Beginner’s guide to options trading: how it works, main risks, and ways to get started
Options trading involves buying and selling contracts called options. These contracts give you the right, but not the obligation, to buy or sell an underlying asset, such as shares, an index, or an ETF, at a specific price before a set date.
Unlike just buying a stock or cryptocurrency, options allow traders to potentially earn money whether prices are going up, down, or staying the same. This can often be done with a smaller initial investment. Because of this flexibility, options can be a powerful tool for both protecting investments and making speculative trades.
Example: For example, if you buy a call option for Apple shares (AAPL) at a strike price of $180, you can purchase the shares at that price before the option expires. If Apple’s price rises to $200, you can acquire it at $180 and sell it for $200, making a profit, or you can sell the option itself for a gain.
Options trading may seem complicated at first, but once you grasp the basics — such as calls, puts, strike prices, and expiration dates — you can explore various strategies for earning income, protecting your investments, and growing your capital.
In this type of trading, you are dealing with contracts rather than the actual shares or underlying asset. Each options contract controls 100 shares of the underlying asset and has important components you need to understand.
With options, you can potentially profit whether prices rise, fall, or remain stable:
Example Trade: For instance, if shares are trading at $100 and you buy a call option with a strike price of $105, paying a premium of $2. If the shares rise to $115 before the option expires, the value of your option increases. You can either sell the contract for a profit or exercise the option to buy the stock at $105 and sell it at $115.
Tip for beginners: Start with paper trading (simulated trading with no real money) to learn how premiums, time decay, and price changes affect your options before using real money.
Options trading primarily involves two types of contracts: calls and puts. Understanding these is crucial before moving on to more complex strategies.
A call option grants you the right to purchase the underlying asset at a specific strike price before the expiration date.
Example: You buy a call option on Apple with a strike price of $150. If Apple’s price rises to $170 before expiration, you can purchase it at $150 and either sell the shares or the option itself for a profit.
A put option gives you the right to sell the underlying asset at the strike price before expiration.
Example: You buy a put option on Tesla with a strike price of $250. If Tesla’s price drops to $220, you can sell at $250 or sell the put option for a profit.
Beginner Tip: Start with basic single-leg trades by buying calls or puts before trying more complex multi-leg strategies.
Options trading has unique benefits that attract both new and experienced traders. Here are the main reasons to consider adding options to your trading strategy:
Options allow you to profit whether the market is rising, falling, or moving sideways. You can use call options to benefit from upward trends or put options to protect your portfolio when the market is declining.
Options let you control 100 shares of stock with a relatively small upfront cost (the premium). This leverage means you can participate in price movements without needing to buy the actual shares.
These contracts can serve as a protective measure for your investments. For example, buying a put option can protect your stock holdings from unexpected price drops.
Selling (or “writing”) options, such as covered calls, can create income from premiums even if you never exercise the option. Many investors use this method to generate consistent cash flow.
From simple trades to advanced multi-leg strategies, options provide endless flexibility. Whether you want to speculate, hedge risk, or generate passive income, options can help you achieve your goals.
These advantages make options an appealing tool for traders seeking diversification and flexibility beyond traditional equity trading. However, it’s important to understand the risks involved, which we’ll discuss next.
While these contracts offer flexibility and the potential for profit, they also come with specific risks that every trader should understand.
These instruments lose value as their expiration date approaches, a concept known as time decay. If the underlying asset doesn’t move as you expected before the option expires, you might forfeit the entire amount spent.
Large and unexpected price changes can work for or against you. While volatility can create opportunities, it also raises the risk of quick losses.
Leverage can increase both gains and losses. While you control a large position with a small premium, a small unfavorable price movement can wipe out your entire investment.
These contracts involve more details than just buying or selling shares. Beginners who don’t fully understand strike prices, expiration dates, and pricing models may take on unnecessary risks.
If you write contracts (calls or puts), you may have to buy or sell the underlying asset if the buyer exercises the option, even if this is not favorable for you.
Important: Only trade options with money you can afford to lose. Start with simple strategies, use stop-loss rules, and avoid taking on too much leverage until you gain experience.
The options market attracts a wide variety of participants, from individual retail traders to large institutions. Each group has different reasons for trading options:
These are everyday individuals who use online platforms to speculate, protect their portfolios, or generate income. With the rise of easy-to-use brokers, more retail traders are participating in options trading than ever before.
Hedge funds, mutual funds, and large financial institutions use options to protect large portfolios, manage risks, or implement complex trading strategies. They make up a significant portion of the options market activity.
