What is Options Trading?
Options trading involves buying or selling contracts that grant the right — but not the obligation — to buy or sell an underlying asset at a specified price before the contract expires.
Options trading involves buying and selling options contracts — financial instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset (usually a stock) at a predetermined price before or on a specific date. Options are a form of derivative: their value is derived from the performance of another asset.
Options are used for everything from hedging risk in a long-term portfolio to highly speculative short-term bets. They're more complex than buying stocks directly and carry significant risk, particularly for inexperienced traders.
Calls and Puts
There are two fundamental types of options contracts:
Call option — Gives the buyer the right to buy shares at the strike price before expiration. Call buyers profit when the stock price rises above the strike price.
Put option — Gives the buyer the right to sell shares at the strike price before expiration. Put buyers profit when the stock price falls below the strike price.
Every option contract represents 100 shares of the underlying stock.
Key Options Terms
| Term | Definition |
|---|---|
| Strike price | The price at which the option can be exercised |
| Expiration date | The date after which the option becomes worthless |
| Premium | The price paid to buy the option contract |
| In the money (ITM) | The option has intrinsic value (call: stock above strike; put: stock below strike) |
| Out of the money (OTM) | The option has no intrinsic value — only time value |
| At the money (ATM) | Stock price is at or very near the strike price |
How Options Are Priced
An option's price (premium) is influenced by several factors:
- Intrinsic value — How far in-the-money the option is
- Time value — The more time until expiration, the higher the premium. Options lose value as expiration approaches (called time decay or theta)
- Implied volatility — Higher expected stock volatility increases option premiums, since there's a greater chance of a large price move
- Interest rates and dividends — Have smaller but real effects on pricing
Common Options Strategies
Options can be combined in many ways:
- Covered call — Selling a call option against shares you already own, generating income but capping upside
- Protective put — Buying a put option on shares you own, like buying insurance against a decline
- Long call or put — A directional bet that the stock will rise (call) or fall (put) significantly
- Spreads — Buying one option and selling another to define risk and reduce cost
Risks of Options Trading
Options can expire completely worthless, meaning the entire premium paid is lost. Leverage amplifies both gains and losses. Strategies involving selling options can carry theoretically unlimited risk if not managed carefully.
Options trading requires approval from most brokerages and is generally considered more appropriate for experienced investors with a clear understanding of the mechanics and risks involved. Margin trading and options trading are often combined in advanced strategies, further compounding risk.
Options vs. Buying Stock
When you buy stock directly, your maximum loss is what you paid. Options offer leverage — you can control 100 shares with a fraction of the cost of owning them outright — but that same leverage works against you if the trade goes wrong.