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The Complete Guide on How to Trade Options
Trading options can be one of the most lucrative ways to make money in the stock market.
But many people miss out on these profits because they believe options are too complex, risky, or that you need to be a professional to access them.
This couldn't be further from the truth.
While there are a few more moving parts to trading options than buying and selling stocks, options can be intuitive to trade and can even reduce your risk. And just about anyone with a brokerage account can do it.
We put this guide together with one goal in mind: to help make you comfortable with options trading so you can take part in the explosive profit opportunities they provide.
No matter your experience level with options, after reading this guide you'll be as knowledgeable as the pros and ready to start making money with options today.
You'll learn everything from how options work, why it's better than trading stocks, how to limit your risk, and how to get started trading today.
What Is Options Trading?
An option is just what it sounds like: it's the option to buy (or sell) a certain amount of shares in a company on a certain date and at a certain price.
Options are a type of derivative, which is a fancy way of saying their value is tied to the value of another asset. When you buy options, you're not buying shares of a company. You're paying for the right to buy (or sell) shares at a certain price on a certain date. Because you're buying the right to buy a stock, options trade for pennies on the dollar relative to the share price of the stock.
This leverage – the ability to use a small amount of money to control a much more expensive stock – is what makes options trading so profitable.
Instead of buying 10 shares of a stock, you could buy options controlling 100 or 200 shares or more for the same price. Instead of buying 100 shares, you could trade options on 1,000 or 2,000 shares.
That means if the share price of the stock goes up 10% you're seeing that gain amplify across hundreds of shares for the cost of owning just a few. That way, you end up with a much bigger gain than if you had just bought shares in the company.
Say, for example, you have an option to buy a stock on Sept. 30 for $50 a share. If that date comes around and the stock is trading for $100 a share, that's $50 of built-in profit for each share when you exercise the option.
The trick, of course, is that no one really knows what those shares will be worth when that date comes around. So the option goes up and down in value based on the specified buy or sell price (called the "strike" price) relative to the current trading price of the stock.
And since option contracts come in bundles of 100 shares a piece, rather than go through the trouble of buying $5,000 worth of stock just to immediately sell it for $10,000, it's easier to sell the option – that is, close your position – before it expires.
According to the Options Clearing Corp., nearly 70% of options are closed before expiration. Only about 12% are exercised. The rest expire without being exercised.
So in most cases, options traders close out their position before the contract expires.
Of course, that's the 30,000 foot view of how options trading works.
Let's dig a little deeper and look at the two basic types of options…
What Are Puts and Calls in Options Trading?
As you've learned, in its most basic form an option is a contract giving its owner the right to buy a stock at a certain price or to sell a stock at a certain price. These two types of contracts are called calls and puts.
A call option gives you the right to buy a stock at a particular price until a particular date. That makes buying a call option a bullish strategy.
Generally you would buy a call option if you expect the stock's share price to rise between now and the end of the contract. When that happens, the value of the option rises and you can sell for a profit or you can exercise the contract and buy shares of the stock for the below market price. Either way, you've made money.
A put option gives you the right to sell a stock at a particular price until a particular date. That makes buying a put options a bearish strategy.
You would buy this kind of option when you expect the share price to fall. As the share price falls below the strike price, the option will increase in value and allow the holder to profit, or you can exercise the contract and sell shares of the stock for an above market price.
Now, there are a few more specifics to the options contract you need to know about before you can get started trading. But knowing call options are a bullish trade and put options are a bearish trade is all you need to know for now…
Our Latest on Options
How Does Options Trading Work?
Now that you've got an understanding of what options are and how trading them can be profitable, let's dive in a little deeper. There are three very important parts of every options contract, whether a call or put, and they all affect your ability to make money with options.
The predetermined price (agreed upon by both the buyer and the seller of the option) at which the call buyer can buy his shares, and the put buyer can sell his shares, is also called the strike price.
For example, if you bought the "$125 call" on a stock that rises to $250 per share, you can exercise your option to buy the shares for half their going rate – just $125 a share. If you sell them straight away after exercising, your profit will be $125 per share (minus the cost of the call itself).
On the other hand, the person who sold you the call has to sell you those shares for $125 per share, even if this means they have to first go out to the market and buy them for twice that – $250 per share.
