Options trading explained: A beginner's guide

If you want to go beyond stocks, mutual funds or bonds in your portfolio, buying options could be a good fit. 

You may have heard that options trading is difficult or only for the most advanced investors. Options can provide diversification, they can also cause you to easily lose an unlimited amount of money. And while selling options is a more advanced investing strategy, buying options is a better starting place for beginners.

Here we'll cover the basics of buying options contracts (calls and puts, to be specific) and cut through the investing jargon and around options trading.

Options trading can seem more complicated than it is. So, what is options trading, exactly? If you're looking for a simple options trading definition, it goes something like this:

Options trading gives you the right or obligation to buy or sell a specific security on a specific date at a specific price. An option is a contract that's linked to an underlying asset, e.g., a stock or another security.

Options contracts are good for a set period, which could be as short as a day or as long as a couple of years.

When you buy an option, you have the right to trade the underlying asset, but you're not obligated to. If you decide to do so, that's called exercising the option. When you sell an option, you have an obligation to fulfill the contract. Selling options is where things get more complicated, and you could be at risk of losing an unlimited amount.

If you're a DIY investor diving into options with a self-directed account, you're in full control of your trading decisions and transactions. But that doesn't mean you're alone either. Many communities bring traders together to discuss the current market outlook and options trading strategies.

You can do options trading via an online brokerage account that allows self-directed trading. To form your knowledge base, start by getting familiar with the different types of options you can trade. The two basic categories of options to choose from are calls and puts.

A put option is the opposite of a call option. Instead of having the right to buy an underlying security, a put option gives you the right to sell it at a fixed strike price (think of this as putting the underlying security away from you.)

Put options also have expiration dates. The same style rules (i.e., American or European) apply when you can exercise them.

Read more about put options

For example, say you buy a put option for 100 shares of ABC stock at $50 per share with a premium of $1 per share. Prior to the option's expiration date, the stock's price drops to $25 per share. If you exercise your option, you could still sell the 100 shares at the higher $50 per share price, and your profit would be $25 x 100 (less the $1 per share premium) for a total of $2,400.

On the flip side, if the stock's price rises, you'll be out your premium, plus any commission.

A call option gives you the right to buy an underlying security at a designated price within a specific period (think of it as calling the underlying security to you.) The price you pay is called the strike price. The end date for exercising a call option is called the expiration date.

Call options can be American-style or European-style. With American-style options, you can buy the underlying asset any time up to the expiration date. European-style options only allow you to buy the asset on the expiration date. 

Read more about call options

For example, say you buy a call option for 100 shares of ABC stock with a premium of $3 per share, but you're hoping for a price increase this time.

Your call option contract allows you to buy shares at $50 each. Meanwhile, the stock's price climbs to $100 apiece. You could effectively use a call option contract to buy that stock at a discount, saving yourself $4,700 ($50 x $100, minus the $3 per share premium).

If the stock's price dropped and the option contract expired, you'd still be out the premium cost of $3 per share.

We usually see selling options as a more advanced trading strategy for experienced investors. With buying options, you have the right to buy or sell an underlying security, whereas when you sell an option, you’re obligated to fulfill the options contract. Let’s look at an example:

Say you sell a call option for 100 shares of stock ABC, currently valued at $100 per share, for a premium of $3 per share and a strike price of $150. If the value drops, the buyer is likely to let the contract expire worthless, and you keep your $3 per share premium (that’s $300). However, if the value rises to $200 and the contract buyer exercises the call option, you’re obligated to sell them the stock at the strike price of $150 per share — but you'd still have to buy the shares at the new price of $200. While you still get to keep the premium of $300, you’re at a net loss of $2,700 ($50 per share less the premium).

Because selling options comes with a lot of risk, it’s considered to be a strategy for more advanced traders.

Options based on equities, more commonly known as “stock options,” typically are a natural lead for traders new to options. Stock options are listed on exchanges like the New York Stock Exchange in the form of a quote. It is important to understand the details of a stock option quote before you make a move.

You can calculate options pricing using two different models. But at its core, options trading prices are based on intrinsic value and time value.

An option's intrinsic value represents its profit potential based on the difference between the strike price and the asset's current price. Time value measures how volatility may affect an underlying asset's price until expiration.

The stock price, strike price and expiration date can all factor into options pricing. The stock price and strike price affect intrinsic value, while the expiration date can affect time value.

As with any other investment strategy, options trading has its lists of potential benefits and risks, and it's important to understand these to try to avoid making costly mistakes .

In terms of advantages, options trading tends to offer more flexibility and liquidity. You can invest with smaller amounts of capital compared to other investment options. Options might create downside risk protection and diversify your portfolio.

On the other hand, options trading can be much riskier than buying individual stocks, ETFs or bonds. Predicting stock price movements is difficult, and if your guess about a particular security turns out to be wrong, options trading could expose you to severe and unlimited losses. Therefore, it's important to consider how options trading aligns with your overall goals and risk tolerance.

Once you've mastered options trading basic concepts, you may be interested in more advanced options trading strategies. As you become more comfortable with options trading, your investing efforts may include some commonly used techniques.

A covered call strategy has two parts: You purchase an underlying asset. Then you sell call options for the same asset. As long as the stock doesn't exceed the strike price, you can realize profits by selling call options for your assets.

A married put strategy involves purchasing an asset and then purchasing put options for the same number of shares. This approach gives you downside protection by allowing you the right to sell at the strike price.

A long straddle strategy involves buying a call and put option for the same asset with the same strike price and expiration date at the same time. You can use this approach when an investor is unsure which way prices for the underlying asset are likely to move.

If you're interested in beginner options trading, consider these factors as you get started.

It's worth noting that while this discussion references calls and puts in relation to stocks, options can be attached to other types of securities. The most common underlying securities are equities, indexes or ETFs .

Quite a few differences separate options based on indexes versus those based on equities and ETFs. It’s important to know the differences before you start trading.

If statistics and probability are in your wheelhouse, chances are volatility and trading options may be too. As an individual trader, you really only need to concern yourself with two forms of volatility: historical and implied.

Historical volatility represents the past and how much the stock price fluctuated daily over one year.

Implied volatility is based on what the marketplace is “implying” the volatility of the stock will be in the future, over the life of the option contract.

Implied volatility is one of the most important concepts for options traders to understand because it can help you determine the likelihood of a stock reaching a specific price by a certain time. It can also help show how volatile the market might be.

When trading options, you can buy or sell calls or puts. You can be long or short —and neither has anything to do with your height. Consequently, you can also be in-the, at-the or out-the-money. Those are just a few commonly used words in a room of options traders. Simply put, it pays to get your terminology straight. That's why we created an options trading glossary to help you track everything.

We’re not talking about Aphrodite and Zeus. Options traders use the Greek alphabet to reference how options prices are expected to change in the market, which is critical to success when trading options. The most common ones referenced are delta, gamma and theta.

Although these handy Greek references can help explain the various factors driving movement in options pricing and collectively indicate how the marketplace expects an option's price to change, the values are theoretical. In other words, there is never a 100% guarantee that these forecasts will be correct.

Like many investors, options traders clearly understand their financial goals and desired position in the market. How you approach and think about money, in general, will directly impact how you trade options. Before you fund your account and start self-directed trading , the best thing you can do is clearly define your investing goals.