In a normal market, millions of investors are buying and selling shares of companies in the form of stock with the aim of earning a profit. Simply buying, and selling. Really only hoping for the stock’s price to rise. There aren’t any options for you to make money if the stock’s price declines. And your options are quite limited if you want to hedge against your positions as an intelligent means of risk management.
But what if you had more options to earn profit and hedge risk?
That’s exactly what options contracts give you. Quite literally, more options. There are many ways you can hedge risk, and there are ways to earn money if a stock’s price goes up, down, or sideways. You can even use options if you don’t know what direction a stock’s price is going to move—but you still want to get your hands dirty.
We’re going to give you a complete guide on the basics of options trading strategies to provide you with everything you need to get started. We’ll even get into some basic options techniques you can use with different combinations of strategies.
Ready? Let’s dive in!
What you’ll learn
Options Trading – Explained
The first few terms that you will inevitably hear when you’re just starting to learn about options are referred to as “calls” and “puts”. These two types of derivatives essentially represent two categories within options. Calls are associated with bullish strategies, whereas puts are associated with bearish strategies.
Calls and puts are two different types of contracts that are associated with an underlying security, which is why these are referred to as derivatives contracts. A single options contract itself represents 100 shares of whatever underlying security it’s associated with. This will make more sense in a second. For now we’ll explain the definition of calls and puts.
- A call is a contract that is associated with a security, that gives you the right, but not the obligation, to buy 100 shares of the underlying security it’s associated with at a set price, over a set period of time. Another way to think about it is, a call gives you the right to “call” stock away from somebody else.
- A put is the inverse. Puts give you the right to sell 100 shares of the underlying security at a set price over a set period of time. Puts give you the right to “put” the shares on someone else.
Now that we know options are contracts, the two types of contracts are calls and puts, and each contract represents 100 shares of an underlying security, let’s get into the components of an options contract.
When you are looking at options contracts you can purchase on your trading screen, they look something like this:
TSLA Jan 19, 2024 $300 Call at $78.85.
Let’s break this apart:
- Ticker Symbol: TSLA – this is the ticker symbol of the security that the options contract is associated with. In this particular example, TSLA is the ticker for Tesla Inc., the electric vehicle manufacturer led by Elon Musk.
- Expiration Date: January 19, 2024 – this is the date the contract will expire. Remember in the definitions of calls and puts you have the right to buy or sell stock “over a set period of time”. Your right to buy or sell only pertains to the time between the purchase of your contract, and its expiration date.
- Strike Price: $300 – This is the price at which the contract allows you to buy or sell the underlying security.
- Type of Contract: Call – This annotates whether it is a call or a put contract.
- Premium: $78.85 – This is the price you pay for the contract for each individual share (remember – there are 100 shares for each individual options contract). So in this example the premium is $78.85 per share, so the total price, or premium for the contract is $7,885.00 ($78.85 per share multiplied by 100 shares).
For now, digest these key terms as best as possible, and later on some examples should help the information coalesce, and make more sense.
At any given point in time, a call or put can be in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM). In a general sense, ITM contracts will cost the most, meaning they have higher premiums than ATM, or OTM contacts, OTM having the lowest premiums of the three. We’ll explain why that is here shortly.
The way to determine if a contract is ITM, OTM, or ATM, is to compare the current underlying price of the security the contract is associated with, to the options strike price.
- For calls, if the strike price is below the current underlying price, which is the price of the security the option is associated with, the contract is considered to be ITM. This is because it would be more advantageous for you to be able to buy the shares below what the current price is, rather than above the current price (you would essentially be buying them at a discount through your options contract, as opposed to buying them directly through a broker at their current price). A call would be OTM if the strike price was above the underlying price.
- For puts, it’s the opposite; if the strike price is above the current underlying price the contract is ITM, because of course it would be better to be able to sell the stock at a higher price than what it is currently trading at. A put would be OTM if the strike price was below the current price of the underlying security.