Options traders have a few phrases to describe how their options' strike price relates to the stock's price.
"In the money" means the price of the stock is favorable to the option holder. So if you have a call option to buy a stock at a strike price of $50, and the current share price is $55, you are in the money. If you have a put option to sell a stock for $55 and it's trading for $50, then you're in the money. You can see in both instances that you're making money on the stock.
"At the money" means the share price is the same as (or very close to) the strike price. And "out of the money" means the share price is unfavorable to the option holder.
Call options with strike prices below the underlying stock's current price, or in the money, will be more expensive because they are worth more, while call options with strikes above the underlying stock's current price, or out of the money, will be cheaper because they are only valuable if the stock rises in price.
The same goes for put options. Puts with strike prices above the underlying stock's current price, or are in the money, will be more expensive because they are worth more, while put options with strike prices below the stock's current price, or out of the money, will be cheaper because they are only valuable if the stock price drops.
Think of it this way: Everyone wants to have the right to buy shares below their current price (which is what a call with a strike price below the stock price gives you the right to do) or sell shares above their current price (which is a put wit a strike price above the stock price).
Every option has a set date in which it expires, called the "expiration date."
If your option is in the money on the expiration date, the contract will automatically execute to either buy or sell the shares of the underlying stock. If the option is out of the money on the expiration date, the contract ends worthless.
Most options traded in the U.S. expire on the third Friday of their designated expiration month. Using our same GLD example, an "August 2021 $125 call" would expire on the third Friday of August 2021.
However, there are many other kinds of option to choose from:
• LEAPS or Leaps – an acronym for Long-term Equity Anticipation Securities – which have nine or more months to expiration.
• 30-, 60-, 90-, or 120-day options, depending on the cycle in which they trade. This is determined by the Chicago Board Options Exchange (CBOE).
• "Quarterly" options, which expire on the last trading day of the designated quarter.
• Weeklys, which are short-term options that expire in one week or less. These options are quickly growing in popularity among options traders and now represent 20% of the total option volume.
The premium is the price of the option and it can change dramatically based on the strike price and expiration date you choose.
The premium will be higher for in-the-money options than for out-of-the-money options. And in-the-money options near the expiration date will be much more expensive than out-of-the money options far away from the expiration date.
As the option's position gets better, the premium goes up, allowing you to sell for a higher price before expiration. That's why most options traders try to strike a balance between paying a reasonable premium but also giving themselves a chance to profit.
For example, buying an options far out of the money might be a lot cheaper, but it means the stock price has to move dramatically for the contract to be profitable. Similarly, options in the money will cost a lot more in premium, so if the trade doesn't go your way then you've lost more money than you needed to.
To help make smarter decisions about the relationship between the strike price, expiration, and the movement of underlying stocks, traders turn to a few different metrics you'll want to be familiar with. These are called "The Greeks" in options trading. While they aren't part of the options contract, they can help you make sense of the cost of the options and your profit potential.
Understanding the Greeks in Options Trading
The Greeks are simply metrics that help traders understand the price of their options relative to the price of the underlying stock. We've talked before about how the price of a call options, for example, will rise if the share price of the underlying stock rises. But that's a general understanding of the relationship.
Because options contracts have specific strike prices and expiration dates, the price of each contract will vary depending on the specifics. The Greeks helps us make sense of that.
Now, the Greeks are typically used by more advanced traders, but we think it's important for new traders to know what they are. You'll be well ahead of the pack just by knowing the basic definitions of each.
The main four Greeks are called delta, gamma, theta, and vega, and we'll briefly define them below.
Delta shows us how sensitive the value of the option is to the underlying stock's price movement. You can use delta to calculate how much your option will be worth if the underlying stock price moves to a specific price.
Gamma measures the change in delta. Since delta will change as the share price of the stock moves, trades who want to know how that will affect delta can use gamma.
Theta measures the relationship between the value of the option and the time left until it expires, or what we call time decay. As we explained above, the distance between the start of the contract and the expiration date affects the value of the contract. If you buy an out of the money option then you only have until the expiration date for the option to find its way into the money, which means the contract slowly loses value each day it's not in the money.
Theta shows us how the options price will change each day until expiration.
