Options trading allows you to earn income in down markets, protect your portfolio and even speculate on price movements of various asset classes. But given the complexity of trading, these products are risky and better suited to sophisticated investors, so read on to make sure you know how they work.
How to trade options in 5 steps
To start trading options in
the US, you'll need to have a broker, a trading strategy and some form of identification. You may also need to undergo a competency test.
1. Find a trading platform
You'll need to sign up to a stock broker that offers options trading. You can compare popular brokers in the table below. To open an options trading account, you'll need:
To be 18 years or over and a resident in
the US.
Have basic information with you – the broker will usually ask you to prove who you are before signing up.
Be able to pass an options trading assessment. Before you can trade options, you'll need to show the broker you have some understanding of how they work.
Before signing up you'll need to decide whether you want to trade American-listed stock options or options from overseas markets as many platforms offer one or the other. Although less common, it's also possible to trade options on other types of securities, such as commodities, indices, futures and forex.
Once you know what you want to trade, you can more easily compare the fees, features and trading tools to find the best broker for you.
Here are some factors to consider when selecting a platform:
Fees: Find an options broker that offers low commissions and contract fees.
Markets: Ensure that the platform has access to the markets you're interested in trading. For instance, some brokers offer US stock options and others feature options listed in other overseas markets.
Assets: Make sure the platform offers the assets you want to trade options with, such as stocks, indexes, commodities, futures and ETFs.
Educational Resources: Look for a platform that provides educational resources, such as webinars and articles, to improve your trading skills.
Security: Check that the platform is authorized by your local regulator, has a solid track record and has robust security measures in place to protect your personal and financial information.
Customer Support: Choose a platform with responsive customer support that can assist you with any trading-related issues.
User Interface: Choose a platform with an intuitive and user-friendly interface to save time and prevent confusion when trading options.
2. Have a plan
To trade options successfully, it's crucial to have clear investment objectives and a plan in place. Consider what options you want to trade, how much you want to invest, which strategies to use, and your risk tolerance.
Remember that options trading is riskier than passive investing, so it may not be suitable for more conservative investors. Despite the potential for large returns, statistically speaking, trading options is more likely to result in losses.
Knowing your end goal will help to inform which options trading strategy you use, including your entry and exit strategies and the assets you select. For instance, are you hoping to make a profit by speculating on asset price volatility? Or are you intending to use options to hedge against falling prices of stocks you already own? Perhaps you're trying to build up a passive income? These goals require very different strategies and planning.
Once you know all this, you can start to decide which assets to focus on and how you'll be trading them.
Regardless of your approach, research becomes a critical part when trading options. A good place to start in researching stock options is company fundamentals and financial information, volatility levels, upcoming events and company announcements. Besides company-related updates, you'll also need to stay on top of business news and macro conditions. Both will have an impact on the future prices of stocks.
The following questions will help to inform your trading plan:
What's my risk tolerance and how much I can afford lose?
What's my entry and exit strategy?
What's my overall investment objective?
3. Select your options contract
Once you've decided which company stock or other asset you want to trade (called the underlying asset), you'll need to select your contract.
Every contract has a different expiration date, strike price and option type, so you'll need to decide all of these factors when choosing.
The expiration date is the date on which the options contract expires. After this date, the contract is no longer valid and the option either becomes worthless or is exercised by the holder, meaning the underlying asset is bought or sold.
The strike price is the price at which the underlying security can be bought or sold when the option is exercised. This price is predetermined and is stated in the options contract. For example, if you buy a call option with a strike price of $150 on Apple stock, you have the right to buy Apple stock at $150 per stock before the expiration date.
Finally, the option type refers to whether you want to buy or sell a call option or a put option. A call option gives you the right (but not the obligation) to buy the underlying security at the strike price, while a put option gives you the right to sell the underlying security at the strike price.
Which contract type you pair with your chosen asset depends on how you think that asset will perform.
Generally speaking, if you think the asset's price will rise, you should buy a call option or sell a put. Alternatively, if you predict the stock or market price will fall, you should buy a put option (also called shorting) or sell a call option.
US options contracts usually expire on the third Friday of the month, but there may be weekly or monthly expiration dates available for some contracts.
4. Fund your account
Before placing your trade, you'll need to top up your account with enough funds.
Depending on who you sign up with, there's usually a few ways to fund your account, including direct deposit, via a credit card, PayPal or even BPAY.
You can usually fund your account by following the prompts in your broker's account.
If you're using leverage, keep in mind that you'll need enough funds to cover potential losses, which may be greater than your initial trade amount.
There's also usually a minimum amount required when trading options. This will vary from broker to broker but generally speaking, you'll need to start with at least $1,000.
