How Options Trading Works: A Step-by-Step Guide

There is a parallel universe that exists within the stock market, and we have the ability to traverse this universe and learn its new, exotic opportunities. A place that exists underneath a copious number of securities. 

This strange world is called derivatives, or options. Options literally give you, well, options.

But what kind of options? Well, they can be used to hedge against risk, leverage positions, and make money no matter what direction a stock goes. 

This article will provide all of the necessary information to give anyone the ability to jump into this exciting environment in the stock market. Let’s dive in.

What is Options Trading?

Options trading is a completely different ball game than trading stocks. Options are derivatives of an asset. They are intimately tied with stocks and other forms of securities, but most commonly stocks. At their essence, they grant you the right, but not obligation, to either buy or sell, depending on the type of option you have, a security at a set price over a set period of time.

There are two primary types of options contracts, a call and a put. A call gives you the right to buy, or ‘call’ stock away from someone, and a put allows you to sell, or ‘put’ stock to someone. Both calls and puts represent 100 shares of the security they’re associated with.

A call is a contract that is associated with a security, and gives you the right, but not the obligation, to buy 100 shares of the underlying security at a set price over a set period of time. Underlying security just means the security that the option is tied to. 

A put is the inverse of a call. Puts give you the right to sell 100 shares of the underlying security at a set price over a set period of time.

Options Trading Terminology

It is imperative to understand several key terms associated with options trading. All of which revolve around one thing – the price of the contract, aka, its premium. 

Strike Price

An option’s strike price is the price that you can buy the underlying asset at, if you long a call, or the price you can sell the asset at, if you long a put. The underlying price means the current price of the security the options is associated with. 

The distance between the strike price from the underlying price is a crucial element that affects an options premium. Based on where the strike price is compared to the current underlying price, an option can be in-the-money, at-the-money, or out-of-the-money.

In the Money

In-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) are terms used to describe the relationship between an option’s strike price relative to the current underlying price. 

In-the-money means two slightly different things for calls and puts. Namely, a call that is ITM has a strike price below the underlying price. This is because calls give you the right to buy stock at a set price, therefore it is more advantageous to purchase the underlying asset at a price lower than its current market value.

Puts are the opposite. Puts are ITM when the strike price is above the underlying price. This is because it would be better to have the right to sell stock at a higher price than the current market value, of course. 

It is worth noting that options that are ITM are more expensive than those that are at, or out of the money. This is because a contract that allows you to buy or sell ITM is more valuable than a contract that is OTM. The demand is higher for a contract that allows you to buy stock for less than its current market value, for example. Lastly, the further in the money the contract is, the higher its premium will be. 

At the Money

At-the-money (ATM) contracts are calls and puts that have a strike price equal to the underlying price. You won’t typically see contracts available on a trading platform that are exactly ATM. “At-the-money” is more so a good center point to measure how far in or out of the money a contract is. 

You can see in the image below there is a gray line that says “Share Price: $16.66”. That means that any call that is below that ATM line will be ITM, and any contract above the line is OTM. Note that the strike prices are listed in white. You’ll also notice different dollar amounts that are in orange. Those are the option’s prices per share, or their premium. You can see that the further ITM the call is, the higher the premium, and visa versa for OTM contracts. 

Out of the Money

Out-of-the-money (OTM) contracts are the flip side of the coin. A call is out of the money when the strike price is above the current underlying price – and puts are OTM when the strike price is below the current underlying. 

Expiration Date

An option’s expiration date is a key factor that influences the value of the contract. All it really is, is the amount of time you have to exercise your right to use the contract. Remember though that you are not obligated to exercise the contract, and actually, only about 10% of options contracts are actually exercised. Most contracts are just flipped, just as you would buy low and sell high with shares of stock, you trade contracts and profit from the differences in the premium.

There is a concept called “time value”, and the way that applies to options is, as the expiration date gets closer, the option’s premium will decrease. Picture ice cream being an option’s premium and the nearing expiration date being the sun. Slowly but surely, it melts its value. This effect is called “time decay”. The closer the contract is to the expiration date, the faster the premium will melt – see image below.

Premiums

An option’s premium is the price of the contract that is based on several factors. These factors include what has been listed above, such as if the contract is in or out of the money, as this affects the option’s premium, and how close a contract is to its expiration date.