Vega measures the relationship between and options implied volatility (IV) and its price. Because options with higher implied volatility are worth more, traders want to know how much they can expect higher IV move the price of the option.
Don't worry if the Greeks sound complicated. They're simply theoretical models traders use to evaluate options. You don't need to know anything about them to make money with options trading, we just want our readers to be as knowledgeable as possible.
And now that you are, it's on to the fun stuff…
How to Make Money Trading Options
Congratulations, you've now mastered the basics of options. You've learned why options trading can be so profitable, the difference between calls and puts, and what makes up an options contract.
Now it's time to start thinking about how to use your knowledge of options to make money.
When it comes to trading options, there are three different ways to profit. We'll lay them out below.
Exercising the Options
The most straightforward way to make money on options is to exercise profitable contracts.
Take call options for example. Since these contracts give you the right to buy the underlying stock for a specific price, you can make money by taking advantage of that right.
If your contract gives you the right to buy a stock at $100 a share and the stock is trading for $200 a share, then you can exercise the contract to buy the stock for half the price it's trading for. You can either turn around and sell it for an immediate 100% profit, or you can hang out the stock for as long as you want.
The reverse goes for a put. If you have the right to sell a stock for $200 and it's trading for $100, then you can buy shares of the stock for $100 and sell them for $200. This works even better if you already own the stock. You can simply unload your shares at a much higher price. Many investors buy put options as a hedge in case something happens that pushes shares of their stock down.
Imagine owning a company that announced its latest product was a flop and it's now teetering on the brink of bankruptcy. The stock price would likely plummet. But if you owned a put contract on the stock your portfolio would be protected since you could still sell the stock for the strike price.
But the real money in trading options comes from selling the contracts before expiration.
Options traders aren't always interested in exercising the contract. Instead, they simply sell the contract when it's value is high.
Trading options like this is very similar to trading stocks: buy low and sell high.
Traders scope out stocks they expect to move higher or lower in the future – whether because of an upcoming event like an earnings report or their analysis of the business – and buy an options contract that will gain if their prediction is right.
When that happens, they simply sell the contract for a profit.
Writing Options for Income
Every options contract has a buyer and a seller. So far we've only talked about buying options. But you can write, or sell them, too.
In this situation you "write" the contract and someone buys it from you. You collect the premium from the sale, but you're responsible for fulfilling the terms of the contract.
When you buy a call option, you have the right to buy the stock at the strike price. When writing the call option contract, you're the person who's responsible for selling the stock to the contract holder at the strike price.
As you can imagine, this carries a bit more risk than simply buying a contract and your gains are capped at the premium. So why would anyone write a contract?
The simple answer is with a bit of risk management you can make consistent income doing this.
If you own enough of a stock to cover the contract, then the risk of writing calls is limited to having to sell stock you already own for a below market price. But if the stock never reaches the strike price of the contract, then you bank the entire cost of the contract. And you can keep doing this over and over until a contract is exercised or you decide to keep the stock.
Selling puts is slightly different but comes with some advantages too. Since the writer of a put contract has to buy the stock from the contract holder, your risk is limited to having to buy a stock at an above market price. That may not sound ideal, but think about a stock you'd love to own but you think is too expensive. You can write a put contract for a price you believe is more fair, get paid for the contract, and your risk is limited to buying shares of a stock you like at a price you like. That's a win-win.
Why Options Trading Is Better Than Stock Trading?
There are two big reasons traders prefer options to stocks.
The first is leverage. Using options lets you control more shares of a stock for less money than buying the stocks. If you're thinking of making a trade on a stock, using the leverage options offer can amplify your profit potential.
Think about it this way. Stocks are more expensive now than ever before.
One share of Amazon.com, Inc. (NASDAQ: AMZN) costs well over $3,000 right now. And if you want to own multiple shares of Amazon it will cost you tens of thousands of dollars.
But with options, you can actually control 100 shares of expensive stocks, like AMZN, for less than it would cost to own just one share outright. So while Wall Street wants you to shell out over $300,000 for 100 shares of AMZN, you don't have to. You could pay roughly $3,000 to essentially "rent" 100 shares of the stock instead.
Since you can control shares of a specific stock, you can also increase your leverage without tying up a large amount of capital in your trading account.