5. Place your trade
After you've chosen your contract and funded your account, it's time to execute your buy or sell trade.
First, you need to decide on the price at which you want to enter the trade, known as the premium. This is the price you're willing to pay the seller for the contract or the price you're willing to accept if selling. It's influenced by factors such as the current market price of the underlying security, implied volatility, the expiration date and other market factors.
You also need to consider the premium that the market is currently offering for the options contract. This market premium is set by the bid-ask spread, which is the difference between the highest price a buyer is willing to pay for the option (the bid price) and the lowest price a seller is willing to accept (the ask price).
Did you know?
The strike price of an option is the price you can buy or sell the underlying security, at the time when the option is exercised. It does not change. Meanwhile, the spot price is the current market price of the underlying asset
Then there's the time frame. In traditional trading of assets, you're looking to buy and hold over the long-term. In options, it's the opposite – the shorter the time, the better. This is because the closer an option gets to its expiry date, the less it is worth. As such, you're looking for sharp movements of the underlying asset in a short period.
Once you have determined the price, it's time to place your order. You can choose between a market order or a limit order.
A limit order allows you to set the maximum price you are willing to pay (if buying) or the minimum price you are willing to receive (if selling) for the option. A market order will execute at the current market price, which may result in paying a higher premium than you initially intended due to the bid-ask spread.
What is an option?
An option is an agreement between 2 parties to enter into a contract that gives the owner the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon strike price before an unspecified date.
Options contracts are derivatives investments, which means you're exchanging contracts rather than buying and selling physical assets. There's always an underlying asset attached to the contract, such as stocks or commodities, which is how a price is determined.
You can trade different financial products through options, including the following:
Stocks and shares
ETFs
Currencies
Indices
Bonds
Similar to trading stocks, you'll profit based on the difference in the contract's price from the day you enter the contract to its future price.
Options listed on overseas markets are also possible to trade from
the US, depending on the platform you use.
Options vs stock trading
At this point, you might be asking yourself, why not just buy stocks or commodities? While there are various reasons to trade options over buying stocks, most investors trade options for the following reasons:
Options can amplify profits using leverage
They can protect stocks from loss
They can provide extra income from stocks
They allow you to speculate/make money in a falling market
They can be a lower-cost way to invest
They allow investors to have more flexible or complex strategies
On the downside, trading options is usually much riskier than directly buying or selling stocks. While buying stocks is a relatively simple process, options trading can be complicated and has a greater chance of miscalculation leading to loss.
Options traders also typically use leverage which means they can enter a large trade with a small amount of initial capital. While this can amplify profits, it will also amplify losses if the trade goes against the trader.
While investing in the stock market directly is suitable for investors of any level of experience, options trading is best suited to more experienced traders.
The 2 main participants in an options contract are the "buyer", who is the person that purchases the contract, and the seller of the contract, dubbed the "writer".
There are 2 types of options that you can either buy or write. A call option gives its buyer the choice to purchase stocks from its writer at a specific price (the "strike price") before a set time (the "expiry date"). A put option is the opposite, where the buyer enters a contract to sell the stocks to the writer at a set price within a specific time frame.
The buyer of a call option is hoping that the underlying stocks will rise in price, while the put option buyer is betting that prices will fall. The writers of the contract are hoping for the opposite.
Remember that the buyer of the contract has the right to buy or sell the underlying stock as laid out in the contract (called exercising) but is not actually required to do so.
If the option is not exercised, it will expire worthless on the expiration date. If the option is exercised, the buyer of the option will either buy or sell the underlying asset at the agreed-upon price. If the trader is holding a short option position that is exercised, they will need to fulfill the obligation to buy or sell the underlying asset.
Example: If a trader buys a call option on a stock with a strike price of $50 and the stock price rises to $60, the trader can exercised the option and buy the stock at $50, then sell it at the market price of $60, realising a profit of $10 per stock.
Types of options
The 2 main types of options contracts are call options and put options.
Call options
Buying call options gives you the right to buy an asset at a predetermined price within a specific time frame. Selling call options obligates you to sell your assets to the buyer of the option if they exercised their option.
Day traders often use call options to control multiple stocks with a low amount of money.
Example: How it works if you buy call options:
Company X stocks currently trade at $100 per stock. That's expensive for you, but you believe the stock price will move higher and you can turn a profit.
You buy 1 call option, which is the right to buy 100 stocks of the company at an agreed upon price ($100 per stock). To buy this options contract, you pay a premium of $500 ($5 x 100 stocks). With a $500 investment, you control 100 stocks worth $10,000.
A week later, the stock price climbs to $120 per stock. To exercised the option, you would need to have $10,000 in your account to buy the 100 stocks at the agreed-upon price of $100 each.
