An option is a financial instrument whose value is tied to an underlying asset; this is known as a derivative. Instead of buying an asset, such as company stock, outright, an options contract allows the investor to potentially profit from price changes in the underlying asset without actually owning it.
Because options contracts may be much cheaper to come by than the underlying asset, trading options can offer investors leverage that may result in significant gains if the market moves in the right direction. But options are very risky, and can also result in steep losses. That’s why investors must meet certain criteria with their brokerage firm before being able to trade options, SoFi explains
Knowing how options trading works requires understanding what an option is, and what the advantages, disadvantages, and risks of options trading may be.
Buying an option is simply purchasing a contract that represents the right, but not the obligation, to buy or sell a security at a fixed price by a specified date.
Options buyers and sellers may use options if they think an asset’s price will go up (or down), to offset risk elsewhere in their portfolio, or to increase the profitability of existing positions. There are many different options-trading strategies.
Quick tip: Options can be a cost-efficient way to place certain trades, because you typically purchase options contracts, not the underlying security. That said, options trading can be risky, and best done by those who are not entirely new to investing.
An option is considered a derivative instrument because it is based on the underlying asset: An options holder doesn’t purchase the asset, just the options contract. That way, they can make trades based on anticipated price movements of the underlying asset, without having to own the asset itself.
In stock options, one options contract typically represents 100 shares.
Other types of derivatives include futures, swaps, and forwards. Options that exist for futures contracts, such as the S&P 500 index or oil futures, are also popular derivatives.
What is the difference between trading using margin vs. options? Having a margin account does offer investors leverage for other trades (e.g. trading stocks). But while a brokerage may require you to have a margin account in order to trade options, you can’t purchase options contracts using margin. That said, an options seller (writer) might be able to use margin to sell options contracts.
There are two main types of options: calls and puts.
When purchased, call options give the options holder the right to buy an asset.
Here’s how a call option might work. The options buyer purchases a call option tied to Stock A with a strike price of $40 and expiration three months from now. Stock A is currently trading at $35 per share.
If Stock A appreciates to a value higher than $40 per share, the option holder may choose to exercise the contract, or sell their option for a premium. If the value of Stock A goes up, the value of the call option should, all else being equal, also go up.
The opposite would also be true. If shares of Stock A go down, the value of the call should, all else being equal, go down.
If the options holder wanted to exercise their call option, with American-style options they have until the expiration date to do so (with European-style options, the option must be exercised on the expiration date). When they exercise, they can buy 100 shares at the strike price.
Meanwhile, put options give holders the right to sell an asset at a specified price by a certain date.
Here’s how a put trade might work. A trader buys a put option tied to Stock B with a strike price of $45 and expiration three months from now. Stock B is currently trading at $50 per share.
If the price of Stock B falls to $44, below the strike price, the options holder can exercise the put. Alternatively, the value of the option would likely also rise in this scenario, as owners of Stock B might look to lock in profits and sell shares before the stock falls further. A scenario like that may give the option holder the choice of selling the option itself for a profit.
A stock’s put-call ratio is the number of put options traded in the market relative to calls. It is one measure that investors look at to determine sentiment toward the shares. A high put-call ratio indicates bearish market sentiment, whereas a low one signals more bullish views.
Quick tip: It’s smart to invest in a range of assets so that you’re not overly reliant on any one company or market to do well. For example, by investing in different sectors, you can add diversification to your portfolio, which may help mitigate some risk factors over time.
For an out-of-the-money put option, the shares of Stock C may be trading at $60, while the put’s strike price is $50, so therefore, not yet exercisable.
Traders use a range of Greek letters to gauge the value of options. Here are some of the Greeks to know:
The market for stock options is typically open from 9:30 a.m. to 4 p.m. ET, Monday through Friday, while futures options can usually be traded for almost 24 hours.
Log into your investment account with your chosen brokerage.
2. Get Approved
Your brokerage may base your approval on your trading experience. Trading options is riskier than trading stocks because losses can be steeper. That’s why not all investors should trade options.
3. Place Your Trade
Decide on an underlying asset and options strategy and place your trade.
4. Manage Your Position
Monitor your position to know whether your options are in, at, or out of the money.
Options offer a way for holders to express their views of an asset’s price through a trade. But traders may also use options to hedge or offset risk from other assets that they own. Here are some important options trading strategies to know:
In simple terms, if the buyer purchases an option — be it a put or a call — they are ‘long’. A long put or long call position means the holder owns a put or call option.
Covered and Uncovered Calls
If an options writer sells call options on a stock or other underlying security they also own outright, the options are referred to as covered calls. The selling of options helps the writer generate an additional stream of income while committing to sell the shares they own for the predetermined price if the option is exercised.
Uncovered calls, or naked calls, also exist, when options writers sell call options without owning the underlying asset. However, this is a much riskier trade since the exercising of the option would oblige the options seller to buy the underlying asset in the open market, in order to sell the stock to the option buyer.
Note that the seller wants the option to stay out of the money so that they can keep the premium (which is how the seller makes money).
Spreads
Option spread trades involve buying and selling an equal number of options for the same underlying asset but at different strikes or expirations.
Strangles and straddles in options trading allow traders to profit from a move in the price of the underlying asset, rather than the direction of the move.
Like any other type of investment, or investment strategy, trading options comes with certain advantages and disadvantages that investors should consider before going down this road.
Options are derivative contracts on an underlying asset (an options contract for a certain stock is typically worth 100 shares). Options are complex, high-risk instruments, and investors need to understand how they work in order to avoid steep losses.
The contracts work differently for options sellers/writers.