Not only does that mean your costs are lower, but by controlling hundreds of shares at a time, any gain in the price of the stock is multiplied that many times over. A 10% increase in the value of the stock can potentially translate into a 100%, 200%, or higher gain by owning options contracts on the same stock.
The second, and related, reason traders prefer options trading to stock trading is that it can control your risk.
By putting less money at stake, your downside is capped at the cost of the option. Owning hundreds of shares of a stock, on the other hand, means you could lose significantly more money if something happens to the business or the trade goes against you.
This is doubly true for traders looking to profit on a stock they think is going to fall. Shorting a stock – selling shares of a borrowed stock to buy back later – carries unlimited risk since there's no limit on how high share prices can go. But options traders can profit on a stock dropping by buying put options instead. Here, your risk is limited to the cost of the put and that's it.
You can also buy and sell other options to offset the risk of your trade even more. Buying an option on a stock while simultaneously selling an option with a different strike price on the same stock is called a spread. In this type of trade, your risk from selling the option is offset by owning a similar option.
We'll cover spreads in more depth on our options trading strategies guide, but for now it's simply an example of how trading options gives you many more ways to profit and control your risk than simply trading stocks.
Now, let's dig into the risks a bit more…
What Are the Risks of Options Trading?
While options can be used to lower your risk when trading – whether you use them as a hedge or you use the leverage to control more stock shares for a lower price – they are riskier than simply buying and selling equities.
We want to make sure you're fully aware of all the ins and outs of options before diving into this exciting and lucrative world. The last thing we want to see happen is for a trader to make a decision they aren't fully comfortable with. Knowing the risks and how to limit them is the best way to make sure you're confident in your trading.
There are two main risks we want to talk about when it comes to options trading.
The first risk is your premium. The price of an options contract is called the premium. You risk losing the entire premium anytime you buy an options contract.
While there is a similar risk in owning stocks – the company could go bankrupt and shares fall to $0 – it's much less likely. Even if the share price drops you still own a stake in a tangible asset that has the potential to find profitability again.
However, each options contract has an expiration date, and if the options aren't in the money by the expiration date then your contract expires worthless. That means anytime you buy options you could potentially lose what you paid for an option.
But there are ways to limit this risk.
You can make sure you never pay more for an option than you're comfortable losing. By staying disciplined with your options budget and using strategies like limit orders, you can keep your costs down and ensure you never take on more risk than you can afford.
You can also use spreads to limit the cost of your options contracts and your downside risk. Spreads are a bit more complicated and involved simultaneously selling an options on a stock at the same time as you buy one.
Spreads limit your profit potential, but they also keep you from losing all of your initial purchase price. You can learn more about how to create an options spread right here.
The second risk is comes from using more advanced options strategies.
Since you can both buy and sell calls and puts, there are a near limitless number of ways to construct trades. Many strategies protect you from losing money, but other strategies, if done wrong, can expose you to near infinite risk.
While we would never recommend taking on this level of risk, beginner options traders can be attracted to the upside potential and overlook the downside. We want to show you how to avoid that.
Selling a naked call, or naked call writing, is the riskiest options trade you can make. While buying a call option gives you the right to buy shares of a stock at a fixed price, writing a call option means you are responsible for delivering the shares at the contract price.
That means if you write a call contract and it winds up in the money, you have to purchase hundreds of shares of the stock on the open market and sell them to the contract holder at a below market price. As you can tell, the risk level is infinitely high.
Of course, you never have to make this kind of trade. Even professional options traders avoid this trade. But a new trader could unknowningly expose themselves to this kind of risk by listening to bad advice or looking at a juicy premium.
That's why we're here to make sure you have the options knowledge to be totally comfortable with any trade you want to make.
How Do You Trade Options?
To start trading options you first need a brokerage firm that offers options trading and clearance to trade options.
If you've got a retirement account, such as an IRA or a 401(k), you can actually trade options in it. In fact, all you need to do is contact your broker to get it converted for options trading. Then, you're ready to move on to the next step: getting your options clearance.
But if you don't have an existing account or would prefer using a separate account for options trading, you'll need to choose a broker first.
