What is Options Trading?

Options are financial derivatives that give you the right but not the obligation to buy or sell a tradable asset, such as stocks.

In this guide, I explain what you need to know about options trading – from strike prices and premiums to contract expiry dates, calls, puts, and more.

Do you already know what is options trading? Then consider reading my guide to the best options trading platforms May 2023

Key Takeaways

Here are the key takeaways from my beginner’s guide on what is options trading:

Options trading explained

Options are financial derivatives that are popular with traders that wish to speculate on the future price of an asset with leverage. Traders will pay a small fee to enter an options trade, known as the premium. This represents a small fraction of the overall options position.

By purchasing call options, you are speculating on the price of the asset increasing at some point in the future. You will make money if the price of the options surpasses the strike price.

• For example, let’s suppose you buy an options contract on Bank of America stock with a strike price of $35.
• If the call option expires at $40, you make a profit of $5 for each option contract that you hold.

Put options, on the other hand, enable you to go short on the asset. This means that you need the asset to trade below the strike price to make money on the options position.

When trading American-style options, which are offered by many US brokers, you can sell the contracts before the expiration date. This is ideal for risk-management, as you can lock in your trading profits at any given time.

Options are becoming popular with retail traders in the US and most online brokers now offer access to this market at 0% commission. In many ways, options trading is a low-risk, high-upside market way to generate income, considering that you can only lose the premium on an unsuccessful trade.

When trading calls, there is no limit on how much you can make. This is because the profit aspect of options trading is the difference between the strike price and the price of the asset when the position is closed, this is known as the intrinsic value..

Puts do come with limited upside, considering that the price of an asset can only drop to $0.

How options trading works

The different types of options

Options trading entails predicting whether you believe the underlying stock or asset will increase or decrease in value, on or before the contract expiry date.

• If you buy call options, you are going long on the asset.
• If you are buying put options, you are going short.

It is also possible to sell both calls and puts, but this is a highly risky strategy that does not limit your losses to the premium paid. Therefore, as a beginner, it is best to remain a buyer in this market.

In doing so, you will have the right, but not the obligation to purchase or sell the underlying asset when the contracts expire.

This means that if the options expire above or below your target price (depending on whether you are long or short), then you will only lose the premium.

In terms of markets, most options traders focus on US-listed stocks with a large market capitalization. This ensures that there is plenty of liquidity and trading volume on offer. It is also possible to trade options contracts for commodities, indices, currencies, and more.

How to read a stock option quote

This is the price that your options trade will need to surpass to make a profit.

• If you are going long through call options, then the asset needs to close above the strike price on or before expiry.
• If you are short through put options, then it needs to sit below the target price.

To enter an options trade, you need to pay a non-refundable fee known as the premium. The size of the premium will depend on the probability of the options trade landing above or below the strike price.

• With that said, you won’t need to pay the full price of the options contract upfront, as the premium is similar to margin trading.
• For instance, if you are buying 10 stock options worth $1,000 collectively, you might only need to pay a premium of 10%, or $100.

This means that even retail clients in the US can trade options with high levels of leverage.

All information surrounding strike prices and premiums are provided by brokers via an options chain.

This displays real-time pricing for both calls and puts across various strike prices and expiry dates.

Pick which options to buy or sell

For instance, let’s say you are looking to trade options on PayPal stock. The current stock price of Paypal is $75 and the options have a three-month expiry.

The call premiums quoted on the options chain for each strike price (SP) might look something like this:

• $80 Strike Price : $16 premium
• $90 Strike Price: $11 premium
• $100 Strike Price: $7 premium

As per the above, an $80 strike price on PayPal stock options requires a premium of $16 per contract. But a $90 strike price only requires a premium of $11.

The reason for this is that there is a greater probability of the PayPal stock price surpassing $80 before the contracts expire in three months, when compared to $90. Therefore, lower premiums are available when there is less chance of the options trade landing in the money (ITM).

This is also the case for put options, but in reverse. For instance, you would pay a higher premium for PayPal stock closing below $70 then you would on a strike price of $60.

Calculating profits and losses

You will, however, also need to factor in the premium.

I will break this down in more detail through a simplified example:

• Let’s suppose that you are looking to trade Wells Fargo stock, which is currently priced at $45 per share
• You believe that the Wells Fargo stock price will be at least $50 in a month’s time
• The premium on a strike price of $50 is $6 per contract
• So you purchase 100 call options with a one-month expiry date
• When the contracts expire, Wells Fargo stock price is $65
• You make gross gains of $15 per contract, considering the strike price of $50
• But you also need to subtract the $6 premium that you paid, so that’s a net gain of $9 per options contract
• You purchased 100 call options, so you made a total profit of $900

As per the above, the break even point of a call options trade is the strike price plus the premium paid. In this example, you would have needed Wells Fargo stock to close at $56 ($50 SP plus $6 premium) to break even.

When purchasing put options, you would need to subtract the premium from the strike price to ascertain the break even point.

Not every options trade will go to plan.

• For example, let’s say that Wells Fargo stock closed at $42 per share when the options contracts expired.
• This means that you are $14 short of the break even point stock price $56, taking into account the premium.
• In this scenario, you would still only lose the $6 premium that you paid for each contract purchased.

While this might not sound like a lot, the total loss will invariably depend on how many contracts you bought.

Nevertheless, limited downside risk is one of the most appealing aspects of option trading.

What does exercising an option mean?

This will be at the strike price that you opened the trade at and not the price of the stock on the date of expiry.