Premiums for contracts are typically represented by its premium per share. For example, you’ll see that one of the premiums in the image above is $0.46. This means the contract costs $0.46 per share, and since options represent 100 shares of an underlying asset, the premium (i.e. the cost of the contract) would be $46.00 in total. 

Different Options Trading Strategies

Now that we have some of the basics of options trading down – what the different types of contracts are, how they work, how they’re priced, and the associated terminology, let’s dive into some basic strategies. Options trading can quickly become complex, so it’s important to nail the basics first and build a strong foundation.

Covered Call

Just like stocks, you can long and short options. A big difference is that when you sell options, you receive money in the form of a premium. To keep that money, you just want to hope that the direction of the underlying security doesn’t move in a direction that would make you lose the premium initially received. 

The other thing that can happen is the contract you sold to someone can be exercised, meaning you are now assigned the contract and are responsible for either buying or selling 100 shares of the underlying security, depending on if you sold a call or a put. With a call, you would be responsible for selling 100 shares. 

To protect yourself from a potential assignment, you can use a strategy called a covered call. This is when you own the equivalent number of shares associated with the contract(s) you sold. This is what is meant by “covered”. Otherwise, if you were to sell a contract and not cover it, it would be referred to as a “naked” call or put.

Married Put

A married put is a very common play, especially among hedge fund managers. You have to have a relatively large amount of capital to perform this play. This is because the play works by first longing 100 shares of a security, and then purchasing a put of the same security. You “marry” the put to the shares. Oftentimes traders using this strategy will choose a strike price at the price they longed the shares for. 

This is an effective strategy because if the stock price goes up, you will make money from the shares you long, and hopefully not lose out very much in comparison to your put. But, if the price falls, you have your put that gives you the right to sell at a set price, so you can sell the 100 shares you long at a much higher price, protecting you from larger losses. 

Straddles and Strangles

Straddles and strangles are great strategies to employ when you are feeling a little unsure about either the direction of the underlying price, or the amount the underlying price will move. A straddle is a good play when you are totally unsure of the direction of the underlying price, but you feel that it will move significantly. 

A strangle has a similar setup as a straddle, but a strangle is used more when you feel that you know what direction the underlying price is going to move, but you want to protect yourself just in case it doesn’t move as much, or in the direction you thought.

A straddle is a very simple play, and it involves the simultaneous purchasing of two contracts, one call and one put, that are associated with the same security. The call and put need to have the same strike price and expiration date for the strategy to be considered a straddle. 

A strangle is similar to a straddle, only with a strangle you have a call and put with the same expiration date, but two different strike prices. Again, this is a good strategy when you are confident in what direction the underlying price will move, you just aren’t sure how much it will move. 

Spreads

There are three main types of spreads, a horizontal (aka a calendar spread), a vertical spread, and a diagonal spread. Each type of spread requires the investor to purchase two option contracts of the same type. The reason they are called these names can be seen quite easily if you graph them.

In the image above, you see strike price on the y-axis and expiration dates on the x-axis. With calendar spreads, you buy either two calls or two puts, and they have the same strike price but different expiration dates. Vertical spreads work when the contracts have the same expiration date, but different strike prices. And lastly, diagonal spreads have different strike prices and different expiration dates. 

Choosing to employ a spread can be an effective strategy that is used to bet on different market outcomes. Longing just one contract is sort of like hitting a target price with a rifle, and using spreads is more like using a shotgun to hit your target. 

Advanced Plays

There are much more advanced plays beyond what has been discussed here. Understanding the dynamics of basic options trading strategies will help you grasp the concepts of more advanced plays later on.

For example, if you understand how a credit spread works or even the basics of a debit spread, then grasping the concept of what’s called an iron butterfly will be much easier. This is because an iron butterfly is built with a short put and a short call spread. But – let’s stick to the more fundamental aspects of options trading for now.

Options Calls vs. Puts – A Deep Dive

We know that calls and puts serve as the cornerstone of options contracts. Let’s dive into the different ways calls and puts are used by traders – and what the different strategies aim to achieve.

Long Call

A long call is when you purchase a call option. “Long”, in the world of finance, is a fancy way of saying “own”, or “purchase”. Options are contracts, and you figuratively sign them when you long one.