Instead of buying the stocks, you sell the options contract to another trader for a higher price than what you paid and pocket the difference between the premium you paid for the option and the price for which you sold it on the market.
Put options
Buying put options gives you the right to sell an asset at a predetermined price within a specific time frame. These are the opposite of call options.
Put options are often used to insure your investment.
Example: How it works if you buy put options:
Suppose you buy 100 stocks of Company X at $100 per stock. That's $10,000 invested. You believe the stock price will continue higher, but there's economic news that may negatively affect your stock price.
To protect your investment, you buy a put option contract for $500. That's 100 stocks x $5 premium per stock, an arbitrary number as the premium varies depending on multiple factors.
One put option contract gives you the right to sell 100 stocks at an agreed-upon price until a specific date. In this case, let's say the agreed-upon price is $100 per stock and the expiration date is 30 days later.
The stock price starts to drop. By the time the contract reaches the expiry date, Company X stocks are worth $70 apiece. Without the options contract, you could have lost $3,000 (100 stocks x $30).
Luckily, you bought the put option and decided to exercised it. You sell your 100 stocks for $100 each – 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. Much better.
American vs European options
There are 2 main styles of options contracts: American style and European style options. While American style options are more common around the world, both types of contracts tend to exist in any one market.
American style options: American style options can be exercised by the buyer at any time prior to the expiration date. This gives the buyer more flexibility in terms of when they can choose to exercised their option.
European style options: European style options can only be exercised by the buyer on the expiration date. This means the buyer has less flexibility in terms of when they can choose to exercise their option.
There are also other less common styles of options contracts, including:
Bermuda style options: Bermuda style options can be exercised at certain specified dates prior to the expiration date. This gives the buyer some flexibility in terms of when they can choose to exercise their option.
Asian style options: Asian style options are settled based on the average price of the underlying asset over a specified period rather than the price at the expiration date.
It's important to understand the different styles of options contracts because the style can impact the price and the timing of when the option can be exercised, which can affect the potential profitability of the trade.
If you trade options, you'll face a number of different fees, depending on what you trade and where you trade them.
Keep an eye out for:
Broker commissions: These are basically paying for a trade to be executed or any investment advice. Depending on the broker, sometimes these fees are waived.
Contract fee: Charged by brokers when an options contract is exercised or assigned. This fee is typically charged per contract and can vary depending on the broker and the exchange where the option is traded.
Platform fees: You can be charged numerous fees for using the trading platform.
Exchange fees: These fees are usually charged when you trade in a foreign currency. You will pay a small percentage to transfer into and out of the foreign currency.
Many of these fees are a fraction of a cent, but given you will be charged them, it is best to take note of what you're paying to the broker.
Options trading risks and disadvantages
Options trading isn't suitable for everyone and has the following drawbacks to keep in mind.
Market volatility: Options trading can be particularly risky in volatile markets, where sudden price movements can lead to significant losses or gains. Even if the underlying asset moves in the direction predicted, volatility can result in the option expiring out of the money, which means it loses its value.
It's hard to get the price right at the exact time. With options trading, you're not only 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 being correct about when is hard.
The premium is non-refundable. When you buy an options contract, the premium you pay goes to the seller of that contract. 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 under $1–$1.50 per contract. You may also pay up to $19 for an options exercise fee.
Leverage: Options trading involves leverage, which means that traders can control a large amount of the underlying asset for a relatively small upfront investment. While leverage can amplify profits, it can also amplify losses.
Complexity: Options trading can be complex. Traders need to understand the various strategies and trading techniques to be successful. A lack of understanding can lead to mistakes and losses.
Bottom line
Options trading comes with rewards and opportunities, but it also has increasing risks and it can be difficult for newer investors to grasp the concepts behind them.
While options trading gives you the right but not the obligation to own the underlying asset, you are trading with leverage, which should be left to sophisticated investors.
Options trading is the process of buying and selling options contracts.
Buying options gives the buyer the right – but not the obligation – to buy or sell an asset.
Selling options obligates the seller to buy or sell assets from the options buyer.
The minimum you will need to trade depends greatly on who you sign up with. Some brokers will allow you to start trading options from $1,000 while others will require more than $10,000 before you can trade.
Stock option contracts typically are packaged in 100 stock allotments, but in some cases you can trade "mini options" which are designed for retail investors and often have less than 100 stocks.
Cameron Micallef is an investments writer for Finder. He has previously worked on titles including Smart Property Investment, nestegg and Investor Daily, reporting across superannuation, property and investments. Cameron has a Bachelor of Communication and Media Studies/ Commerce from the University of Wollongong. Outside of work Cameron is passionate about all things sports and travel.
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