Contracts are legally binding agreements designed to serve specific purposes and needs. In financial markets, contracts are crafted to make a profit and are also known as “financial instruments” – abstract tools made to generate profit. One such instrument that’s been developed to make a profit is options.
As with other derivatives, options contracts track the underlying asset's price, i.e., its value is dependent largely on other instruments' price (cash or derivatives). Options trading is how investors can speculate on the future direction of the overall stock market or individual securities, like stocks or bonds. In this article, we’ll dive into what is option trading and how does option trading work.
What Are Options?
Options are tradable contracts that investors use to speculate about whETHer an asset’s price will be higher or lower at a certain date in the future, without any requirement to actually buy the asset in question.
At first glance, options seem a little counterintuitive, but they’re not as complicated as they appear. To understand options, you just need to know a few key terms:
- Derivative: Options are what’s known as a derivative, meaning that they derive their value from another asset. Take stock options, where the price of a given stock dictates the value of the option contract.
- Call and Put Option: A call option gives you the opportunity to buy a security at a predetermined price by a specified date while a put option allows you to sell a security at a future date and price.
- Strike Price and Expiration Date: That predetermined price mentioned above is what’s known as a strike price. Traders have until an option contract’s expiration date to exercise the option at its strike price.
- Premium: The price to purchase an option is called a premium, and it’s calculated based on the underlying security’s price and values.
- Intrinsic and Extrinsic Value: Intrinsic value is the difference between an option contract’s strike price and current price of the underlying asset. Extrinsic value represents other factors outside of those considered in intrinsic value that affect the premium, like how long the option is good for.
- In-the-money and out-of-the-money: Depending on the underlying security’s price and the time remaining until expiration, an option is said to be in-the-money (profitable) or out-of-the-money (unprofitable).
How Does Option Trading Work
You can deploy a range of options trading strategies, from a straightforward approach to intricate, complicated trades. But broadly speaking, trading call options is how you wager on rising prices while trading put options is a way to bet on falling prices.
Options contracts give investors the right to buy or sell a minimum of 100 shares of stock or other assets. However, there’s no obligation to exercise options in the event a trade isn’t profitable. Deciding not to exercise options means the only money an investor stands to lose is the premium paid for the contracts. As a result, options trading can be a relatively low-cost way to speculate on a whole range of asset classes.
Option trading allows you to speculate on:
- WhETHer an asset’s price will rise or fall from its current price.
- By how much an asset’s price will rise or fall.
- By what date these price changes will occur.
With call and put options, you need the underlying asset’s price to rise or fall to break even, which is a rupee amount equal to the premium paid plus the strike price. Here’s how you earn a profit:
- Call options. Once the underlying asset’s price has exceeded the break-even price, you can sell the call option – called closing your position – and earn the difference between the premium you paid and the current premium. Alternatively, you can exercise the option to buy the underlying asset at the agreed-upon strike price.
- Put options. Once the asset’s price has fallen below the break-even level, you can sell the options contract – closing your position – and collect the difference between the premium you paid and the current premium. Alternatively, you can exercise the option to sell the underlying asset at the agreed-upon strike price.
If the asset’s price moves in the opposite direction than desired for either a call or put option, you simply let the contract expire – and your losses are equal to the amount you paid for the option (e.g., the premium plus associated trading fees).
Options trading strategies can become very complicated when advanced traders pair two or more calls or puts with different strike prices or expiration dates.
Pros of Options Trading
Options trading combines specificity with flexibility. Traders need to choose a specific strike price and expiration date, which locks in the price they believe an asset is headed toward over a certain timeframe. However, they also have the flexibility to see how things work out during that time – and if they’re wrong, they’re not obligated to actually execute a trade.
Because options contracts have an expiration date, which can range from a few days to several months, options trading strategies appeal to traders who want to limit their exposure to a given asset for a shorter period of time. Options traders need to actively monitor the price of the underlying asset to determine if they’re in-the-money or want to exercise the option.
Options trading is also attractive as a hedging tool. For example, if you own shares of a company, you could buy put options to mitigate potential losses in the event the stock’s price goes down. This is one reason that options for broad market benchmarks, like the S&P 500, are commonly used as a hedge for potential declines in the market in the short term. As a result, options trading can be a cost-efficient way to make a speculative bet with less risk while offering the potential for high returns and a more strategic approach to investing.
Cons of Options Trading
Options trading doesn’t make sense for everyone – especially people who prefer a hands-off investing approach. There are essentially three decisions you must make with options trading (direction, price and time), which adds more complexity to the investing process than some people prefer.
Unlike trading stocks, there’s also an additional hurdle for options trading: Brokers are required to approve customer accounts for options trading only after you fill out an options trading agreement. This is used to assess your understanding of options trading and its associated risks.
To make money from options trading, you’ll need to set price alerts and keep a close eye on the market to see when your trade becomes profitable. And you’ll need to be mindful of the risks and trading fees that can add up with various options strategies. While many brokers have eliminated fees for trading stocks or exchange-traded funds (ETFs), these still exist for options. Commissions may range from a flat rate to a per-contract fee based on the amount you trade – both when you buy or sell options. As a result, options traders must take into account these fees when considering the profitability of an options strategy.
How to Start Trading Options
It’s best to have a strong understanding of trading under your belt before you dive into options. Then you should outline what your investment objectives are, such as capital preservation, generating income, growth or speculation. Your broker may have additional requirements, such as disclosing your net worth or the types of options contracts you intend to trade.
As with any other type of investing, it’s best to educate yourself thoroughly before you begin and use online simulators to get a feel for how options trading works before you try the real deal. When you’re ready to begin options trading, start small – you can always try more aggressive options strategies down the road. In the beginning, it’s best to focus on an asset you know well and wager an amount you’re comfortable losing.
Closing Thoughts
So what is option trading and how does option trading work? Options trading is an advanced strategy most often used by sophisticated investors as a cost-efficient way to make a speculative bet with less risk, while offering the potential for high returns and a more strategic approach to investing.
However, buying and selling options profitably requires plenty of research and in-depth understanding of your stock positions. If you don't want to make that type of commitment as an investor, then buy-and-hold investing may be a better approach for you to build wealth.