A call option contract represents 100 shares of the security that it is associated with. And a call gives you the right to buy the associated security at a set price (the strike price) for a set period of time (from the time of purchase to the expiration date). 

The break-even point of a long call can be found by adding the strike price to the debit paid (the amount spent on the contract in the form of premium). For example, if the underlying price is $100, the strike price is $105, and the premium is $1.75, the break-even point would be $106.75. 

Short Call

Now, shorting options is a lot different than shorting regular shares of a stock. There are many more factors at play; whereas shorting shares of TSLA, for example, is pretty straight forward. 

Another way traders refer to shorting an option is “writing” the contract. Like writing a covered call. It’s thought of as “writing” because you are hand picking the strike price and expiration date of a call or put that another buyer will long. 

Now, when you sell, or short an option, you receive money in the form of a premium. The amount of premium depends on the factors you chose such as the strike price and expiration date. Your goal is to keep all of, or as much of that premium as you can. 

The break-even point for a short call can be calculated by adding the strike price to the credit received, aka the premium. So say a stock has an underlying price of $50, and a strike price of $55, and the premium for the call you shorted is $1.50, the breakeven point is $56.50. 

Now, as with shorting shares of stocks, you expose yourself to unlimited risk, as theoretically the underlying price can continue to rise infinitely. This is why you protect yourself by setting up a covered call and not sell one ‘naked’. 

Another crucial element to shorting both calls and puts is the risk of assignment. This is when the investor you sold the contract to decides to exercise their right to either buy or sell 100 shares of the underlying stock, and you are then obligated to supply those shares. In the case of a short call, you would be obligated to sell 100 shares of the underlying. 

Lastly, with short positions, you are not stuck in the position once you sell it, you can always close the position by buying the contract back. 

Long Put

A long put is the yin to a long call’s yang. It’s the mirror image, or inverse of a call, so everything works the other way around. Namely, the way that we determined the break-even point for a long call was by adding the strike price to the debit paid, and to calculate it with puts, you subtract the debit paid from the strike price.

So if you have a put with a strike price of $25, and the premium is $1.50, the break-even would be $23.50. 

Short Put

Lastly, the short put. Just as a long put works inversely to a long call, so does the short put to a short call. The break-even point of a short put can be calculated by subtracting the strike price from the credit received. 

In the case of assignment, you will have to buy 100 shares of the underlying asset. So cover the put by longing 100 shares of the underlying security before you short the contract.

Real World Examples of Option Trading

Let’s use Johnson & Johnson (JNJ) as an example. 

Say you are bearish on JNJ because of recent news that the market could be heading for a small re-correction due to the Feds increasing interest rates. You decide you want to long a put to profit off the potential fall in JNJ’s price. You are also unsure of how long it will take for the price to start going down, but you’re confident that it won’t go down in a week or two, but you also don’t want to buy a contract with an expiration date further out than 2 months because it’d be too cost prohibitive. 

So you decide to long a JNJ put on May 28 that expires on July 1. The current underlying price is $180.00. You want a put that is slightly ITM, so you need to purchase a contract with a strike price above the current underlying. You decide to get a contract with a $185.00 strike price. The premium for the contract is $5.93 per share, $593.00 total. 

In the first week or two, the price doesn’t move much, it just kind of teeter totters between 1-2%. But during week three, JNJ’s price is down to $173.70, or 3.5% since you bought the contract. The premium for the contract is now $7.32, the total difference is now $139.00. 

You have two options at this point. Close the position by selling the contract back, or exercise the contract. But what would happen if you exercised it? 

1. Flip the Contract

This is how you would calculate your profit/ loss:

• You spent $593.00 initially on the contract.  
• The total difference in the underlying price to your contract’s strike price is $11.30. 
• Your contract gives you the right to sell 100 shares of JNJ at $185.00. 
• 100 * $11.3 = $111.30. Now you have to subtract what you initially spent, which was $593.00. 
• So your total loss would be $481.70. 

This is one of the reasons why so few contracts are actually exercised, because the underlying price needs to move significantly in order for you to make a profit. 

Now for the second option. 

2. Flip the Contract

The premium for the contract is now $732.00, and you can make $139.00 in profit if you sold the contract now, but maybe you think that there is still potential to make more in the last week you have the contract. But, even if the price does continue to fall, which would make the contract more valuable, remember what happens regarding the effect of time decay. 

