What Is Options Trading?

Options trading is a lot different from trading stocks or mutual funds, but it can come with real advantages for investors. But what is options trading? In this article, we'll take a look at what options trading is and how it might fit into your investment strategy.

The basics of options

An option -- also known as a "stock option" or "equity option" -- is a contract between a buyer and a seller relating to a particular stock or other investment. Options trading officially started in its modern form in the early 1970s. Options exist primarily to allow investors to speculate on the future prices of securities, but as you'll see as we go on, their uses have expanded significantly.

The buyer of an option can force the seller of the option to do whatever the contract specifies within the time set by the option. For example, a "call option" on a stock gives the option buyer the right to buy a set number of shares at a predetermined price any time before a specified expiration date. The option seller must sell the stock to the option buyer if the buyer exercises the option.

Option expiration dates can range from a few days out to several years. Options that expire a year or more from their listing date are typically known as LEAPS (or "long-term equity anticipation securities").

The most important aspect of an option is that, as its name suggests, the buyer of the option has the right to exercise the contract, but is under no obligation to do so. Therefore, the option buyer will only exercise the option when it's smart to do so.

Say that a call option lets the option holder pay $100 per share for a given stock (known as the "strike price" or "exercise price"). If the underlying stock traded in the market for $50 per share, the option buyer would never exercise the option, because it would be silly to pay $100 for shares the buyer could purchase for $50 on the open market. However, if the share price in the market were $175, then the buyer would exercise the option contract, since $100 would be a bargain compared to the prevailing share price.

There are many ways to trade options. In addition to call options as described above, "put options" give the option buyer the right to sell stock at a given price, profiting from a stock moving down, or protecting the option buyer from losses in a stock position. You can also combine various call and put options to use more sophisticated options strategies that turn a profit under a variety of situations. You can also become an option writer and sell options instead of simply buying them.

What are the benefits of options trading?

There are many reasons why options trading can be a great complement to your existing investing strategy. They include the following:

• Options give you leverage in your investing. An options contract can give an investor cheaper exposure to a stock than buying shares outright, magnifying both profits and losses if the stock price moves.
• Options can also reduce risk in your overall portfolio. For instance, you can use an option strategy that combines buying a put option to sell stock at a specified price with ownership of the shares themselves. That trade, known as a protective put, gives you the upside if the stock price rises but protects you from a portion of the losses if the stock price falls.

Options can offer a source of income. By selling options rather than buying them, you receive the payment for the option. Even if the option goes unexercised, you get to keep that payment as compensation for assuming the obligation for the contract.

How call options work

Let’s assume you believe that shares of Company XYZ will move from $20 to $30 in the next six months, and you want to make money based on your belief. The obvious way to invest is to buy shares of stock at $20 and hope they increase in value to $30. If the stock increases in value as you expect, you'd earn a profit of $1,000 for every 100 shares you bought, which translates to a 50% return on your investment. Not bad.

Call options give you another way to profit if the stock price rises. We’ll assume that call options with a strike price of $20 are trading for $2 each, and expire in six months. Buying these options would cost $200, since one options contract covers 100 shares. Purchasing these options gives you the right to purchase 100 shares of Company XYZ for $20 per share at any point over the next six months.

If you're right about what the price does, you can make a lot of money with call options. If the stock rises to $30 before the expiration date, your call options would be worth $10 each. (Each option gives you the right to buy a share of stock worth $30 for just $20 per share, so each option is worth $10.)

After subtracting the $2 cost per share to buy the options, your total profit on one call option (100 shares) would be $800. Making a $800 profit on a $200 investment is a return of 400%.

Of course, not all options trades work out so perfectly. In order for the call options to make any money, the stock has to rise to at least $22 per share in that six months. We can calculate this "breakeven price" by adding the premium paid for each option ($2) to the strike price ($20), for a breakeven price of $22 per share.

If shares of Company XYZ increased in value, but only to, say, $21 per share, the call options would result in a loss. If the stock is worth $21, the right to buy the stock for $20 is only worth $1 per option, less than the $2 you paid. This is one reason stock options are much more speculative than simply buying the stock. You can lose money with call options even if the value of the stock increases.

On the other hand, call options also have one major advantage over simply buying shares of stock: The potential losses are limited to the price of the option. Even if Company XYZ falls to $0 per share, the most you can lose is the $2 per share you paid for your options.

