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What is options trading and how does it work?

Use options trading for speculation, income generation or hedging against market risks.

If you’re new to investing and curious about options trading, you’re in the right place. Options trading can seem complex at first, but with the right guidance, you can navigate this financial strategy effectively and make informed decisions about your investments.

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Simplify your investment journey on a single, secure platform. Discover a world of stocks, ETFs, treasuries, crypto, collectibles, and royalties.

  • Invest in stocks, bonds, options, crypto, ETFs and alternative assets in one place, with a high-yield cash account for your uninvested cash.
  • Earn a rebate on every options contract traded, with no commissions or per-contract fees.
  • No payment for order flow (PFOF) on equities, ensuring optimal price execution for your trades.
  • Get up to $10,000 and transfer fees covered when you move your portfolio to Public.

What is options trading?

Options are financial contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. (1)

When it comes to options trading, there are two main parties involved: the option buyer, also known as the option holder, and the option seller, also known as the option writer. Option buyers pay a premium for the right, but not the obligation, to buy or sell the underlying asset. Meanwhile, sellers receive the premium as compensation for the risks they assume by providing the options contract. One risk includes potentially fulfilling the obligation to either buy or sell the underlying security at the strike price if the buyer exercises the option.

Options are derivatives, meaning their value is derived from underlying assets, such as stocks, indexes and exchange-traded funds (ETFs). This versatile tool can be used for speculation, income generation or hedging against market risks. However, holding an option does not mean ownership of the underlying asset or entitle the holder to dividends.

How does options trading work?

Options trading revolves around contracts that give holders the right to buy or sell an asset at a set price on or before a specified expiration date. To understand how options trading works, it’s important to know the types of options and a few key terms.

Types of options

There are two main types of options: call options and put options. Traders can build various strategies and combinations upon these options to achieve different investment objectives.

Call options
Call options give you the right to buy the underlying asset at a predetermined price, known as the strike price, within a certain period. For index options, they offer the right to buy the value of the underlying index. If the asset’s market price rises above the strike price, the option holder can exercise the right to buy the asset at the lower strike price. They could then turn around and sell it at the higher market price and make a profit.

Think of a call option as a coupon that lets you buy an asset at a set price. If the asset’s price goes up, you can use the coupon to buy it at the cheaper, set price. If the asset’s price doesn’t go up, you don’t have to use the coupon. You only lose the small amount you paid for the coupon.

In exchange for the premium paid by the holder, the seller of a call option agrees to sell the stock, or the value of the underlying asset, at the agreed-upon strike price if the option is exercised. (2)

Call option example
Say you buy a call option on a stock with a strike price of $50 and the stock price rises to $60 before the option’s expiration date. You can exercise the option to buy the stock at $50, even though it’s trading at $60. You can then sell the stock at $60 and profit $10. Alternatively, you can sell the option contract without ever exercising the option and receiving the underlying stock, since the option’s price increases as it gets further “in the money.”(3) A call option is in-the-money if the strike price is below the actual stock price.

Put options
A put option gives the holder the right to sell the asset at the strike price within a certain period. If the market price falls below the strike price, the holder can sell the asset at the higher strike price and profit from the difference minus the premium paid for the put option. The seller of the option receives a premium for taking on the obligation to buy the asset if the holder exercises their right to sell. A put option can act as an insurance policy that protects your investment from big drops in value.

Put option example
Say you own 100 shares of a stock and buy a put option with a strike price of $20. If the stock price drops to $10 before the option’s expiration date, you can exercise the option to sell your 100 shares for $20 per share. If you don’t own any of the underlying stock, the option contract you own has still gone up in value because the security’s price is less than the strike price, so you can also sell the option contract for a gain.

Key options terms

  • Strike price. The predetermined price at which the asset can be bought or sold.
  • Premium. The price paid for the option contract.
  • Expiration date. The deadline for exercising the option.
  • Exercise. Using the option to buy or sell the underlying asset.
  • At-the-money. The option’s strike price equals the current market price of the underlying asset.
  • In-the-money. When the underlying asset’s market price exceeds the call option’s strike price or is below the strike price of a put.
  • Out-of-the-money. The underlying asset’s market price is below the call option’s strike price or is above the put’s strike price.