The closer your contract is to the expiration date, or the sun, the faster the premium, or ice cream, will melt. So even if the price keeps falling, you could be fighting a losing battle against time, so it’s best just to chop off the greens and close the position. 

How to Start Trading Options

Okay, with all the information we’ve gone over, it’s time to start trading! But how?

To get started trading options you need the right platform. There are tons of good choices these days. Brokerages like Fidelity and TD Ameritrade have been around forever and are always pretty reliable and offer options privileges. Other more contemporary brokerages like Robinhood offer a clean interface that is user friendly, and favored by newer generations. It’s all up to you and your personal preferences. Do some research before opening an account to make sure it’s the right one for you. 

Create an Options Trading Account

There are tons of brokerages that offer the ability to trade options. First, search for a couple brokerages, maybe you have heard of some before, maybe not.

TD Ameritrade and Robinhood are two reputable brokerages that you can trade options through. They both have a clean interface, and both are fairly user friendly, Robinhood being a little more user friendly than TD Ameritrade.

Pick Options That You’d Like to Trade

It’s a good idea to have some criteria set for when you go to start picking options to trade. One of the most important, if not the most important factor, is making sure you choose an option that is fairly liquid, otherwise you might get stuck trying to sell it, and there isn’t another person on the other side to buy it from you. 

Also, make sure you choose options that are in the ‘goldilocks zone’. Meaning, weigh your costs and benefits. Do you really need a contract that is deep in the money and really expensive with a long-term expiration date? That might cost you more than the benefits you receive. Always think about your level of risk tolerance relative to the price you are willing to pay for an option.

Choose a Time Frame

This is key, though choosing an expiration date can be a little tricky. The expiration date will greatly affect the premium of the option, so you need to strike a good balance between how much you’re willing to spend on the option, versus the amount of time you think the underlying price will get to a favorable point.

A common time frame investors use is somewhere between 30 to 90 days from the time of purchase.

Options Alerts

Getting started in the realm of trading options is not easy. At first, trading is complicated, full of never-ending vocabulary and concepts to learn.

There are some experienced traders out there that make it seem easy. Yet trying to trade on your own, independently, is usually a much different experience.

To help traders get started successfully, The Trading Analyst offers options trading alerts where a team of experienced traders carefully monitor the markets, executing a proven strategy, and notifying subscribers of potentially profitable moves. Receiving valuable information from veteran traders can remove a lot of the headache that’s initially experienced when starting to trade.

Why Investors Trade Options

Most people think investors use options in an effort to seek gains and grow the overall growth of their portfolio. But that’s not all options are used for. They’re also a part of risk management. Let’s see how.

Speculation

Speculators in the market are often found in the futures market. We’ve mentioned several times that options represent a “security”, and while a lot of times that means stocks, it can also be other types of securities, like futures. So it is very common for futures traders to use options to capitalize on gains to capture profit both in upward movement with calls, and downward movement with puts.

Hedging

Hedging investments mean protecting them from downside risk, or “hedging” risk. And since put options give you the right to sell stock at a set price, they are an ideal candidate to use to protect shares you want to long. The best way to set this up is to perform the married put strategy. So for every 100 shares you long, buy one put to protect them in case the price falls. 

Be mindful of the expiration date you choose for the put. Ask yourself how long you plan to hold the shares, and make sure the life of the option is well within that time frame. The strike price is another thing to consider. You can pay more for a put that is in the money, but if you don’t want to spend as much and you’re happy with potentially taking a small loss, you can buy at, or an out-of-the-money put for a much cheaper price. 

Leverage

Inherently built into options is the ability to leverage. A contract represents 100 shares of the underlying, but the cost of an option is far less than longing 100 shares, or even one share for that matter, of the same security. 

Further, relatively small moves in price of the underlying result in much larger moves in the premium of an option. Much like the securities that you see that are two or three times leveraged. So gains and losses are essentially magnified with options. This is how leverage works in the world of options trading – it’s inherently risky, so inexperienced traders should stay away from leverage.