• For example, let’s say that Johnson & Johnson stock options expire at $150 per share.
• You have options contracts at a SP of $120 per share and you paid a premium of $5 per contract.
• In this example, you will exercise your right to purchase Johnson & Johnson stock at $120, as opposed to $150.
• This means that after the $5 premium, you are purchasing the stock at a discount of $25.
• You are then effectively selling the stock at the current price, meaning an upside of $25 per contract

With that said, if Johnson & Johnson stock closes at $115 upon expiry, this is below the strike price.

Therefore, you will not exercise your right to buy the stock, as you will be paying more than the current market value. In this scenario, you simply lose the $5 premium that you paid to enter the options trade.

Advantages and risks of trading options

Options are just one way of stock trading and trading other assets.

As such, you will need to determine whether options are right for you by considering the advantages and risks of this derivative product.

Advantages

One of the main advantages of options trading is that your risk is limited to the premium.

As I briefly noted earlier, this is only the case when buying calls or puts. If, however, you are selling calls or puts, then your downside can exceed the premium paid.

Nonetheless, the premium is often just a small percentage of the contract value. This enables you to trade with much higher levels of leverage when compared to conventional margin trading.

• For example, you will only need to pay a premium of $5.05 to buy Amazon stock calls as of writing, on a SP of $100.
• This means that you are only required to put up a margin of 5.05% to enter the position.
• In other words, you are getting leverage of nearly 20x.
• And, if Amazon stock does not surpass the SP of $100, you will only lose the $5.05 premium.

Another benefit of options is that you can trade asset classes that would otherwise be challenging to access. This includes commodities like gold, silver, oil, natural gas, and corn. Options can also be traded on currencies and indices.

Risks

Options trading also comes with risks. For instance, on the one hand, you can only lose the premium when purchasing calls and puts. But you will still lose money if the trade is unsuccessful. Too many losing trades can have a major impact on your trading capital.

Call and put options writers face even more risk, as they are selling the right to purchase or sell the respective asset. As noted above, this means that options writers can lose significantly more than the premium.

Another risk to consider is that trading options too frequently might put you in the ‘pattern day trader’ bracket.

This will happen if you trade more than four times in a five-day period via your brokerage account. Not only options, but any asset class.

Pattern day traders need to have at least $25,000 in their margin account, so do bear this in mind.

Why trade options?

Lack of access to capital

Casual traders on a budget might only have access to a small amount of trading capital. This will limit the trader’s ability to make suitable investment gains.

But by trading options, those on a budget can turn a few hundred dollars into many thousands. This is because the trader only needs to pay the premium.

In other words, it is possible to make sizable gains from a successful options trade even if the initial capital outlay is small.

Bullish and bearish markets

By investing in the stock market in the traditional sense, you will only make money if the price of the shares increase.

However, options offer a lot more flexibility as you can attempt to profit from both rising and falling stock prices.

• If you believe a stock will rise, you can purchase calls.
• If you believe a stock decline is likely, you can purchase puts.

Short-selling a stock via put options is a lot more budget-friendly when compared to borrowing shares from a broker. The traditional route requires traders to put up a margin of 150%.

This means that for every $1,000 in short-selling positions, $1,500 needs to be kept in your margin brokerage account.

Puts, on the other hand, only require a small premium to speculate on the price of a stock declining.

Time flexibility

Options trading enables you to enter and exit positions in a flexible environment. For instance, short-term traders can purchase call or put options with a one or three-month expiry date.

But longer-term traders are catered for too. This is because stock options can be purchased with an expiry date of up to two years ahead.

It is also important to remember that American-style options enable you to offload the contracts before the expiry date. This means that you do not need to wait until the contracts expire to lock in your gains.

This is also the case should you wish to cut your losses and recoup some of the premium that you paid to enter the options trade.

Do note that some online brokers also offer European-style options. These cannot be offloaded before the expiry date, which in many ways increases the risk exposure.

On the flip side, European-style options often come with more competitive prices, especially premiums.

Ideal for hedging

Another benefit of options trading is that this market is ideal for hedging. Put simply, hedging is a strategy that enables you to offset an identified risk.

For example, let’s say that you are holding Exxon Mobil stock but you are concerned at growing rumors of a dividend cut. In this instance, you could purchase put options.

• This means that if Exxon Mobil does announce a dividend cut and the stock’s price subsequently declines, you will make money from your put options trade.
• And equally, you will lose money from your original Exxon Mobil stock position.
• This means that the outcome is neither a net gain nor loss.

You can also hedge an existing options position. For instance, if you already have calls on a stock you could also purchase puts to hedge the trade.

Is options trading better than stocks?

The case for stocks

For instance, if you are a casual trader that is looking to build a long-term portfolio for your retirement years, then trading stocks on the stock market will likely be the better option.

You won’t need to actively monitor the markets like you do with options, and you can ride out short-term volatility by holding long-term.

Stocks also enable you to benefit from a more consistent dividend strategy. This is especially the case when investing in dividend aristocrats and kings.

Stocks are also suited for investors with limited experience, as you won’t need any knowledge of complex terms like options strike prices, expiry dates, or premiums.

The case for options

On the other hand, options may be more suitable for your financial goals if you have prior experience in short-term research principals.

Options trading may also be right for you if you have limited capital and wish to enter larger positions. In this sense, the upside potential on options will always be higher than traditional stocks.

You will also know exactly how much you stand to lose when trading options, which in itself is a risk-management practice.

Options trading will also be suitable if you wish to engage in short-selling. After all, you won’t need to cover a huge margin requirement of 150% like you do when borrowing stocks from a broker.

Conclusion

I also found that options trading is popular for limiting risk. This is because when purchasing calls or puts, you can only lose the initial premium.

With that said, options trading is not a beginner-friendly investment scene, so you should ensure that you have a firm grasp of the risks before proceeding.