Options Trading: What It Is And How To Get Started

When it comes to investing, you’re not limited to simply buying a stock or asset at its current market price. Another way to invest is through options trading. By using options, you can minimize your investment risks or earn a profit by accurately predicting whether the price of a stock or asset will go up or down in the future.

Although you can benefit from using options, like all investment products, they come with risks. Before you start using them, learn what those risks are and how they work to decide if options trading is right for you.

What Are Options?

In finance, an option is a type of contract that gives you the right (not obligation) to sell or buy a security or asset at a certain price in the future. Like other forms of derivatives, its value is based on the change in price or volatility of the underlying security or asset.

An option is different from employee stock options in that you aren’t granted the option to buy a specific stock from a company. Instead, you decide what options you want to buy.

Options Contracts

When you buy an options contract, it gives you the right to buy or sell an asset at a future date for a specified price. Here are four key terms you should know when purchasing an options contract.

• Strike price: The strike price is what you can buy or sell the option for in the future. For example, if you purchase an option that gives you the right to sell a stock for $50 in the future, $50 is the strike price.
• Premium: Your premium is the amount you pay upfront to purchase an options contract.
• Expiration date: This is the final date you can exercise – buy or sell – the underlying stock or asset.
• Number of shares: When you buy an options contract for a stock, the number of shares included in the contract is usually 100.

American Vs. European Options

Two of the most common types of options are American and European. Although they operate similarly, they have different restrictions on when the contract can be executed.

• European-style option: When you purchase this type of option, you can only buy or sell the underlying asset on your contract’s expiration date.
• American-style option: You’re allowed to buy or sell the underlying asset any time prior to or on the contract’s expiration date.

Calls Vs. Puts

Calls and puts are how investors make wagers on whether a stock or security is going up or down. One gives you the right to buy an asset at a certain price at a later date, while the other gives you the right to sell an asset for a certain price at a later date.

Call Options

A call option is a contract that gives you the right to buy an asset at a specific price in the future. If you believe a stock price is going up in the future, you can check with your brokerage firm to see if you can buy a call option on the stock.

For example, let’s say you believe the price of ABC stock will be higher than $10 per share in 3 months. While you could purchase 100 shares of the stock for $1,000, you decide to purchase a $10 call option at a $1 premium for a total amount of $100 ($1 x number of shares).

After purchasing the options contract, the ABC’s stock price increases to $20 per share before the option expires. If you decide exercise your right to purchase 100 shares for $10 apiece, you essentially purchase the stock at a discount of $900 (100 shares x $10 profit share - $100). This would be a return of 900%.

If you didn’t want to purchase the underlying stock, you could sell your options contract for $10 and still earn a profit of $900 ($10 increase in price - $1 premium = 9 x 100 shares).

Alternatively, if you were wrong and the price of ABC stock decreased to $2 per share, you could simply let it expire. Your loss would be $100 – the total amount you paid for the options contract.

Put Options

Put options give you the right to sell an asset at a specific price in the future. If you want to bet on a stock’s price going down, you could buy a put option through your stockbroker. Similar to call options, you could also sell your put options.

For example, let’s say you believe XY stock that’s currently trading at $30 per share will go down in 3 months, and you purchase a put options contract for 100 shares with a $30 strike price for a $1 premium ($100 total). If the price of the stock falls below the strike price before its expiration date, you could earn a profit.

Let’s pretend XY’s share price falls to $10 per share and you decide to execute the contract. In this scenario, you could earn $20 per share. When you account for the premium fee of $100, your potential profits would be $1,900 ($2,000 - $100).

How To Trade Options

If you’ve decided that options trading is right for you, follow these steps to get started.

Open A Brokerage Account

To start trading options, you must open a brokerage account (if you don’t have one). You can open one by downloading an investment app, applying online or visiting a brokerage in person. When doing your research, be sure to look at the fees, if any, a brokerage may charge you for trading options. These fees can reduce your potential earnings from options trading.

Once you find a brokerage, you’ll be asked to connect your checking or savings account to fund any future investments. Before you trade options, you must transfer funds from one of your bank accounts to the brokerage firm.