It's also worth noting that investors can sell call options as well as buy them. If you own 100 shares of a particular stock, for example, you can sell a call option that gives someone else the right to buy your shares at a certain price. This is known as selling a "covered call."

How put options work

A put option gives the owner the right, but not the obligation, to sell a stock at a predetermined price before its expiration date. Therefore, a put option is profitable when a stock falls below the value of the strike price minus the cost for each option.

Let's say you believe shares of Company XYZ will fall from $20 to $15 in the next six months. The typical way to profit on this wager is to sell the stock short (borrowing shares to sell, hoping to buy them back later at a lower price). If you sell it short at $20 and shares fall to $15, you have a $5 profit for each share you sell short.

Put options give you an alternative. We'll assume that put options with a strike price of $20 are trading for $2 each and expire in six months. Buying one contract (100 shares) costs $200. By purchasing a contract, you have the right to sell 100 shares of Company XYZ for $20 per share any time over the next six months.

If you're correct and the stock drops to $15 by the expiration date, your put options are worth $5 per share. (You then have the right to sell the $15 stock for $20.) After subtracting the cost of each option ($2), your total profit on one option contract would be $300, a 150% return on the $200 you spent to buy the put option.

Just like we did for call options, we can calculate the "breakeven price" by subtracting the premium paid for each option ($2) from the strike price ($20), for a breakeven price of $18 per share. If the stock is higher than that price at expiration, you lose money. And if the stock price is more than $20 at expiration, the option expires, worthless.

Just like call options, put options also cap your potential losses if the stock moves in the wrong direction. If Company XYZ stock rises in value to $60 per share, for example, buying put options would result in a much smaller loss than shorting the stock.

It's also worth noting that investors can sell put options as well as buy them. If you have a positive outlook on a stock that you wouldn't mind owning at a lower price, you can sell a put option that gives someone else the right to sell you shares at a certain price. This is known as a "short put" position, or as a "cash-secured put," because you're typically required to maintain enough cash to buy the shares if the put option is exercised.

Call options vs. Put options

What are the risks of options trading?

Offsetting these benefits are some real risks to options. First and foremost, options often expire worthless, resulting in a total loss of whatever the buyer paid for the option. For those used to seeing stock moves of even 5% to 10% as a really big deal, the volatility of options can come as a huge shock.

Second, there's a learning curve involved with options trading. Many brokerage companies offer options trading, but you'll have to meet some added regulatory requirements before your broker will let you actually use options as part of your trading strategy. For instance, you'll have to read some educational material about the options market as well as learn how your broker handles accepting orders for options. In addition, you'll need to know what you have to do to tell your broker that you want to exercise an option -- as well as what'll happen if you sell an option and the buyer decides to exercise it against you.

Finally, there are some options strategies that only work well when you make multiple trades simultaneously. Because options markets aren't always as liquid as the stock market, those simultaneous trades don't always work perfectly -- and that can introduce the risk that your strategy won't work the way you intended or hoped.

Picking the best options broker

If you want to trade options, then finding a top stock broker is crucial. Here's what to look for:

• Low commissions: Virtually all online brokers have eliminated commissions on stock trades. But the same typically isn't true with options -- a few brokers offer free options trades, but the majority charge a modest per-contract position for options.
• Good research: Special tools for evaluating options can be very useful, but not all brokerage companies offer them.
• Good trading platform: Any no-frills trading platform can be fine for buy-and-hold stock investors, but a feature-packed platform can be a major advantage for an options trader.
• Great customer support: Options traders are more likely to have to talk to customer service agents in order to get their trades done the way they want, especially for more complicated strategies. Nothing's more frustrating than having a broker's customer service representatives not really understand what you're trying to do with your options trading.

There are some excellent choices when it comes to options, but as you can see in the bulleted list, the best platform for you can vary. If you're looking for a full-featured options trading platform, E*TRADE could be right for you. On the other hand, if you're simply looking to occasionally buy and sell options, check out a user-friendly but low-frills platform like Robinhood. Or better yet, check out all of our top picks for the best options trading platforms to find the right one for you.

Take a closer look at options

Of course, options trading is a far more complex subject than we can explain in a 1,000-word article, so it's important to spend some time learning about various options strategies and the risks involved before you get started.

Options trading takes more effort to do well than stock trading, and options can downright scare some investors. But by understanding the pros and cons involved with trading options, you'll be able to decide whether options are right for you -- and then find a broker that'll help you get the job done.