How to Trade Options

An option is a contract that allows its owner to buy or sell 100 shares of a security at a specific price on or before an agreed-upon date. Options contracts can be purchased or sold at any time before expiration.

Options can be traded for a wide range of financial products, including ETFs, indices, and equities. Trading options involves using various strategies to either profit from certain market moves or hedge existing positions in the spot market.

1. Open an account and get approved for options trading

After opening an account and funding it, you must be approved for trading options before you can begin trading advanced derivatives like options or futures. This usually involves answering a few questions that demonstrate you understand the risks involved in trading these complex instruments. There are multiple options levels, and the higher the level you’re approved for, the riskier options bets you will be allowed to make. For beginner investors, option level 1 is all that’s needed - it will allow you to trade options and use the most common strategies.

2. Learn the lingo

To learn options trading, it’s necessary to become familiar with a unique set of terminology. Here are a few of the most common terms used for options:

• Strike price: The price at which the option becomes in-the-money (ITM). For calls, an option above the strike is ITM. For puts, an option below the strike is ITM.
• Expiration date or expiry: The date by which the contract must be exercised. Beyond this date, the option becomes invalid.
• Underlier: The underlying asset that the options contract represents.
• Premium: The price that an option buyer pays to an option seller.
• Greeks: These are variables that impact the price of an option. I'll cover the Greeks in-depth later.
• Implied volatility (IV): The likelihood of a significant move in the underlying asset’s price in a given timeframe.
• Intrinsic value: The value of an option as determined by the difference between the price of its underlying asset and the contract's strike price.
• Extrinsic value: The value of an option derived from factors other than intrinsic value, such as time premium and implied volatility.

Becoming familiar with the above terms is a good first step for anyone who wants to learn how to trade options.

3. Determine your objective and conduct research

As with any trade, it’s best to have a plan beforehand. This involves setting an objective, understanding the risk, having an exit strategy, and researching the fundamentals of the underlying asset and its options market.

Some common objectives for options traders include speculation on price movements, hedging an existing position, or generating income. Writing options is the most common strategy for generating income while buying calls and puts is the most common for speculation.

To research the options market, it can be helpful to look at an options chain. An options chain is a list of all the available options for a given asset, as well as their respective variables, such as Delta, implied volatility, and more. Traders can use this information to determine which option best suits their desired risk/reward profile. In general, options that are less likely to expire in the money have lower premiums.

An options chain inside the E*TRADE's trading platform.

For example, a call on SPY with a strike price of 450 and an expiration date of one week when the current price is 449 will have a higher premium than a call with a strike of 460 and the same expiration date. Calls with an expiration date far in the future will also tend to have lower premiums. Finding the desired balance between premiums, strike prices, and expiration dates is one aspect of conducting research on options and will vary depending on your goals.

Once you’ve decided on an objective and know exactly which options bet you’re looking to take, it’s time to place a trade.

4. Place the trade

Placing an options trade is more complicated than placing a stock trade. With stocks, traders only need to select a ticker and initiate a buy order, simply choosing whether to open a market order or a limit order.

With options, traders must choose:

• The underlying asset
• An option strategy (call, put, spread, etc.)
• Strike price
• Expiration date

Here is what an options ticket typically looks like:

There are several choices under the “action” tab. When writing an option, choose “sell open.” When buying an option, select “buy open.” When selling an option, you’ll need to choose “bid x size” to sell into existing bids in the market. For buying options, choose “ask x size” to buy options other traders have written.

To close out a position, select “close open” in the action tab and enter your price and order type. Traders also have the option to close out a position and immediately enter a new one with different conditions. This is called “rolling” an option and might be displayed on a different screen inside a portfolio snapshot.

5. Manage your position

Once the position has been placed, the last step is to manage it. Options are generally not a “set it and forget it” type of investment. They usually require constant monitoring to determine the best exit strategy as timing may be essential.

Have a predetermined exit plan

Having an exit plan can help when managing an options trade. When will you decide to take profits, and when will you cut losses? What market conditions might result in a different outlook on this position? Do you intend to exercise the option or sell it early for a profit? Answering questions like this before placing a trade can remove a lot of uncertainty and help prevent unfavorable decisions.

Pay close attention to timing

It’s also important to monitor things like the remaining time premium and implied volatility when managing your options position. As an option approaches its expiration date, it loses extrinsic value due to time decay. Sudden market moves can lead to dramatic spikes or declines in implied volatility, which can also impact the price of an option.

