In Brief:
| Feature | Options | Stocks |
| Leverage | High (control 100 shares cheaply) | Low (1:1 investment) |
| Expiration | Yes | No |
| Income Potential | Premiums + capital gains | Dividends + capital gains |
| Risk | Limited (buyers) / Unlimited (sellers) | Depends on position size |
Done poorly, options trading has been a way for unsophisticated investors to lose money quickly. That has given options trading something of a bad name and, coupled with the less-familiar jargon of options trading, has made options trading intimidating to many investors.
That’s too bad, because making options trading part of your overall investment strategy can provide you with leverage as well as the ability to hedge some of your other investments, reducing your overall risk.
Options trading is a financial strategy that involves buying and selling contracts granting the right to buy or sell an underlying asset (e.g., stocks, ETFs, commodities) at a predetermined price (the strike price) by a specific date (the expiration date). As an options buyer, you have the right but not the obligation to exercise your options contracts (to buy or sell the underlying asset); as an options seller, you have the obligation to buy or sell the underlying assets.
Please note: This article is intended to introduce you to basic concepts and terminology of options trading. We have included a separate section in this guide that goes into far greater, practical detail about strategies and tactics, as well as practical “how-to” information.
These contracts are called options and fall into two categories:
- Call Options: The right to buy the asset.
- Put Options: The right to sell the asset.
Options are derivatives, meaning their value is derived from the underlying asset. They are used for hedging, income generation, and speculation.
Options Terminology
| Term | Definition |
| Strike Price | Price at which the asset can be bought/sold. |
| Expiration Date | Last day the option can be exercised. |
| Premium | Cost to buy the option (paid by the buyer to the seller). |
| In-the-Money (ITM) | Call: Stock price > strike. Put: Stock price < strike. |
| Out-of-the-Money (OTM) | Call: Stock price < strike. Put: Stock price > strike. |
| Intrinsic Value | Difference between stock price and strike price (for ITM options). |
| Time Value | Premium minus intrinsic value (erodes as expiration nears). |
How Options Work
1. Buying vs. Selling Options
- Buyers (Holders): Pay a premium for the right to exercise the option. Max loss = premium paid.
- Sellers (Writers): Receive a premium but have the obligation to fulfill the contract if exercised. Max loss = unlimited (for naked calls) or substantial (for puts).
2. American vs. European Options
While options markets operated largely similarly on both sides of the Atlantic, be aware of one significant difference. In the U.S., options can be exercised any time before expiration. In Europe, options are exercised only on the expiration date.
3. Options Pricing
Options contracts represent (in the case of equities and ETFs) 100 shares of the underlying asset, but they are priced on a per-share basis. In other words, an option that is quoted at $1 would cost $100 to buy and would net $100 in proceeds should you sell it.
4. Example: Buying a Call Option
Scenario: Stock XYZ trades at $50. You buy a $55 strike call expiring in one month for $2 (premium).
- Breakeven: $55 (strike) + $2 (premium) = $57.
- Profit: Unlimited if XYZ rises above $57.
- Loss: Limited to $200 if XYZ stays below $55.
6 Common Options Trading Strategies
Options strategies cater to different market outlooks: bullish, bearish, or neutral. Below are six popular approaches:
1. Covered Call
Objective: Generate income from stocks you own.
How It Works: Sell a call option against shares you already hold.
Example: Own 100 shares of ABC at $100. Sell a $110 call for $5/share.
- Income: $500 premium.
- Max Profit: $1,500 ($10/share appreciation + $5/share premium).
- Risk: Missing out on gains if ABC surges past $110; downside risk of stock price decline is partially mitigated by income received.
| Outcome | Profit/Loss |
| ABC ≤ $110 | Keep premium + stock. |
| ABC > $110 | Stock called away at $110 + keep premium. |
2. Protective Put
Objective: Hedge against a stock decline.
How It Works: Buy a put option for every 100 shares owned.
Example: Own 100 shares of DEF at $80. Buy a $75 put for $3.
- Cost: $300.
- Protection: Limits losses to $5/share ($80 - $75) + $3/share premium.
| Price at Expiration | Profit/Loss (vs. Stock Only) |
| $90 | $1,000 stock gain - $300 (put cost) = $700 gain (vs. a $1,000 gain). |
| $70 | $500 stock loss - $300 (put cost) = $800 loss (vs. a $1,000 loss). |
3. Bull Call Spread
Objective: Profit from moderate upside with limited risk.
How It Works: Buy a lower-strike call + sell a higher-strike call.
Example: Buy a $50 call for $5; sell a $60 call for $2; net cost = $3/share. Total cost = $300.
- Max Profit: $700 ($10 spread - $3 debit per share).
- Max Loss: $300 (if both expire OTM).
| Stock Price | Profit/Loss |
| $55 | ($55 - $50) - $3 = $2/share |
| $65 | ($60 - $50) - $3 = $7/share (max) |
4. Long Straddle
Objective: Profit from significant volatility (direction-agnostic).
How It Works: Buy a call and put with the same strike/expiration.
Example: Buy a $100 call and $100 put for $5 each. Total cost = $1,000.
- Breakeven: $90 (put side) or $110 (call side).
- Max Profit: Unlimited.
- Max Loss: $1,000 (if stock stays at $100).
5. Iron Condor
Objective: Profit from low volatility.
How It Works: Sell a call spread + sell a put spread.
Example: Sell $95 put / buy $90 put + sell $105 call / buy $110 call. Net credit = $4. Total proceeds = $400.
- Max Profit: $400 (credit).
- Max Loss: $100 ($5 spread - $4 credit) if stock breaches $90 or $110.
6. Married Put
Objective: Protect a new stock position with a put.
How It Works: Buy a put option for each newly purchased 100-share lot.
Example: Buy 100 shares at $50 + buy a $45 put for $2.
- Downside Protection: Loss limited to $7/share ($5 decline + $2 premium).
Benefits of Options Trading
- Leverage: Control more shares with less capital.Example: Buying a $5 call instead of $100 stock.
- Hedging: Protect portfolios from downturns (e.g., protective puts).
- Income Generation: Earn premiums via covered calls or cash-secured puts.
- Flexibility: Profit in rising, falling, or sideways markets.
- Defined Risk: Buyers know max loss upfront (premium paid).
Risks of Options Trading
- Time Decay (Theta): Options lose value as expiration nears. For example, a $10 premium could drop to $2 if the stock stagnates.
- Unlimited Losses (for Sellers): Naked call writers face infinite risk if the stock soars.
- Complexity: Requires understanding Greeks (Delta, Gamma, Theta, Vega).
- Liquidity Risk: Low-volume options may have wide bid-ask spreads.
- Assignment Risk: Sellers may be forced to fulfill obligations unexpectedly.
Options trading offers versatile strategies for hedging, income, and speculation. However, it demands a solid grasp of mechanics, risks, and market behavior.
Beginners should start with trading on paper and then move to low-risk strategies like covered calls or cash-secured puts before advancing to complex spreads.
Always prioritize risk management, and each time you consider undertaking a new options technique, use paper trading to practice without financial exposure.
By integrating options into your portfolio thoughtfully, you can enhance returns, reduce risk, and navigate diverse market conditions effectively.
Options trading expert and former CBOE market maker Jacob Mintz has an outstanding track record of success with his advisory services, Cabot Options Trader and Cabot Options Trader Pro. Due to the need to moderate trading volume, these services regularly close to new subscribers.