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What is options trading?

What is options trading?

What is options trading?

Options trading was always popular among advanced traders, but as trading becomes more accessible, more and more retail clients learn how to use options to their advantage, regardless whether they're longer-term investors or speculators looking for quick gains.

Keep on reading to get a better understanding of options and gain a deeper understanding of the most basic concepts of this product.

What is options trading?
Definition of options trading

Options is a collective term for financial contracts that give the right to buy or sell a certain product at a pre-agreed price. This opportunity is optional, you don't have to use it, hence the name: option.

The pre-agreed price (or agreed-upon price) is commonly referred to as the strike price.

As this trade is based on a contract, it has some similarities with futures: it is a legal, standardized agreement between two parties over the underlying asset.

To trade options, you'll need a broker that gives you access to the option markets. Usually, this is possible at most US and major international brokers.

An option is a contract that gives the buyer the right - or opportunity  - to trade a stock (or any other underlying security) at a pre-negotiated price (strike price) by a certain date (the expiration of the option).

In exchange for this right, the contract buyer pays a premium to the seller of the contract.

Depending on whether the contract buyer would like a right to buy or sell the underlying asset, we distinguish two main categories:

Call options are options that provide the right - but not the obligation - to buy the underlying securities for a pre-agreed price before the expiry of the contract. In other words, a call options grants the buyer have the right to buy at the strike price, no matter what the actual market price of the underlying asset is.

Put options are options that provide the right - but not the obligation -  to sell the underlying security for a pre-agreed price before the expiry fo the contract. In other words, it allows the buyer of the put option to sell a stock at the strike price, no matter what the actual market price of the underlying asset is.

 

What is the timeframe of an options contract?

For stocks, monthly options expire on the third Friday of each month. For some more heavily traded securities, there are also weekly options that expire on Fridays.

Let's say you'd like to buy a call option on the Tesla stock that gives you the right to buy the stock at a later date.

In practice what you'd do is, select the Tesla stock in your broker's app and go to 'Option chains'.

You'll then select an expiry date (Tesla has weekly and monthly options) that you prefer and also choose a strike price that you fancy.

After buying the option you can sell it any time if you so wish, you don't actually have to wait until expiry. The option contract will rise and fall in value as the price of the underlying asset (the Tesla stock in this case) moves, so it is possible to generate a rather big profit or loss even before expiry.

What happens at expiration?

In the US, the Options Clearing Corporation (OCC) will automatically exercise any expiring equity or index option that is $0.01 or more in-the-money at expiration. 

For example, if your call is in the money (say you have a $600 call and the stock is trading at $620) then this means you'll buy shares for $600 and the stock will be put in your account next Monday.

What is the underlying stock? Can it be something else? Are there other types of options?

The underlying security can be almost anything. ETFs, ETNs, futures, bonds, commodities, FX-based products to name a few. The most popular underlying securities are stocks. Each options contract represents 100 shares of the underlying stock.

American options vs European options

  • US options let you exercise your contract at any given time until the expiry
  • European options can only be exercised upon the date of expiration

It is important to note that this distinction doesn't refer to the underlying security being a US or European-based entity.

Individual stocks and ETFs (exchange-traded funds) have American-style options while equity indexes, including the S&P 500, have European-style options most of the time.

In practice, it rarely makes sense to exercise an option before expiry, because you lose some premium by giving up time value. It is more sensible to sell the option instead if you want to cash in your profits. This means that the difference between US and European-style options is not that significant.

What is options trading?
Pros and cons of options trading

Some pros/advantages include:

  • Options can give leverage, while your possible losses can be kept in check. Traders can get a bigger exposure to the underlying stock or ETF than buying shares outright for the same amount of money, magnifying profits if the price moves up rapidly.
  • Options can also reduce risk. For example, you can buy a put option for a stock you're holding. As a protective put, this will let you have the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.
  • Options can be used to generate income. By selling options, you're the one to receive the payment (the so-called premium) for the option. A low-risk example of this is when an investor sells covered call options on a stock he or she owns.

Some cons:

  • Timing the markets is difficult, but when you buy options, market timing is even more important. If your thesis works out to be correct 2 days after your option expired, you're not reaping any benefit, but you lose money.
  • If you're the one selling options, time decay works in your favor. However, be aware that selling options on instruments you don't already own (called naked selling) can generate huge losses in a very short order if volatility picks up and prices go in the 'wrong' direction.

What is options trading?
Where to look for more?

Author of this article

Bence András Rózsa

Author of this article

Bence András Rózsa is an experienced broker analyst. Having an MSc in international economy and finance, he focuses on equities, cryptos and newcomer financial services. He also has 2+ years of experience within the brokerage industry specializing in stock- and CFD/forex brokers, crypto providers and robo-advisors.

Bence András Rózsa

Broker Analyst

Bence András Rózsa is an experienced broker analyst. Having an MSc in international economy and finance, he focuses on equities, cryptos and newcomer financial services. He also has 2+ years of experience within the brokerage industry specializing in stock- and CFD/forex brokers, crypto providers and robo-advisors.

Everything you find on BrokerChooser is based on reliable data and unbiased information. We combine our 10+ years finance experience with readers feedback. Read more about our methodology

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