- And ATM, for both calls and puts, means the strike price is the same as the underlying price. This is essentially a breakeven.
“In-the-money” is a term also used outside finance to describe something that’s more favorable than something that’s OTM. Like the first three finishers of a horse race are “in-the-money”, so you’d better hope one of those are the ones you put your money on. If calls give you the right to buy stock at the strike price, and puts give you the right to sell stock at the strike price, it becomes more apparent what ITM and OTM means.
Here’s an example: Let’s say Apple (AAPL) is currently trading at $175.00, and you want to buy a call (because you are bullish on AAPL) that has a strike price of $177.00. Remember that a call gives you the right to buy stock at a set price, in this case the strike price at which you can buy AAPL at is $177.00. So this contract is considered outside-the-money, or OTM.
So you decide to buy the call. What you have done is purchased the privilege, or right, to buy 100 shares of APPL at $177.00 before the contract expires. The reason a trader would want to do this is because he/she believes AAPL will soar far above $177.
Let’s assume AAPL reaches $195 prior to the expiration of this particular options contract. The trader could then exercise his/her contract, by buying 100 AAPL shares for $177. And then, the trader can sell those AAPL shares for the current price, which is now $195.
Now, getting into the next key term, let’s imagine a scenario where you’ve purchased a call option for AAPL, with a strike price of $190, but the current price of AAPL is $170. Your expiration date is quickly approaching. If you exercised options contract, you’d be buying 100 shares of AAPL at the price of $190. But why would you want to do that, if the current price of AAPL is $170. To put it simply, you wouldn’t want to do that. So what happens to your contract then?
Remember – options contracts give you the right to buy or sell the underlying security – but not the obligation. If it’s not in your best interest to exercise the contract—if it’s out-of-the-money (OTM) as you’re approaching expiration, then you can either close out the position by buying to close or selling to open (we’ll get into this later – but for now, just think of this as a trader closing out the position), or let the contract expire worthless, without exercising it. In this case, you will lose the premium that you paid when you initially purchased the contract.
Notably, what’s interesting about options, is only about 10% of contracts are actually exercised by the investor who owns them. According to the Chicago Board Options Exchange (CBOE) here are the more accurate statistics:
So what happens with the other 90%?
What happens most of the time with options is the contracts themselves are traded back and forth. Factors such as time progressing closer to the options expiration date (which influences options premiums), fluctuations in underlying price, etc., all change the value of the option contract. So most options traders are looking to earn profit from the difference in what they bought a contract for versus what they sold it for.
This sounds similar to trading normal shares where you “buy high, sell low”, but the difference between options trading and the typical buying and selling of stocks is, with options you can generate profit if the underlying price goes up, down, or sideways—not only up. Puts are a bearish play because as the underlying price falls, your contract gets more valuable because you own the right to sell stock at a set price, so it only gets better for you when the price goes down.
The last term we’ll review is assignment. Assignment is what happens if you sell a call or put (or short a call or put) and the buyer of the contract decides to exercise their right to buy or sell the underlying stock. The buyer assigns the shares to you, and you are then responsible for selling the shares, or buying the shares, depending on what type of contract you sold, a call or a put. If you are assigned a put, you are obligated to buy 100 shares of the underlying stock, and if you are assigned a call, you are obligated to sell 100 shares of the underlying stock.
It’s crucial that every investor has the necessary capital to cover themselves in the event that they sell a contract which gets assigned to them.
A good understanding of calls and puts will make it easier to grasp the concepts of more advanced strategies with options. Just flipping calls and puts is barely scratching the surface of what can be done with options. We’ll show you some pretty cool examples of how to use them in various plays later on. Remember – there’s a lot of risk involved with options trading, so it’s important to build a solid foundation of knowledge before diving into trading.
Example of an Options Trade
Now let’s tie everything together that we learned in the first section with some examples. We’ll give two examples here, one with a call and the other with a put.
For this first example we’ll look at call options for Ford (F).
Here is what an actual list of different call options looks like on the trading platform, Robinhood. They’re laid out differently than we showed before, but it is easy to identify the components.
