Options Trading Basics

Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a specific price before or on a specific date. Investors use options to speculate on price moves, generate income or hedge existing positions.

This page explains the core building blocks: calls and puts, how option pricing works at a high level, common strategies and the main risks to be aware of before trading options.

Calls and puts: the two basic option types

Every standard option is either a call or a put:

• Call option: gives the buyer the right (but not the obligation) to buy the underlying asset at the strike price before expiration.
• Put option: gives the buyer the right (but not the obligation) to sell the underlying asset at the strike price before expiration.

The price you pay to buy an option is called the premium. This is the most you can lose as an option buyer, but sellers (writers) of options can face much larger potential losses depending on the strategy.

Key terms in options trading

When you read about or trade options, you will often see:

• Underlying: the stock, ETF, index or other asset the option is based on.
• Strike price: the price at which the option buyer can buy or sell the underlying.
• Expiration date: the last day the option can be exercised.
• In the money (ITM): an option that currently has intrinsic value.
• Out of the money (OTM): an option that would not be worth exercising at current prices.

Why investors use options

Options are flexible tools that can be used in several ways:

• Speculation: betting on a rise or fall in the price of a stock or index.
• Income: collecting option premiums by writing covered calls or cash-secured puts.
• Hedging: buying puts to limit downside risk on an existing position.

Because options can be combined into many different structures, they are sometimes described as “financial building blocks” that can shape a payoff diagram in many ways.

Simple options examples

Suppose a stock trades at $50. You buy a call option with a strike price of $55 that expires in two months, paying a premium of $2 per share. A few possibilities:

• If the stock rises to $65 before expiry, the call is worth at least $10 (intrinsic value).
• If the stock stays below $55, the option expires worthless and you lose the $2 premium.
• If the stock moves only slightly above $55, you may not fully recover the premium paid.

A put option works in the opposite direction: it gains value as the underlying price falls below the strike.

Common beginner strategies

Some options strategies are simpler and easier to understand than others. Examples include:

• Covered call: you own the stock and sell a call option against it, collecting premium in exchange for potentially selling your shares at the strike price.
• Cash-secured put: you set aside enough cash to buy shares and sell a put option, collecting premium while agreeing to buy if the price falls to the strike.
• Protective put: you own the stock and buy a put option to limit downside risk, similar to an insurance policy.

More complex strategies involve combinations of multiple options (spreads, straddles, strangles, iron condors and so on) and should only be used once you have a solid grasp of the basics.

Risks in options trading

Options are often described as “leveraged” instruments. Small moves in the underlying price can lead to large percentage changes in the option's value, especially as expiration approaches. Major risks include:

• Time decay: the value of many options falls as expiration nears.
• Volatility risk: changes in implied volatility can affect premiums.
• Assignment risk: option sellers can be assigned and must fulfill the contract.
• Complexity: it is easy to misunderstand payoff diagrams or underestimate risk.

Because of these factors, options are usually better suited to experienced investors who fully understand the potential outcomes of each position.

How options fit into an investing plan

For many long-term investors, options – if used at all – play a small, supporting role. A few ways relatively conservative investors may use them include:

• Writing covered calls on long-term stock holdings.
• Selling cash-secured puts on stocks they are willing to own.
• Buying protective puts during periods of unusual uncertainty.

Speculative, highly leveraged options trades should only be done with money you can afford to lose, and only after practising with paper trades.

To see options in the context of other markets, you can also review our pages on futures, forex, mutual funds and bonds.