Options trading levels

Options trading is categorized into beginner, intermediate and advanced strategies. Think of them as different levels, each allowing for progressively more complex strategies and transactions. Options trading levels can vary by broker, but here’s an overview of what those levels might involve in terms of complexity:

  • Level 1. The most basic level, allowing traders to buy and sell covered calls and protective puts. Covered calls are where you sell call options on stocks you own. Protective puts involve buying put options on an asset you own. This level is generally for beginners with limited trading experience, as it involves relatively low risk because the options are backed by owned shares.
  • Level 2. Includes all Level 1 strategies, plus the ability to purchase options contracts, such as calls and puts. Risk is limited to the price paid for the contract.
  • Level 3. Includes all Level 1 and 2 strategies, plus more complex strategies like straddles and debit spreads, which involve multiple options contracts. This level requires more capital and the use of a margin account.
  • Level 4. Includes Level 1, 2 and 3 strategies, plus naked options trading, where the seller does not own the underlying asset. This level carries the potential for unlimited losses if the market moves against the seller, but it also offers the possibility of higher returns, as traders can sell options without hedging.
  • Level 5. The most advanced and riskiest level, Level 5 permits uncovered writing of index options and straddles.(4)

How options are priced

Options prices are determined by a few main components, as shown by the Black-Scholes model published in 1973:(5)

  • Intrinsic value. The difference between the current price of the underlying asset and the strike price. For example, if a call option has an intrinsic value of $5, it means the stock is trading $5 above the strike price.
  • Time value. The amount of time remaining until the option expires, influencing its potential for profitability. As expiration approaches, the time value decreases.
  • Volatility. The measure of the underlying asset’s price swings. Higher volatility often leads to higher option premiums.

Advantages and disadvantages of options trading

Options trading offers several advantages and disadvantages:

Advantages

  • Leverage. Options allow for amplified returns with a smaller upfront investment.
  • Income generation. Strategies like covered calls can generate consistent income, but no strategy is risk-free.
  • Risk management. Options can be used to hedge against market volatility.
  • Limited downside for buyers. The maximum loss for options buyers is capped at the premium paid.(6)

Disadvantages

  • Complexity. Options trading can be intricate, requiring a thorough understanding of various strategies.
  • Costs. Transaction costs and bid-ask spreads can erode profits.
  • Unlimited risk for sellers. Selling call options can lead to unlimited losses because there’s no cap on how high the stock price can rise. Selling put options, however, has a maximum loss limited to the strike price of the stock, since the worst-case scenario is the stock price dropping to zero.

Bottom Line

Options trading presents opportunities for both profit and risk. By understanding the basics and considering your objectives and risk tolerance, you can make informed decisions in your investment journey. If you’re interested in trading options, start small, educate yourself continuously and always consider seeking professional advice when needed.

Frequently asked questions

What time do options start and stop trading?

Options typically start trading at the market open and stop trading at the market close, usually from 9:30 a.m. to 4:00 p.m. ET for US exchanges. Some options also trade in after-hours sessions depending on the exchange and the underlying asset.

How much can you make trading options?

The potential profits from options trading vary widely and depend on the strategy used, market conditions and the amount of capital invested. While options can offer substantial returns, they also carry the risk of significant losses.

Is options trading better than stocks?

Whether options trading is better than stocks depends on your investment goals, risk tolerance and market knowledge. Options provide flexibility and leverage but also come with higher complexity and risk.

Is options trading for beginners?

Options trading can be suitable for beginners if they take the time to learn the basics, start with simple strategies and use risk management techniques. Before committing significant capital, beginners should gain experience with simulated trading or small investments.

Can you avoid taxes on options trading?

Options trading is subject to capital gains taxes, but strategies like tax-loss harvesting can help minimize tax liabilities. Consulting with a tax advisor can provide specific guidance tailored to your trading activities and financial situation.

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