How to Trade Options

Learn what it takes to trade options

Reviewed by Samantha SilbersteinReviewed by Samantha Silberstein

Options trading can generate big profits, or big losses, through financial leverage. The leverage allows investors to protect their portfolio while giving speculators an opportunity to amplify profits from price moves. This dynamic generates tantalizing opportunities that constantly abound in the option market. However, would-be options traders need a clear understanding of how options pricing works,  the risks involved, and the best practices for choosing the best platform on which to trade. We’ve compiled the basics every option trader should know, and have structured this guide for trading options to answer the questions most novice option traders have. 

How to Trade Options

Understand the Basic

Traders who want to get started with options need to understand the following key topics: 

• The definition of an option and the two types of options: calls vs. puts
• How options are priced (in the money vs. out of the money)
• How option prices change (measured by the options Greeks)
• How to open and get started trading in an options account
• How to avoid losing money

Call and Put Options Defined

Options allow traders to make a leveraged bet on what might happen next with a security’s price. Each standard option controls 100 shares and has a designated strike price and expiration date. 

Option contract holders aren’t required to exercise their rights to buy or sell shares. They can let the option expire worthless (and forfeit what they spent on it), or they can sell the option contract to another trader for whatever amount that trader is willing to pay. If the contract’s value increases, they can make a profit without ever exercising the option or having to own the stock. However, if the value decreases, losses result. 

Calls vs. Puts

Call options let you purchase the security at its strike price, which can be done any time before expiration. At expiration, the broker will automatically exercise the option if the price of the underlying shares exceeds the value of the strike price. Put options give you the right to sell the security at the strike price any time before expiration. The broker will exercise the option at expiration, but only if the price of the underlying shares is below the value of the strike price before the contract expires.

The value of call options will generally increase as the underlying security goes up in price, while the value of put options will increase as the security falls in price. But there are certain basic elements that go into option pricing that every trader should be aware of, and the price of the underlying shares is only one of them. 

European vs. American

Call option buyers can exercise their right to purchase shares and establish a long position in the stock. Put option buyers exercise their right to sell shares and establish a short position in the stock. But there is a difference in the moment when a contract can be exercised based on the style of the option contract. 

American-style options can be exercised at any time leading up to the close of the expiration date, but European-style options can only be exercised on the date of expiration. However, both option styles can be bought or sold up until expiration. Most exchange-traded securities are American-style options, while most index-based options are European-style options.

Physical vs. Cash Settle

When an option contract reaches expiration, the terms of the contract are settled, meaning both parties in the contract receive what they are due. Call options for stocks or other exchange-traded securities are settled by assigning shares of the underlying security to the call option buyer and assigning the call option seller the obligation to provide those shares. If the seller holds those shares already, they are removed from the seller’s account and placed in the buyer’s account. If the seller does not have the shares in their account, the buyer is still given shares, but the seller is assigned a short position in the security.

For options on indexes, the contract is settled to cash. Option buyers who find their contracts in the money at expiration will receive a cash equivalent of the intrinsic value of the option, while the option sellers are required to pay that cash from their account. Options that expire out of the money are worthless and no cash changes hands at expiration.

Best Options Trading Platforms

Steps Required to Open an Options Trading Account

Once you’re prepared to explore the world of options trading, you will need to research the brokers with which you can open an account. After you have selected a broker to use and filled out the account application (this is usually done online and is fairly quick), then you can request options trading approval.

Step 1: Select a broker. Choose a reputable online broker, such as Interactive Brokers, tastytrade, or E*TRADE, where you have access to critical options trading tools, including options calculators, extensive charting tools, screeners, demo accounts, strong trading technology, extensive educational materials, and a transparent fee structure. 

Step 2: Register an account. Broker requirements for approving options trading in your account can vary widely. Some brokers may have a tiered level of option trading approval (lower tiers include buying and selling options; higher tiers include spread trading, index trading, and selling uncovered options). 

Some brokers may ask you to complete a questionnaire or take an online course to demonstrate your knowledge of options trading. All such requirements are stipulated by the broker simply to manage their risk. Consequently, the higher your net worth or the larger your account, the less strict a broker is likely to be about such requirements.

Step 3: Fund your account. Once your application is processed and you are approved for options trading, you will want to fund your account with more than the minimum required amount, and review and accept the language of the options agreement. If you plan to trade options on margin, you’ll need to meet your brokerage firm’s margin requirements. This can include meeting ongoing minimum balance requirements and promptly addressing margin calls. Once these are complete, your account will be capable of trading options. 

Step 4: Research option strategies. Successful option trading is more complex than stock trading because it requires factoring critical elements, such as volatility and time decay. Options trading strategies range from simple one-leg strategies, like simply buying puts or calls, to complex multi-leg strategies like iron condors. All strategies have varying sensitivity to the passage of time, fluctuations in price, and changes in implied volatility, and it is critical to understand what trade-offs each strategy includes.

What You Need to Open an Options Trading Account

Before you can start trading options, you need to open an account with a brokerage firm. To do this, you’ll need to provide personal information such as:

• Name
• Address
• Social Security number 
• Employment status
• Job title 

These are provided for account ownership and standard banking purposes. 

The broker will also ask you to provide additional information regarding the following key items: 

• Financial status
• Liquid assets
• Trading experience 
• Risk tolerance
• Option trading knowledge

This information is used to assess the risk of having you as a customer. It helps the broker reduce the risk that you might make a trading mistake that could somehow spill over from your account and impact their business. 

How to Read an Options Chain

Bid

The bid is the price you can sell the quoted option for with a market order. It is the price of the highest limit order that a buyer from any exchange is willing to spend to buy the contract you want to sell.