Market makers help ensure there is enough buying and selling activity by continuously trading options. Professional traders often use advanced strategies to capture small price movements or manage risks.
Companies sometimes use options to protect against changes in currency values, interest rates, or to manage employee stock options.
While institutions and professional traders dominate the trading volume, retail traders now have more access to the options market thanks to online brokers and educational resources.
Starting to trade options can be straightforward if you follow these steps:
Select an online brokerage that allows trading these instruments, such as TD Ameritrade, E*TRADE, or Robinhood. Make sure the broker is regulated and offers educational tools, real-time data, and competitive fees.
Unlike equity trading, brokers require you to apply for permission to trade these financial instruments. You’ll answer questions about your financial background, investing experience, and risk tolerance to determine your trading level.
Understand key terms such as calls, puts, strike prices, expiration, costs, and time decay. Many brokers offer free courses and demo accounts for you to practice before using real money.
Deposit money into your trading account. Some brokers have no minimum deposit requirement, but it’s wise to start with an amount you can afford to risk, typically at least $500 to $1,000 for basic options trading.
For beginners, focus on basic trades involving these contracts like:
Options can expire worthless, making risk management crucial:
Tip for beginners: Maintain a trading journal to track each transaction, including your reasons, strategies, and outcomes. This will help you learn from both your successes and mistakes.
To illustrate how options trading works, let’s look at two simple examples.
These examples illustrate that your maximum loss when purchasing contracts is limited to the cost you paid, while your potential profit can be substantial, especially with strong market movements.
Trading options is a flexible and powerful way to engage with the markets. This approach provides opportunities to hedge against risks, generate income, or speculate on price fluctuations. With the ability to profit in rising, falling, or even sideways markets, options can complement both long-term investing and short-term trading strategies.
If you’re new to this, consider these steps to build a solid foundation:
Successful trading in this arena is not solely about quick profits; it demands discipline, planning, and continuous learning. As you become more experienced, you can delve into advanced strategies like spreads, straddles, and covered contracts to enhance your trading approach.
With the right preparation and risk management, options can be an exciting way to expand your trading toolkit and take advantage of various market opportunities.
If you’re interested in learning about other growing markets, check out our next guide, “What Is CFD Trading – A Beginner’s Guide,” which explains how contract for difference trading works, the risks to consider, and how to start safely.
When you’re prepared to start trading contracts, ensure you collaborate with reputable brokers. Our “Best Broker for Option Trading” page compares trusted brokers side by side to help you choose one that aligns with your goals.
This content is for educational purposes only. Nothing on this page is financial advice or a solicitation to buy or sell any security or derivative. Trading involves risk. Past performance does not guarantee future results. Always verify broker licensing on official regulator registers.
Options trading involves buying and selling contracts called options that give you the right, but not the obligation, to buy or sell an underlying asset (like a stock or ETF) at a set price before a certain date.
Options trading works by purchasing calls (to bet on a price rise) or puts (to bet on a price drop). You pay a premium for each contract, which gives you the right to buy or sell 100 shares of the underlying asset at the strike price before expiration. You can close the trade at any time by selling the option itself or exercising it if it’s profitable.
Suppose you buy a call option on Tesla with a strike price of $200, paying a $5 premium ($500 for one contract). If Tesla rises to $220 before expiration, the option is worth at least $20 per share ($2,000 total). Your profit would be $2,000 – $500 = $1,500.
Yes, but your options will be limited. Some options contracts have premiums under $1 per share ($100 per contract), allowing you to start small. However, with only $100, your trades will likely be basic and high-risk. Starting with more capital is recommended for better flexibility and risk management.
Yes, options are riskier than simply purchasing shares. While purchasing options limits your maximum loss to the premium you pay, selling or writing options can carry unlimited risk. Time decay, market volatility, and leverage can all lead to losses if not managed carefully.
A call option gives you the right to acquire an underlying asset at a set strike price before expiration, typically used when you expect the asset’s price to rise.
A put option gives you the right to liquidate an underlying asset at a set strike price before expiration, typically used when you expect the asset’s price to fall.
Yes. Many brokers provide beginner-friendly tools and paper trading accounts. Start with executing simple trades like calls or puts and avoid complex multi-leg strategies until you gain experience.
Most brokers don’t require a high minimum deposit, and you can sometimes acquire a single option contract for under $100. Still, starting with at least $500-$1,000 is recommended for proper diversification and to manage risk effectively.
Neither is “better” universally; they serve different purposes. Options provide flexibility and leverage; however, they also involve higher risk. Stocks are simpler and better for long-term investing, while options are ideal for traders seeking hedging, income generation, or short-term opportunities.
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