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What is options trading? A beginner’s guide

Want to try your hand at options trading? Here’s what you need to know before you dive in.

An options contract is a financial derivative contract that gives the buyer the right — but not the obligation — to buy (call options) or sell (put options) an asset at a predetermined price within a certain time frame. The upfront cost you pay to buy an options contract is called the premium.

Options buyers aren’t under any obligation

The buyer of the options contract isn’t obligated to exercise the contract, meaning they don’t have to buy or sell the asset, such as stocks, in the contract if they don’t want to. This makes options useful for those willing to let go of some of their stocks gains to get insurance if their investment goes south. But it’s also useful for day traders because options trading requires low capital to get started.

Four main aspects of options contracts

Every options contract has:

  • An expiration date. You can only exercise, or sell, your options contract by the expiration date. Then you lose the right to buy or sell the underlying stock.
  • A strike price. This is the price you pay for the underlying stock — regardless of the market price — should you exercise the option.
  • A premium. The amount you pay to buy the options contract, excluding brokerage fees. The premium varies depending on factors like the asset’s price and the expiration date.
  • A contract. One options contract typically represents 100 shares. So if you buy one call option, you get the right to buy 100 shares at the strike price until the expiration date.

Options trading has two advantages over stocks

When you buy an options contract, the only money you put at risk is the premium. Because of that, options trading can be highly rewarding and reduce the risk of your investment.

Here’s when to consider buying options contracts:

1. Insure your investment

Suppose you buy 100 shares of Company X at $100 per share. That’s $10,000 invested. You believe the share price will continue higher, but there is economic news that may negatively affect your stock price.

To protect your investment, you buy a put option contract for $500. That’s 100 shares x $5 premium per share, an arbitrary number as the premium varies depending on multiple factors. One put option contract gives you the right to sell 100 shares at an agreed-upon price until a certain date. In this case, let’s say the agreed-upon price is $100 per share and the expiration date is 30 days later.

The stock price starts to drop. By the time the contract reaches the expiry date, shares of Company X are worth $70 apiece. Without the options contract, you could have lost $3,000 (100 shares x $70). Luckily, you bought the put option and decide to exercise it. You sell your 100 shares at $100 per share — the agreed-upon price in the contract — instead of the market price of $70.

In this scenario, you’re $500 down for the premium you paid to buy the options contract, instead of $3,000. Not bad.

2. Trade with lower amounts

Call options give you the right but not the obligation to buy shares at a set price. Day traders often use this to control a large number of shares with a low amount of money. This is how it works:

The shares of Company Y cost $100 per share. That’s expensive for you, but you believe the stock price will move higher and you can turn a profit.

You buy one call option, which is the right to buy 100 shares of the company at an agreed price ($100 per share). To buy this options contract, you pay a premium of $500 ($5 x 100 shares). With a $500 investment, you control 100 shares worth $10,000.

A week later, the stock price climbs to $120 per share. To exercise the option, you would need to have $10,000 in your account to buy the 100 shares at the agreed-upon price of $100 per share. Instead of buying the shares, you sell the options contract to another trader at a higher price and pocket the difference between the premium you paid for the option and the price you sold it on the market.

Who is on the other side of the trade?

When you buy a call or a put option, you have the right — but not the obligation — to buy or sell a certain stock. On the other side is a trader, just like you, who is willing to take your risk for a fee.

That fee is the premium you pay. So if you pay a $500 premium to buy a put option, that $500 goes to the trader who sells the options contract.

Unlike the buyer of the options contract, the seller is obligated to buy or sell the shares from the buyer. However, this is only the case if the buyer decides to exercise the option. Whether the option is exercised or not, the seller of the option contract keeps the premium.

Options aren’t without drawbacks

Options trading can be profitable, but there are drawbacks to keep in mind.

It’s hard to get the price right at the exact time

With options trading, you’re not just betting on the stock price; you’re betting on the stock price at a specific time. This means you may be right that the stock price will rise or fall, but getting the when part right is hard.

The premium is nonrefundable

When you buy an options contract, the premium you pay goes to the seller of that contract. Basically, that’s how you pay the other side to take your risk. Whether you’re right about the stock price or not, the premium you pay is non-refundable.