On the left hand side we see various prices in white, these are the strike prices for the calls. In the middle there is a gray bar that says “share price $16.66.”, which is the current share price of F. Lastly on the right side we see red numbers, which are the premiums per share for the particular contracts (remember the contracts represent 100 shares, so this is the premium per share. A contract that lists $0.68 will actually cost $68.00).
You’ll notice that all of the call options below the share price have higher premiums than the calls above the share price. This is because the call options with a strike price below the current underlying price are ITM, and the strike prices above the current underlying price are OTM.
Lastly, you’ll see at the top a list of dates ranging from the near future to the very distant future. These are the various expiration dates you can choose from. The farther away the expiration date is, the higher the premium for the contract is because the underlying price has more time to potentially move into the money. Generally speaking, the more time it has the less risk it entails, making the contract worth more than one that’s much closer to expiration.
Okay, so let’s say we decide to purchase the $16.00 call on Mar 31. The strike price is $16, and the premium per share for the contract is $1.03, and the expiration we chose is Apr 22. That means we have the right, but not obligation, to purchase 100 shares of F at $16.00 from the time we buy the contract (March 31) until Apr 22.
A quick, but important side note: If for some reason we decide to hold onto the contract past expiration and it expires OTM and we don’t end up selling it, the contract will expire worthless and your max loss would equal the amount you spent on the contract (the premium). About 30-35% of all options that are traded expire worthless, or OTM.
Continuing with the example, as time progresses, F’s price continues to rise. On April 18th the price of F is now $17.50 so you’re in a great position to sell. The premium for the option has increased quite a bit because the contract you own is now, how options traders would put it, deeper in the money. The deeper into the money it goes, the more profit you can make. So you decide to sell your F call at a $1.30 premium.
Your profit would equal the premium you sold the option for ($1.30), minus the premium at which you bought the contract ($1.03), multiplied by 100. In this example, we’d be looking at: ($1.30 – $1.03) * 100 = $27.
Here’s one of our key trading tips: it is very important that you make sure that the market for the options is liquid before you even think about buying a contract. This is a frequent mistake with options trading that can be easily avoided and can save you a lot of heartache. The last thing you want is to not be able to sell out of your position because the market lacks liquidity.
One way you can sell is by looking at what the trading volume of the underlying security is. If it’s well over a million, that typically means the options market will be liquid enough for you to trade without issues. This is one of the few obvious, but often overlooked, options trading tips.
For the second example, let’s look at puts for Squarespace (SQSP).
Let’s assume the current share price of SQSP is $27.00, and we are feeling bearish so we look at some puts. In the last example we chose a call that was ITM, so for this example let’s choose a put that’s OTM. It’s riskier to purchase a contract OTM because you don’t want it to expire worthless, so instead of choosing an expiration date less than a month out, let’s choose an Aug 19 expiration date so the underlying price has more of a chance to move ITM.
A SQSP put with a $25.00 strike price that expires on Aug 19 has a $3.95 premium, so the cost of the put is $395.00.
Just to give a bit of perspective before we continue with the example: if we bought a SQSP put that was ITM at a $30 strike price the contract would have cost $695. So we can purchase OTM contracts for much less, but again, they’re riskier than ITM contracts.
On Aug 10 the current share price is $24.60, so it is just ITM. You decide to not be greedy and sell the contract because you predicted the direction well, and you earned a healthy profit because you didn’t spend nearly as much as you could have initially. So you sell the contract for a premium of $4.90.
Profit = ($4.90 – $3.95) * 100 = $95.
Options Strategies for Beginners
Now that we’ve gone over the basics of options, and tied all that information into some examples, we’re going to explain some of the more common, and highly effective strategies that you can use when starting to trade options. Remember that with options you can earn profit so matter what direction the underlying price goes. And even when you’re not totally sure what direction the underlying price is headed, there’s even a play for that.
Let’s go over some bearish, bullish, and some ‘in-between’ strategies.
