The Basics of Options Trading: What You Need to Know

The stock market has attracted many individuals who want to build wealth, and it’s no wonder why. Stocks can generate higher returns than your savings account and may set you up for earlier retirement. That’s one of the many reasons why billions of dollars flow into the stock market every year. Although many people buy individual stocks and funds, another asset can help you make money in the stock market: options. Options trading has enticed investors in recent years because of the potential for high returns. This article will reveal how options trading works and the fundamental concepts to keep in mind before you get started.

Options Trading Explained

Options trading provides leverage without debt. Each option contract revolves around an underlying stock. For instance, if you buy Amazon options, the contract’s value depends on how Amazon’s stock price moves. You have to pay a premium to buy options, but you can also receive a premium for selling an option contract. Every options contract has an expiration date. When that date arrives, the contract either gets exercised because it is in the money, or it becomes worthless because the contract is out of the money.

Key Option Trading Terms You Have to Remember

Options trading can feel complex with all the fancy terms and the time-sensitive nature of expiration dates. These are the key options trading terms to know.

• Call option: A call option goes up in value when the underlying stock’s price increases. Buying a call is bullish.
• Put option: A put option goes up in value when the underlying stock’s price decreases. Buying a put is bearish.
• Derivative: Financial contracts that rely on underlying assets for their values are called derivatives.
• Premium: The amount a trader must pay to buy a contract. Sellers receive the premium.
• Strike price and expiration date: The strike price represents the price point at which the option is considered in the money. The expiration date is the deadline attached to the option for it to become in the money.
• Intrinsic value and extrinsic value: Intrinsic value is the option’s inherent value. Extrinsic value is the market value of the contract, which is often different from the intrinsic value.
• In-the-money and out-of-the-money: In-the-money contracts are profitable and get exercised at expiration. Out-of-the-money contracts are unprofitable and become worthless at expiration.
• Covered calls: An investor with 100 shares of a company can sell a covered call to realize additional profits while minimizing their potential downside.
• Married puts: An investor with 100 shares of a company buys a put to minimize their losses in the event the stock performs poorly in the short term.
• Straddles: An options trading strategy in which a trader buys an equal number of calls and puts. This trader hopes for a dramatic price movement in either direction.
• The Greeks: Four metrics that options traders use to assess each position and determine if it makes sense to enter or exit a contract.
• Hedging: Minimizing your risk in financial assets by investing in a mixture of bullish and bearish positions.
• Option Spreads: An investor buys an option, while simultaneously selling and option. Usually with defined risk and profit potential. 

How Options Trading Works

Options traders employ several strategies to increase their returns and minimize risk. While you can explore many strategies, each approach lets you employ at least one of the following four actions.

Buy Calls

Buying calls is a bullish strategy that rewards traders when the underlying asset’s price goes up. Suppose a trader buys a call of a stock currently trading at $50 per share. The trader pays a $2.50 premium for a contract with a $50 strike price, and it expires in four weeks. The stock must reach $52.50 per share for the call contract to break even. Any amount above $52.50 per share represents a profit. Call holders have the right but not the obligation to buy 100 shares at the strike price at or before expiration. 

Sell Calls

Selling a call is a bearish strategy where a trader hopes to increase cash flow from their existing shares. An investor with 100 shares of a company valued at $35 per share may not believe the price will reach $40 in the next three months. The trader realizes a $1.25 premium, or $125, for selling a call to another trader. If the stock surpasses $40 per share, the trader must sell their 100 shares at $40 per share, regardless of how high the stock price goes. Having 100 shares caps your gains and can save you from significant losses. However, if the stock never reaches $40 per share, the option contract will expire worthless, and you get to keep the premium and shares.

Buy Puts

Buying puts is a bearish strategy that rewards traders when the underlying asset’s price goes down. If you pay a $1 premium to buy a put with a $20 strike price, and the stock is currently priced at $25 per share, you need the stock to fall below $19 per share before expiration to break even on this position. You can also get out of the put before the expiration date if you are satisfied with the current gains. Put holders have the right but not the obligation to sell 100 shares at the strike price at or before expiration.

Sell Puts

Selling puts is similar to covered calls, but you need cash set aside for this trade, just like a security deposit. You can sell a put and receive a premium in the process. Some people sell puts to get stocks at more reasonable prices. Assume an investor wants to buy 100 shares of a company that is currently valued at $200 per share. The investor believes the company’s intrinsic value is $180 per share. This investor can sell a put that expires in six months at the $180 strike price. The investor would receive a higher premium for picking an expiration date that is further out. If the stock is not lower than $180 per share at expiration, you do not get 100 shares but get to keep the premium. If the stock falls below $180 per share, you are obligated to buy 100 shares at $180 per share regardless of the market price.

How Options Pricing Works

Options prices fluctuate drastically based on how underlying assets move, but you can use several metrics o assess options prices:

• Strike price: Options that are far out of the money are more affordable than contracts that are deep in the money.
• Expiration date: A contract that expires in 1 year is more valuable than a contract that expires in 1 week. A longer expiration date will increase the option’s value.
• Volatility: If the underlying asset is volatile, it’s subject to more dramatic price swings. This factor translates into higher options prices.
• Stock price: A stock that trades at $2,000 per share will have higher premiums than a stock trading at $50 per share. Some options traders get started with stocks trading at low price points for this reason.

Advantages of Options Trading

Every dollar you invest can only go into one asset. A diversified portfolio covers a lot of ground, and for some people, options trading can be a great fit. Here are some of the advantages options trading can provide.

Can be Cheaper than Stocks

An options contract gives your portfolio short-term exposure to the price movement of 100 shares. Buying 100 shares of a $ 200-per-share company would require $20,000. However, buying a call contract for the same company may only cost a few hundred dollars, depending on the strike price and expiration date. It takes less money to give your portfolio exposure to 100 shares.

Can be Low Risk, High Reward 

Options trading can be a low-risk strategy to generate high returns if you allocate a small percentage of your portfolio to options trading. Using less than 5% of your portfolio to trade options can help you generate returns that may offset losses from your long-term positions.

Flexible and Liquid

You can quickly enter and exit options contracts without much delay. Options are highly liquid, with most of them processing within a few seconds if you set the right bid. Real estate and less liquid assets can become cumbersome and don’t present an immediate exit strategy if you need funds right away or are nervous about the economy.

Requires Smaller Capital

You don’t need as much money to trade options as you do to buy stocks. Options contracts are more affordable than buying 100 shares of a company, and if you pick options for stocks that trade under $50, the premiums will be even more affordable.

Portfolio Diversification

Portfolio diversification helps you navigate economic uncertainties and hedge against risks instead of putting all of your eggs in one basket. You don’t have to invest as much money to diversify your portfolio with options and hedge against risks. You can buy a call instead of saving up enough capital to purchase 100 shares. You can also buy a put contract if you want temporary protection against a potential correction.

Things to Consider 

Every investment has risks, and options are no different. You should consider your risk tolerance and how options trading aligns with your portfolio goals before getting started. Options contracts can expire worthless and are more volatile than most assets. There is a possibility of losing money with any investment, and options are no exception to this rule. It is a good idea to paper trade options before using real money.

Mastering the Basics So You Are Ready to Go

Options trading can be a great addition to many investors’ portfolios. Traders can deploy small amounts of capital to gain more exposure to stock price movements and potentially experience higher returns. 

Frequently Asked Questions