Understand The Greeks

The Greeks are measurements of risk based on mathematical formulas. They measure how sensitive the price of an option may be as certain variables change, such as the underlying value and volatility of an asset, how close the options contract is to its expiration date and interest rates.

When trading options, you can use the Greeks to help you predict how likely an option is to earn or lose you money. Although using the Greeks doesn’t guarantee you’ll earn money, it can help you make a more informed investment decision.

• Delta: Delta measures how much an options price may change after the underlying asset moves $1. For example, if the options contract has delta of .20, this means the price of your option could increase by $.20 if the underlying asset increases $1 in price.
• Gamma: The delta of an option also fluctuates when the underlying asset moves. Gamma is used to measure how much the delta changes when the underlying asset moves $1.
• Theta: When trading options, as you get closer to the options expiration date, the value of your option tends to decay or decrease. Theta is used to help you quantify how much it will decrease in value as each day passes.
• Vega: Vega is used to measure how the price of an option will change after its underlying asset experiences a 1% change in volatility. When it increases, the value of an option typically increases. Conversely, as it decreases, the value of an option typically decreases.
• Rho: Option prices may be impacted by changes in interest rates. Rho measures how much the price could change after interest rate changes by 1%. In the United States, rho is usually based on the U.S. treasury bill’s interest rate.

Determine Your Strategy

When it comes to using options, there are several options trading strategies you can use to generate income or minimize your investment portfolio’s risk. Here are some of the most common strategies:

• Options spreads: This strategy involves buying or selling two or more options (calls or puts) on the same underlying stock to diversify your risks or bet on different price outcomes.
• Hedging: To reduce your losses, you can take a different position in an asset. For example, to limit your downside of owning a certain stock, you could take out a put option that allows you to sell the stock at a minimum price.
• Income: If your goal is to generate income from options, you can sell or write an options contract to collect the premium.
• Speculation: By purchasing an options contract, you can earn a profit by speculating whether a certain stock’s price will go up or down. 

Options Vs. Other Financial Strategies

If options aren’t right for you, you can choose some other investment strategies. For example, you could simply purchase the underlying stock instead or purchase futures. Like options, other strategies come with their own pros and cons.

Options Vs. Stocks

Buying stocks are different from buying options in that you commit to executing the purchase upfront. If you want to purchase X stock, you pay its current market price. There is no expiration date - you can hold the stock for as long as you wish.

A pro of purchasing a stock instead of an option is that it can be less risky since you’re limited to losing your initial investment. With options, although the upfront price may be cheaper, your potential losses can be unlimited. If you sell a call (the right to buy at a certain price) and the price keeps going up, your losses are indefinite.

Options Vs. Futures

When you use options, you aren’t required to execute the contract. By contrast, futures require a buyer or seller to purchase an asset at a specific date in the future, regardless of its market value. Futures are riskier than options because you don’t have the option to let the contract expire if the price of the asset plummets.

Are Options Right For You?

Before you use options trading, you should weigh the benefits against the risks.

Pros

Using options trading as an investment strategy comes with multiple benefits:

• Less expensive than buying shares: Purchasing an options contract is usually cheaper than paying the market price for 100 shares of a certain stock.
• Can reduce risk in portfolio: If you use certain hedging strategies properly, you can limit your losses if a stock crashes.
• Can generate income: By using certain options strategies, you can generate income on a regular basis.

Cons

Although options can be cheaper and more rewarding, they also come with risks:

• Complicated: Since the price and reward of options are based on multiple variables, it can be difficult to learn.
• Not suitable for beginning investors: Although all investors may lose money trading options, investors who are just starting out are more likely to make mistakes trading options.
• Potential for huge losses: When you sell a call, your potential losses are unlimited.

The Bottom Line: A Good Option For The Experienced Investor

Experienced investors can earn a profit or minimize their risk by using some of the tools mentioned above. However, if you’re a beginner, it might take you a while to master a complicated investment strategy like options trading. Instead, you’ll likely be better off starting with a different way of investing, like investing in ETFs or index funds.

If you believe you’re ready to trade options, try practicing with a simulator that uses virtual money first. That way, you can get a feel of how good you are with trading options without risking real money. It’s also never a bad idea to consult a financial advisor.

Whether you’re a pro or beginner, you can get some stock ideas from reading our list of the top stocks of 2021.