Long Call / Put
Long calls and puts are the most basic, and an easy to understand “play” within options. It is simply when you purchase, own, or long a call or a put.
Example: you are bullish on TSLA, so you purchase an ITM call with a strike price of $1,000, and you choose an expiration date about one month out from the time of purchase. The premium is $156.70, so the contract costs $15,670. The share price at the time of purchase is $1,050. A week before expiration, the underlying price is now $1,100, and the premium is now $170, and you decide to sell your contract.
Your total profit = ($170 – $156.70) * 100 = $1,330.
Type of play:
For calls this strategy is bullish. Use this strategy when you think the underlying price is going to go up. This is because calls give you the right to buy stock at a set price, so if the underlying price rises, you have the right to purchase at the lower price, which increases the value of your contract that you can then resell at a higher price, or exercise the contract if you have the capital and want to go that route.
For puts, this strategy is bearish.
Perhaps the most common play in options other than just purchasing a call or a put, is a play called a “married put”. This play incorporates a long put, and is used to protect against potential losses against say, a stock you want to own, or long. If you long 100 shares of a stock, to perform a married put, simply purchase an ATM put on the same stock.
You have probably heard of “hedging” before but maybe you weren’t quite sure what it meant. What you are doing with a married put is literally hedging against downside risk by purchasing a put. The way this works is, puts give you the write to sell stock at a set price for a set period of time. So if the stock you long starts to fall in price, that’s okay, because you have purchased the write to sell 100 shares of the stock at the strike price.
Example: Say you long 100 shares of AMC, and the current underlying price is $23.00. To perform the married put play, simply purchase a put option with a strike price of $23.00. The expiration date you choose will depend on how long you want to hold onto the underlying shares. If you want to hold it for a year, choose an expiration date well over a year in advance, and if you only want to hold the shares for a couple weeks, choose an expiration date a month out.
Type of play: we consider this a defensive, but bullish strategy because really the goal here is to have the shares you long rise in price. The put is just there as a ‘plan b’.
So this play has very low risk as it is essentially a means of risk management. Yet at the same time, it does not feature as high of a reward you can get from other plays.
Short Call / Put
This can be likened to writing a call/ put, or a naked call/ put.
Just as you can long and short (or own and sell) stocks, you can do so with calls and puts. Selling, or shorting calls/ puts is synonymous with saying writing calls and puts. When you “write” a contract, you are picking a strike price and expiration date, just as you would if you were buying it, and you sell it to someone on the other end.
What’s interesting about this is, instead of you paying a premium, since you sold the contract, you receive the premium from the buyer. This is how you profit from short calls and puts. Now, the key here is to hold on to that premium. You can lose the premium if the price moves too far OTM, because the value of the contract depreciates, and if it expires OTM you could lose all the premium. The other risk you run shorting calls and puts is needing to be able to supply the shares to the buyer if they exercise the contract.
If the buyer decides to exercise the contract, you are obligated to provide those shares. This is called assignment, if the contract is “assigned” to you. If you sold a call, for example, you would need to sell 100 shares of the stock to the buyer, which means you need to have the capital to purchase 100 shares of the underlying.
If you sell a call or put, and then protect yourself against potential assignment buy longing (or shorting if you sold a put) 100 shares of the underlying. This is called a covered call or a covered put, when you “cover” yourself.
Example: Say we want to sell a MSFT call because we don’t think Microsoft’s underlying price will have much movement in the short term. If MSFT is currently trading at $314, we decide to sell an ITM call at a $310 strike price and choose an expiration date 1 month out. The premium for the contract is $12.65 per share. So we sell one contract and get $1,265 in premium.
At expiration, the price is $318. The contract expires, or the buyer sells it to someone else, and you keep the $1,265 that you initially received.
Type of play: Neutral. This play should be used if you don’t think there will be very much movement in the underlying price for a short-term period of time (about a couple weeks to a month).
Covered calls, similar to covered puts, is a play where you long 100 shares of a stock, and sell a call option.