Pros and Cons

One thing that is always important to bear in mind when trading options, or considering trading options is the amount of leverage they have as we just discussed. You could lose 10x as much with one contract as you would if you had 100 shares of the underlying stock. This is both a pro and a con, because it could either be to your benefit or you could lose out big time. 

A huge pro to options is the diversity of plays you can make. With stocks, you can’t do much more than just shorting and longing them. But with options, you can make money if a stock’s price goes sideways, you can exercise your right to buy or sell at a set price, you can write them to earn money in the form of premium instantly, the list goes on. Options open a whole new world of investment possibilities. 

One negative side to options is the learning curve. Where the learning curve for trading stocks is much more gentle, it gets quite steep with options. It takes time just to get the simple definitions down, and the information keeps getting more complex the more you explore and build from the basics. Then there’s a sort of second learning curve, and that comes when the information is actually put into practice. So it can take some time to both grasp and apply the information in a way that’s consistently profitable.

Conclusion

Options give you options. Much more than buying and selling regular shares for sure. There are inherent risks built into them, but there are dozens of strategies that can be used that are relatively safe. You can earn profit with options no matter what direction the underlying price goes, even if the price moves sideways. 

It’s important to have a healthy understanding of trading regular shares of stocks and other securities before jumping into options because the information builds on itself, and the concepts in options will make much more sense. Remember also to be patient, it can take time for your strategy to become profitable. 

One final note: the best way for the information given here to make sense is to get your feet wet trading options. Things that may seem confusing after reading them start to make much more sense when they’re applied and you get the hands-on experience. You can start with simple plays, like a married put or a straddle. Good luck!

How to Trade Options: FAQs

How Much Money Do You Need to Trade Options?

The minimum amount that you need to trade options depends on what you want to invest in. For example, a Tesla (TSLA) call contract, if you bought it on May 27, 2022 with a strike price of $760.00, and a June 17 expiration would cost $42.20 per share, or $4,720 total. 

Whereas, if you wanted a Squarespace (SQSP) call contract, also buying it on May 27, 2022, with a strike of $17.50, and a June 17 expiration, it would cost $3.70 per share, or $370.00 total. 

You can see there can be a tremendous difference in how much money you need to trade options. So it all depends on what you want to invest in. 

Is Trading Options Good for Beginners?

If you are a beginner trader, options are not a good vehicle to get started. Learning options before learning how to trade stocks would be like learning multiplication and division before addition and subtraction. Everything that you learn as a beginner trader when you’re just trading stocks on the open market translates to learning about options. 

Can You Get Rich With Options Trading?

You have the potential to earn a significant amount of capital trading options. More than simply longing and shorting stocks. As discussed earlier, options are essentially leveraged positions. Plus, the capital you need to long a contract versus purchasing 100 shares of the underlying is much, much less. 

Can I Trade Options With $100?

Yes, you can trade options with $100, but the contracts you can choose from are going to be very limited. It’s a good idea to have more starting capital than $100 because it’d be very easy to lose it trading one or two contracts. 

What is the Safest Option Strategy?

The safest options strategy would be either a married put or a straddle. This is due to the fact that they are perfectly balanced strategies. 100 long shares, 100 short shares with both strategies, essentially.

Are Options Better than Stocks?

No, options are not objectively better than stocks. Both have their advantages and disadvantages. Weigh the pros and cons, and do a cost vs benefits analysis of every trade you are thinking of placing. In some scenarios it might be better for you to use options, and in others, it might be better to simply long stock. 

Is it Easy to Trade Options?

Sometimes it can be easy to trade options, and sometimes it can be quite difficult and complex. It depends on what strategy you choose to employ. If you are bullish on Apple (APPL), for example, you could simply purchase a call and then sell it before it expires. That’s not very difficult. 

If, however, you decide to start employing complex strategies such as a butterfly spread, things get a lot more complicated. 

Are There Any Special Requirements to Trade Options?

Yes, sometimes there are special requirements to trade options. Namely, some brokerages require you to apply for “options privileges”. One of the more common requirements is to have a certain amount of capital and/ or annual income. But each brokerage varies greatly; some allow you to trade options with the same requirements needed just to trade on the open market. You’ll need to check with the specific brokerage you want to use to get exact information. 

Some other brokerages also, like Robinhood, have a level system, where you can slowly work up to having level three options privileges, which is the highest level. This allows you to borrow on margin.