don't forget to account for taxes too. Options trading is often done on a short-term basis, meaning the tax implications can be higher than holding stocks for more than a year, the latter which enables you to often take advantage of the lower long-term capital gains tax rate.
Complexity
Overall, options trading is typically more complex than investing in stocks, bonds, and investment funds directly. It can take time and dedication to understand how it all works, and even that doesn't mean you'll necessarily perform well, as options trading can be unpredictable.
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Getting started with options trading
If you want to get started with options trading, consider the following steps:
Learn the basics
Reading this article is a good first step, but you probably want to do even more to educate yourself through other articles, books, videos, and more to make sure you really understand what you're getting yourself into. Not only do you want to understand different options trading strategies but also gain a full picture of the risk involved.
Open a brokerage account
To start options trading, you need to open a brokerage account with a firm that provides this functionality. Many brokers nowadays do offer options trading, but you should confirm first. You may have to complete additional screening to qualify for options trading, even if you have an existing brokerage account that you're using to trade stocks.
Practice with paper trading
Some brokerages have paper trading functionality, which lets you simulate options trading with pretend money. Or you could look for online tools or track trades on your own as if you were really making them. Doing so helps you get the hang of options trading and see potential pluses and minuses without actually putting money at risk.
Start small
When you're ready to actually start trading options, consider starting small and using basic strategies. You want to gain experience before possibly moving to more complex and potentially riskier investments.
FAQs about options trading
What are the different types of options contracts?
The two main types of options are calls and puts. Buying a call means betting on the price of the underlying security rising, while buying a put means betting on it falling.
How do I determine the value of an option?
In some ways determining the value of an option is like determining the value of a stock, except with an option you're looking at the likelihood of the asset reaching the strike price by the expiration date, known as the time value. You would also look at factors like the intrinsic value of the option, meaning how much you would gain or lose if exercising immediately, and weigh if the premium seems worth the risk.
What are the margin requirements for options trading?
Some brokers have margin requirements for options trading, particularly if selling naked calls or naked puts (not covered by underlying securities or cash). Check with your broker to see what their margin requirements are, but also consider the risk involved with trading on margin in the first place.