Now, this is the first time we’ve discussed what happens when you sell an option so before we get into the play we’ll explain what it means to sell, or write a call.
When you write a call, or sell a call, what you are doing is choosing a strike price and expiration date, just as you would if you were buying it, but then you sell the contract. When your order goes through, another person is now in possession of the contract you “wrote”. That person has to pay a premium for the contract, as you would when you long a contract, but this time you collect the premium.
This is the way that you earn profit from this play is primarily through the premium received from selling the contract. So, what’s the downside then? Is there any way to lose this premium?
There are two things that can happen with covered calls that make them slightly risky. One drawback is that if the underlying price moves above the strike price, you will lose the premium initially received. The other, more notable drawback is, because you are the writer of the call, you will be responsible for providing 100 shares of the underlying stock to the buyer if they choose to exercise the option.
Remember that with this play, you long 100 shares of the same underlying. That is why the play is called a covered call. Because you have the shares to cover yourself. Otherwise this would be called a “naked” call, when you don’t have the shares to cover you. So always make sure you long those 100 shares just in case.
Example: In the above example we used a call as an example, so we’ll use a put in this example. If you want to perform a covered put, you want to make sure you short 100 shares of the underlying, because if you’re assigned the contract, you will be obligated to buy 100 shares. So by shorting 100 shares you cover yourself against that risk.
So you feel like the price of Disney (DIS) will remain relatively the same in the short-term, so you perform the covered put. You sell 100 shares of DIS, and simultaneously sell a put contract. This time you choose a nearer expiration date, and a contract that is deeper in the money. The current underlying price is $138.00, and you sell a put that expires in 3 weeks from the time of purchase, and a $145 strike price. The premium is $7.48, so you receive $748.
This time, the price falls a little bit, and the buyer gets nervous and decides to exercise their contract and assign you the shares. Good thing you covered yourself in case this happened. So you buy the shares you shorted and the contract expires worthless. Another trick up this plays sleeve is, because you received that premium from selling the put, that, in a way, discounts the shares you buy. So you are essentially buying them for less than market value.
Type of play: This is a neutral strategy, and should be employed when you think the underlying price will remain relatively unchanged. This is because you don’t want the price to go too high because you’ll lose your premium and potentially risk what’s call assignment, or when you get assigned the shares because the buyer exercised the contract. And you don’t want the price to fall too low because that wouldn’t be good for the shares you long.
So use this play when you still want to trade, but you’re sort of coasting through a lull in the market.
The last basic play we want to go over is something called a long straddle. We’ve gone over some basic plays you can use if you are bullish, bearish, or neutral, but if there is a play you can use if you really have no idea where the underlying price will go. With options, yes! The play is called a long straddle.
This is a fantastic play to start using if you want to get your hands dirty with options because it is inherently a very low risk play, and can profit in either direction the underlying price moves.
To perform this play, you will long both a call and a put that represent the same underlying stock, and also have the same strike price and expiration date. This is where the name straddle comes from, you have one leg on each side of the current underlying price, so to speak.
How exactly this play will profit or not is a little complex. We recommend just trying this play out on a highly liquid stock. The most you will lose is what you initially invested.
Example: If you want to perform this play on PYPL, you long a call and a put. The current underlying price is $122 and you don’t know what direction it’s going to head. You long a call with a strike price of $120, and a put with the same strike price. You choose an expiration date 2 weeks out, because this play is generally a shorter term play. This is the completed long straddle.
Type of play: Unsure. Use this play if you don’t really know where the direction of the underlying price will go.
Pros and Cons of Options Trading
Options can be a highly profitable investment with a myriad of opportunities to earn profit, but it is a precarious world to navigate, and is a path that needs to be proceeded with caution.
Options can greatly magnify your profits, but they can just as easily magnify your losses. If you jump in blindly, and don’t spend thoughtful time developing a strategy, you can lose a lot of money quickly. If you are more conscientious of how you use options, and start with the basics, the benefits in the long run could be tremendous. Start with longing a call or put, or marrying a put to shares of stock you own. Perform a straddle play to get your hands dirty.