It's important to have a broker that actually specializes in options trading, not a stock broker with a small options platform on the side. There are only a small handful of them that do it right. Here's the way most brokers are broken down:
These are brokerage firms that have advisory services and typically move their clients into managed accounts. They may or may not have an active trading group, and if they do, it may be just for their full-service clients as a way of keeping them happy. Commissions are typically on the high side of the range, as they provide full service, including your own individual investment advisor.
These brokers typically offer a downloadable platform for executing trades, but do not offer any client services beyond this. Execution and commissions may be great, but don't hold your breath if you have a question for this group, because chances are, they don't have a big support team to offer phone support. I personally like this group, but it's only for the most experienced traders who won't need much, if any, support.
Discount Option Brokers
This is the sweet spot for most traders. Most brokers of this type offer web-based platforms, with some downloadable platforms, great execution, and middle-range commissions, but also offer phone support if needed.
If you need help narrowing down the options, take a look at the best online brokers according to Barron's.
|Broker||Web Address||Phone Number|
|Interactive Brokers||interactivebrokers.com||(877) 442-2757|
|TD Ameritrade||tdameritrade.com||(800) 454-9272|
|Charles Schwab||schwab.com||(866) 855-9102|
|Merrill Edge||merrilledge.com||(888) 637-3343|
|Lightspeed Trading||lightspeed.com||(888) 577-3123|
|Trading Block||tradingblock.com||(800) 494-0451|
|Planner Securities||plannersecurities.com||(646) 381-7000|
Please note: We don't receive any compensation from any of these brokers, in any form.
The choice, of course, is yours. Remember, unless you're with a full-service firm that charges you $50 in commissions on each trade (which for daily options trades can end up being very expensive), then you should factor in your needs and experience as a trader, as well as commissions, slippage, and execution as the total expenditure in trading.
Now, once you have a broker chosen, most will require you to get clearance to trade options.
Here's how that works…
The first thing you need to do is get whatever clearance lets you buy "calls" and "puts." Clearance levels can vary from broker to broker but typically include four levels (some include five).
After you've chosen the clearance level you want, your broker will then collect your personal information (such as your income, employment, and trading experience). Like the clearance levels, these questions could vary depending on your broker, but the purpose is the same: verify your identity and determine your suitability for options trading.
When you get to questions about your annual income and net worth, remember that this is only used to determine what types of options you can trade as well as to verify your identity. It's similar to the information you'd provide when filing your annual tax return, too:
Many brokers ask for both "total net worth" and "liquid net worth." Liquid net worth includes all investments that can easily be turned into cash, including funds, stocks, and so on. However, liquid net worth does not include any real estate investments. So don't include the value of your house here.
Your total net worth will include all of your liquid net worth, as well as any illiquid assets you may own (such as real estate).
And don't worry if this seems too complicated to figure out on your own… Charles Schwab, for example, has the Personal Net Worth Worksheet you can use. There are also plenty of calculators and other helpful tools online you can use, such as the "What Is My Net Worth?" Calculator.
The second-to-last step in getting your options trading clearance is providing some information about your trading experience and knowledge. Now this isn't a trick question… you'll want to check the box under knowledge level based on how much you know about options trading. If you've never heard of options (until now, of course), you'll want to check the box next to "None" under "Knowledge Level."
If you've heard of options before, then you'll want to check the box next to "Limited" under "Knowledge Level." If you're pretty familiar with options, you'll want to check the box next to "Good" under "Knowledge Level." And if you know options like the back of your hand, then go ahead and check the box next to "Extensive" under "Knowledge Level."
If you've never traded options before, you'll want to check the box next to "None." If you've placed an options trade before but are still pretty new to them, you'll want to check the box next to "Limited." If you trade them pretty regularly, you'll want to check the box next to "Good." And if you're trading options like a pro, then go ahead and check that box next to "Extensive."
Now the only left for you to do is sign and mail, fax, or upload (depending on your broker) your application.
And remember, if at any point during the application process you have any questions, don't hesitate to call your broker and ask. Their job is to help you, after all, and they'll able to clear anything up in no time.
Resources to Help You Start Trading Options
Commission-free options trading platforms have taken the trading world by storm this year.
If you're new to trading or just looking to try out a new platform, you might be wondering whether Robinhood or WeBull offers the better platform.