You’ll likely pay a fee

Most brokers charge fees for options trading. This fee is often $0.65 per contract. You may also pay up to $19 for an options exercise fee.

Some platforms, such as Robinhood, offer commission-free options trading. With Robinhood, there are no exercise fees or other options fees.

How to read an options chart

Find the options quotes either on a financial website like Yahoo or Nasdaq or on your trading platform.

For example, to find the options quotes on Yahoo, search the company ticker symbol and select the Options tab. There, you’ll see something like this:

Options chain chart

  • At the top, November 19, 2021, is the expiration date. This is the date your options expire. If you don’t exercise your option or sell it before this date, your options become useless.
  • The left columns are the Call options, and the right columns are the Put options.
  • The middle row — Strike — is the strike price, or the price at which you agreed to execute the options. The lowest strike price is always at the top, while the highest is at the bottom.
  • The Last price column is the premium — the price you pay to buy the option. For example, the $152.50 strike price has a $2.05 call option price and $0.26 put option price. This means it will cost $205 to buy one call option and $26 to buy one put option. Each option equals 100 shares, thus $2.05 x 100 shares equals $205.
  • The Change columns show how the premium changes in real time.
  • The Volume column shows how many options contracts are traded at which strike price. For example, there are 15,841 call options and 11,724 put options traded at the $152.50 strike price.

How to trade options

To trade options, you need a brokerage account. However, most brokers require you to request authorization to access options, especially for advanced options trades. Each brokerage can use its discretion to determine how they approve you for access.

The way you trade options varies between trading platforms. For example, Robinhood has simplified the options trading process through its app, and it may not be the same as with other, larger brokers like TD Ameritrade.

But in general, here’s how it works:

  1. Log in to your account and search for the stock’s ticker symbol.
  2. Select trade options.
  3. Choose either to buy calls or puts. You may have to select the expiration date or strike price first.
  4. Select whether you’re buying the options contract or selling it. This is important.
  5. Enter the number of options contracts you’re buying or selling. One contract equals 100 shares.
  6. Review your order and submit.
Closing your options trades is simple

Exercise your option before the expiry date if the strike price is reached or the market price is beyond the strike price. Do this through your broker’s platform by selecting the option and selecting the exercise option button.

If you don’t exercise the option until the expiry date, the broker will automatically exercise it unless the option is worthless at the time. Note, some brokers let you disable the automatic exercise.

An alternative to exercising the option is to close your contract. The way it works is you select your options contract and select close. This will close your options trade in a loss or a profit depending on the option’s value at the time.

Compare options trading platforms

1 - 6 of 6
Name Product Asset types Stock trade fee Minimum deposit Signup bonus
Tastyworks
Stocks, Options, ETFs, Cryptocurrency
$0
$0
$200 in US stocks
when you open and fund an account with min. $2,000 for 3+ mos.
Trade stocks, options, ETFs and futures on mobile or desktop with this advanced platform.
Robinhood
Stocks, Options, ETFs, Cryptocurrency
$0
$0
Get a free stock
when you open a Robinhood account
Make unlimited commission-free trades in stocks, funds, and options with Robinhood Financial.
Vanguard Personal Advisor
Stocks, Mutual funds, ETFs
$0
$0
N/A
Financial advice powered by relationships, not commissions.
Webull
Stocks, Options, ETFs, Cryptocurrency
$0
$0
Get 6 free stocks valued between $3-$3000
when you open an account and make a deposit of any amount
A beginner-friendly broker that offers paper trading, so you can try the platform before depositing funds.
Gatsby
Stocks, Options
$0
$0
Receive up to 1,000 points
when you open a brokerage account, then fund it with a $5 minimum deposit and complete at least 1 trade
Make commission-free trades for or against companies and ETFs.
TD Ameritrade
Stocks, Bonds, Options, Mutual funds, ETFs, Currencies
$0
or $25 broker-assisted
$0
N/A
TD Ameritrade features $0 commission for online stock trades. Online options fees are $0.65/contract.
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