What is Options Trading? How to Trade Options

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During the COVID-19 pandemic, options trading soared in popularity as investors flocked to participate in the financial markets. According to data from the Chicago Board Options Exchange (CBOE), options trading by individual investors has roughly quadrupled over the past five years. Options trading offers a variety of benefits compared with trading stocks, such as access to leverage, higher potential returns and alternative trading strategies. In this article we’ll explore the foundations of trading options.

What is Options Trading?

An option is a contract which gives the holder the right to buy or sell an asset at a set price within a specific timeframe. Options can be traded on a variety of assets, including stocks, currencies and commodities. A stock option contract typically represents 100 shares of the underlying stock.

A call is an option to buy an asset at a set price on or before a particular date. A put is an option to sell an asset at a set price on or before a particular date. The price at which a put or call option can be exercised is called the strike price. The price that is paid to buy the option is called the premium.

For example, imagine that a trader expects the price of gold to rise from $1,750 to $1,800 an ounce in the coming weeks. They decide to buy a call option giving them the right to buy gold at $1,760 (the strike price) at any time within the next month. If gold rises above the strike price of $1,760 before the option expires, they will be able to buy gold at a discount. If gold remains below $1,760, the trader doesn’t need to exercise the option and can simply let it expire. In this scenario, the trader would lose the premium paid to buy the call option.

How to Trade Options

To begin trading options you will need to open a brokerage account. Most leading stock brokers also offer options trading. Due to the higher level of risk and complexity, a larger account balance may be required and clients are screened for suitability.

Once you have enabled options trading permissions, you can start to plan your options trades. If you expect a stock’s price to appreciate, you could buy a call option or sell a put option. If you expect a stock’s price to move sideways you could sell a call option or sell a put option. If you think a stock’s price will fall, you could sell a call option or buy a put option. (See also: Call and Put Stock Options)

To enter the trade you will need to pick the strike price. For example, if Tesla (TSLA) is trading at $770 and you believe it will go to $900, you could buy a call option with a strike price of less than $900. If TSLA rises above the strike price, it means that your call option is in the money – meaning that you have the opportunity to buy TSLA below its current market price.

Conversely, imagine that you think the price of Amazon (AMZN) will fall from $3,400 to $3,000. You could buy a put option with a strike price of $3,200. If AMZN falls below the strike price of $3,200, your put option is in the money – meaning that you have the opportunity to sell AMZN above its current market price.

To find the options that are available, you will need to refer to an option chain. An option chain, also known as an option matrix, lists all available options contracts for each stock. The options chain shows the available calls, puts, expiration dates and strike prices for a given stock.

There are also two styles of options, American and European. European-style options can only be exercised at expiration. American-style options offer more flexibility because they can be exercised at any time prior to expiration.

Options Trading Strategies

Now let’s go over the four foundational options strategies for beginners to understand.

Long Call: In this strategy, the trader is buying a call option. They are bullish and hope that the price of the underlying stock will rise above the strike price before the option expires, allowing them to buy below the market price.

Short Call: Here, the trader sells (writes) a call option. This trader is typically bearish, expecting the price of the underlying stock to fall or move sideways. The trader receives a fee (premium) for selling the call option. If the stock price falls or moves sideways, the trader keeps the premium. However, the call seller is liable to the buyer to sell shares at the strike price if the underlying stock rises above that price, up until the options contract expires.

Long Put: In this strategy, the trader buys a put option in anticipation of a decline in the underlying stock. The put option gives the right to sell the stock at the strike price before expiration. The trader wants stock prices to fall so that they can profit by selling above the market price. A long put could also be used to hedge a long position in the underlying stock.

Short Put: In this strategy the trader sells (writes) a put option and hopes that the stock price rises or stays flat until the option expires. In this scenario, the trader keeps the premium. However, the put seller is liable to the put buyer to buy shares at the strike price if the underlying stock falls below that price, until the contract expiration date.

Trading Options vs. Trading Stocks

Stocks represent ownership in a company. When investors buy stocks they can profit if the share price appreciates. Stocks also have the benefit of sometimes paying dividends. A dividend is a sum of money paid to shareholders, typically on a quarterly basis.

When trading stock options, there is no ownership of the underlying company and there is no opportunity to receive dividends. Options offer the advantage of being cost-efficient. An options trader can take on a similar position in the market to a stock trader but with far less capital. Options offer higher potential returns in percentage terms, due to the lower level of capital required.

Options also give traders access to flexible and complex strategies. These include strategies that can be profitable under any market conditions, for example when the market moves sideways. Options can compliment an existing stock portfolio by providing a reliable hedge against adverse moves in the market.

Options trading can carry greater risk than trading stocks. For an options buyer (holder), the risk is contained to the amount of the premium paid. However, an options seller (writer), assumes far greater risk. For example, when selling an uncovered call option, the potential loss is infinite, because there is no limit on how high a stock price can rise.

Conclusion

The apparent complexity and technical jargon associated with options trading can be off-putting to some investors. Nevertheless, the basic concepts can be grasped fairly easily and options trading can open up a broad new range of opportunities in the financial markets. Once the domain of professionals, options trading is more accessible than ever to retail traders.

FAQ

Is options trading gambling? No, options trading is not gambling per se. In fact, options are often used as a hedge to mitigate risk.

Which option trading book is best? While there are many good books on trading options, one stands out, which is Option Volatility and Pricing by Sheldon Natenberg, widely viewed as a classic among professional options traders.

How long has options trading been around? Options trading can trace its origins as far back as ancient Greece, when options were used to speculate on the olive harvest.

Who invented options trading? American financier Russell Sage developed the first modern examples of call and put options in the late 19th century.