Ask

The ask is the price you can buy the quoted option for with a market order. It is the price of the lowest limit order that a seller from any exchange is willing to sell the contract you want to buy.

Volume

This is the number of option contracts that have transacted today on this specific contract. Contracts with a volume of less than 100 per day might see larger spreads between the bid and the ask prices.

Open Interest

Option contracts which have been purchased, and are still available to be exercised, are counted as part of open interest. This number includes options that are initiated as both buys or sells, so the open interest includes both long and short positions.

Strike Price

This is the price at which the option buyer can exercise the right to buy (in the case of call options) or sell (in the case of put options). Each option contract has a strike price and an expiration date.

Expiration Date

Beyond this date, the option contract cannot be exercised. Up until the close of trading on this date, the option buyer may choose to exercise their right. Options which expire in the money are automatically exercised on the day after trading is closed.

Vega

This option Greek measures an option contract’s sensitivity to changes in implied volatility. If the implied volatility of an option increases by one percentage point, the option contract should increase in price by the vega value (all else being equal). 

Theta

Another option Greek, theta measures an option contract’s decline in price over the next 24 hours attributable to time decay. Theta values rise as the day of expiration gets closer.

Delta

This option Greek is the measure of an option contract’s sensitivity to changes in the price of the underlying security. If the underlying stock, or other security, increases by one dollar in price, the option contract should increase in price by the delta value (all else being equal). 

Gamma

This is an option Greek related to delta. It is the measure of an option contract’s change in delta score if the underlying security increases by one dollar. If the underlying stock, or other security, increases by two dollars in price, all other considerations being equal, the option contract should increase in price by the delta value for the first dollar increase and by the delta value plus the gamma value for the second dollar increase. As a result, gamma measures the potential acceleration of option prices. 

At-the-money (ATM)

The option contract with the strike price closest to the current price of the underlying security is said to be “at the money.” The ATM contract is subjective when the price is equally between two strike prices, but it is common to consider the strike that is currently in the money as the option someone would designate as at the money.

In-the-money (ITM):

In-the-money (ITM) options have intrinsic value, meaning the difference between the option’s strike price and the underlying asset’s market price is favorable, resulting in immediate value if exercised. 

Out-of-the-money (OTM):

Out-of-the-money (OTM) options have no intrinsic value, as the strike price isn’t favorable compared to the market price. It would be worthless to exercise an OTM option.

Factors to Consider When Opening an Options Trading Account

Customer service: As an option trader, you’ll want a broker that can be accessed online or over the phone to give quick answers on things like balance changes, margin requirements, margin call notices or other unusual notifications. A broker representative should also be available to clarify trade-related issues, especially on topics of expiration, assignment, and closing out spread trades. 

Fees and commissions: Some brokers charge commissions on option trades, even if they don’t charge commissions on stock trades. The costs of commissions and fees can vary significantly as certain brokers prefer to remove some or all commissions from the customer transaction. For a better understanding of the fees charged by the best options trading platforms, this guide can serve as an excellent resource. 

Account minimums: For stock and option trading, opening an account with a minimum deposit of several thousand dollars has become a thing of the past. Most brokers will allow customers to open an account without funding it right away.

Research and trading tools: The best options trading platforms supply fundamental, technical, and even proprietary research for traders. Online web-based brokers tend to offer a more sophisticated toolset for trading than mobile-based apps used by some of the newer brokers such as Robinhood, Webull, and eToro. Sophisticated charting tasks are more productive when performed on software-based desktop trading platforms. The same is true for complex order types such as conditional or branching orders. 

Educational content: Highly informative articles, videos, online classes, interactive quizzes, and more are common nowadays for many online brokers. The most popular broker platforms are often featured by option traders who create educational content on social media platforms as well. You shouldn’t have to struggle finding educational content for your trading platform, so if you do, take that as a warning flag.

Demo account: The best options trading platforms include demo accounts so that their customers can fully understand how options Greeks and changing market conditions affect options prices. These practice accounts allow a trader to make simulated trades based on the same platform interface they will use to make trades. This can be very helpful for traders just getting started trading options. But not all brokers provide this tool, so beginner-level traders may want to check out the investopedia simulator if they have no tools available from their broker.

FAQs

Are Futures the Same as Options?

Options differ from futures because an option buyer is not obligated to exercise their right to buy shares. Futures buyers, on the other hand, are obligated to take delivery of the underlying commodity in the contract unless they sell the contract away before expiration. This means that option prices can be highly sensitive to time decay, where futures are not.

How Can You Hedge With Options?

The most common use of options for hedging large portfolios or large positions within a portfolio is to buy put options to protect from catastrophic price drops. This is analogous to buying insurance, in that you are paying a premium for the protection. The adverse event may not occur, but if it does, you can make some gains. Either way, you won’t receive the premium back unless you can sell the contract at a higher price than you paid for it. Any portfolio position can be hedged with option contracts, so long as you are willing to pay the contract prices.

What Are Leap Options?

The term “long-term equity anticipation securities” (LEAPS) refers to publicly traded options contracts with expiration dates that are longer than one year, and typically up to three years from issue. They are functionally identical to most other listed options, except with longer times until expiration.

How Much Money Do You Need to Trade Options?

Broker requirements can vary from zero to a few thousand dollars. Most brokers require account sizes of $2,000 or less. However, trading an option account with only a few hundred dollars is not prudent. Option trading strategies work best when a trader employs only a small amount of their available capital on any one trade.

Read the original article on Investopedia.