Deciding when to take profits is more complicated than with a stock, as even when the underlier moves in the desired direction the option could lose value if held for too long, if volatility declines, or for various other reasons. Traders may be inclined to take profits at the first opportunity by selling their options on the open market or exercising early. If you decide to hold until expiration, the option either expires worthless or yields a profit when exercised on the expiration date.

It helps to see practical examples to learn how to trade options. Let's say you decide to purchase a call option of a stock.

Imagine you expect Company XYZ's stock, currently priced at $50, to go up to $60 in the next month. You could buy a call option that gives you the right to buy 100 shares of XYZ at a strike price of $55 per share, expiring sometime in the next 30 days (expiration dates typically can be selected in increments of either weeks or months ahead of time). This option might cost you a premium of $200.

If XYZ’s stock price rises to $60, you can use your call option to buy 100 shares at $55 each, then sell them at the market price of $60, making a profit. Your profit would be $500 ([$60 - $55] * 100 shares) minus the $200 premium you paid: $300 total.

However, if the stock doesn't rise above $55, your option expires worthless and you lose the $200 premium. This illustrates both the potential rewards and risks of options trading.

A trader can also choose to sell their option early. This works more or less like a stock trade, where a trader sells the contract to the next highest bidder for a specified price.

There are many different options trading strategies that can be used to profit in any kind of market environment. Here are a few of the most commonly used strategies.

Long calls

Long calls involve buying a call option with a higher strike price than the underlying asset's current price, meaning the option is out-of-the-money (OTM). Traders use this strategy when they expect prices to rise significantly.

Covered calls

Covered calls involve writing a call option on 100 shares of a stock that a trader holds. The strategy generates income and works best when the stock's price trades sideways or downwards.

Long puts

A long put involves buying a put option with a strike price lower than the underlying asset’s current price, in which case the put would be OTM. Traders use this strategy when they expect a sharp drop in prices.

Short puts

A short put involves selling or “writing” a put option without owning the underlying asset. This strategy intends to profit from an asset trading sideways or upwards. If the option remains above the strike price until expiration, the contract will expire worthless, and the seller will pocket the premium.

If the price sits below the strike price upon expiration, the option owner can choose to exercise and sell shares, meaning the option seller will have to buy 100 shares per contract at the strike price. This would result in a loss for the option writer, as they will be forced to buy shares at a higher price than what the stock currently trades for.

Options writing versus options buying

Using short puts and covered calls are option writing strategies, which involve traders selling options. The goal of these strategies is to generate income. In these cases, the trader hopes that the option expires worthless while they hold onto the premium they earned in exchange for writing the option.

By contrast, long puts and long calls are options buying strategies. In these cases, traders hope for the option to move into the money, at which point they can profit by either exercising or selling the option.

Many more advanced options trading strategies exist. There are butterflies, condors, and other strategies with multiple “legs,” or combinations of writing and buying options with different strike prices simultaneously. Note that some of these more complex strategies may require a higher level of approved options trading than just level one.

Trading options can be beneficial but also comes with its share of drawbacks.

Pros of trading options

Leverage: By learning how to trade options, traders can place bets using less capital than required for buying shares. The premium for an options contract usually costs much less than the 100 shares the contract represents.

Trading Possibilities: Options allow traders to trade a wide range of assets and indexes. Traders can place long or short bets on volatility, commodities, broad market indexes, and much more.

Profit Potential: Options can be used to make profits regardless of how the market moves. Whether the market moves up, down, or sideways, different options trading strategies can be used to place profitable trades in any market environment. Options can also be used to mitigate losses on existing positions, a strategy known as “hedging.”

Cons of trading options

High risk: While leverage can be beneficial, it also increases risk. Options can be very profitable when the underlying asset makes a quick move in the direction a trader was betting on. Conversely, options can lose value fast, and they can do so for multiple reasons.

High complexity: Unlike equities, which have simple price action that moves up and down, the price of options is influenced by many factors. Some of these factors are known as “the Greeks.” Understanding each of them is necessary for learning how to trade options effectively.

Time decay: Time decay is another factor that influences the price of an option. All options lose value with time, regardless of the price action of their underlying asset. The rate at which an option experiences time decay depends on multiple factors, and the rate varies throughout the option's lifetime.