In our opinion, there are many more pros to options than cons. But the cons are pretty major. Options can get extremely complex, and the more you learn about options, the more you learn how much more there is to learn. So you need to have the time to experiment, learn from mistakes, read articles, books, etcetera. The other major con is how much money you can lose if you’re not careful.
But if you are smart with your strategy, avoid common mistakes, and have some extra time to learn and experiment with options, you’ll discover how rich, fruitful, and even exotic the world of options can be.
Strengthening Your Options Trading Strategy
Depending on your level of experience, there are a few different crucial methods you can leverage in order to sharpen your options trading tools.
The first is the use of a paper trading account, otherwise known as a demo account. These are trading accounts provided by brokers, which all you to trade without any real funds. Your account balance is simulated. In this way, you can test out different strategies, in the actual market environment, but 100% risk-free. For newer traders especially, using a paper trading account is really a no-brainer.
Another tool that traders with any level of experience can use are options alerts. Here’s how it works: Options trading alert services have a team of traders that use their own trading strategy to identify potentially profitable options trades. Whenever a move is setting up, they send their subscribers a real-time alert—often via text message, email, or through an app such as Telegram—notifying their members of the trade immediately. Many traders appreciate having a service which constantly monitors the markets and provides alerts for positions to look into.
Options open a portal to an entire other dimension existing simultaneously with the “regular” market. Options take the concept of just buying and selling shares of stock to a whole new octave. If you think about painting a picture, the picture of your investment goals, and various strategies/ plays being different colors you can use to paint it, just longing and shorting shares is like having blue and red. But understanding even the basics of options, as we’ve discussed here, gives you so many different colors, enabling you to paint whatever picture you want.
So keep learning Picasso – you’re getting there!
Options Trading Strategies for Beginners: FAQs
Which Option Strategy is Most Profitable?
There isn’t a single strategy that’s more profitable than others because there are always a variety of conditions involved. If conditions were held constant, there are certain strategies that could profit more than others depending on the specific circumstance, but the market doesn’t work like that. It is a chaotic, ever changing world.
What is the Riskiest Options Strategy?
The riskiest option strategies are those that invoice shorting. Shorting any form of investment is generally the riskiest play, because when you short an investment your theoretical max loss is infinite. There isn’t really a good reason to just short a call or put without any protection on the other side, so make sure you’re covered.
What is a Calendar Spread?
A calendar spread is a more advanced options play that is vaguely similar to a straddle. With a straddle, you choose a call and a put with the same strike price and expiration date. With a calendar spread, also referred to as a horizontal spread, you choose either two calls, or two puts, with the same strike price but different expiration dates. You can see below why it is “horizontal”, differentiating it from the vertical spread.
Are Protective Puts a Waste of Money?
Protective puts are absolutely not a waste of money. The only reason why they wouldn’t be is if you wanted to use a very aggressive, risky strategy and not use a put to protect yourself against downside risk. But in most to all other scenarios it is a smart thing to do to hedge against risk.
Do You Have to Buy 100 Shares of Stock With Options?
No, you do not have to buy 100 shares of stock with options. An options contract represents 100 shares, but that doesn’t necessarily mean you own them, you just own a specific right associated with the shares. The only time where you have to buy 100 shares is if you exercised a call, or you are assigned a put that you sold.
Are Options Safer Than Stocks?
In general, no, options are not safer than stocks. But it depends on how you use them. If you use the married put strategy, that is safer than just buying 100 shares of stock. But if we’re comparing the overall risk of using pure options versus purely owning stock, there are more ways to lose money with options. But on the same token more ways to earn profit.
Is There an Options Trading Strategy That Can Guarantee Profit?
No, there is no such thing as an investing strategy that can 100% guarantee profit. But besides potentially profiting from options trading, you can also use options to hedge other investments, which can help to reduce losses.