Introduction: What Is Options Trading?
Options trading involves buying and selling contracts called options. These contracts give you the right, but not the obligation, to buy or sell an underlying asset, such as shares, an index, or an ETF, at a specific price before a set date.
Unlike just buying a stock or cryptocurrency, options allow traders to potentially earn money whether prices are going up, down, or staying the same. This can often be done with a smaller initial investment. Because of this flexibility, options can be a powerful tool for both protecting investments and making speculative trades.
Example: For example, if you buy a call option for Apple shares (AAPL) at a strike price of $180, you can purchase the shares at that price before the option expires. If Apple’s price rises to $200, you can acquire it at $180 and sell it for $200, making a profit, or you can sell the option itself for a gain.
Options trading may seem complicated at first, but once you grasp the basics—such as calls, puts, strike prices, and expiration dates—you can explore various strategies for earning income, protecting your investments, and growing your capital.
How Does Options Trading Work?
In this type of trading, you are dealing with contracts rather than the actual shares or underlying asset. Each options contract controls 100 shares of the underlying asset and has important components you need to understand.
Key Terms to Know
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Call Option: This gives the buyer the right (but not the obligation) to buy the underlying asset at a specific price (called the strike price) before the option expires.
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Put Option: This gives the buyer the right (but not the obligation) to sell the underlying asset at the strike price before expiration.
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Strike Price: This is the agreed price at which you can buy (for calls) or sell (for puts) the asset.
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Expiration Date: This is the last day you can use or trade the option.
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Premium: This is the cost you pay to buy the option contract.
Trading Directions
With options, you can potentially profit whether prices rise, fall, or remain stable:
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Buy a Call: If you think the asset’s price will increase.
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Buy a Put: If you think the asset’s price will decrease.
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Sell (Write) Options: You can earn income by selling options to other traders. This is often done by experienced traders who are willing to take on more risk.
Example Trade: For instance, if shares are trading at $100 and you buy a call option with a strike price of $105, paying a premium of $2. If the shares rise to $115 before the option expires, the value of your option increases. You can either sell the contract for a profit or exercise the option to buy the stock at $105 and sell it at $115.
Tip for beginners: Start with paper trading (simulated trading with no real money) to learn how premiums, time decay, and price changes affect your options before using real money.
Types of Options
Options trading primarily involves two types of contracts: calls and puts. Understanding these is crucial before moving on to more complex strategies.
Call Options
A call option grants you the right to purchase the underlying asset at a specific strike price before the expiration date.
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When to use: When you believe the price of the shares or asset will increase.
Example: You buy a call option on Apple with a strike price of $150. If Apple’s price rises to $170 before expiration, you can purchase it at $150 and either sell the shares or the option itself for a profit.
Put Options
A put option gives you the right to sell the underlying asset at the strike price before expiration.
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When to use: When you expect the asset’s price to drop.
Example: You buy a put option on Tesla with a strike price of $250. If Tesla’s price drops to $220, you can sell at $250 or sell the put option for a profit.
American vs. European Options
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American Options: These can be exercised at any time before they expire (common in U.S. markets).
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European Options: These can only be exercised on the expiration date, which is important to remember.
Single-Leg vs. Multi-Leg Strategies
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Single-Leg: Simple trades like buying one call or put.
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Multi-Leg (Spreads/Combos): More advanced strategies involving multiple options (e.g., straddles, strangles, iron condors) to manage risk or enhance profit potential.
Beginner Tip: Start with basic single-leg trades by buying calls or puts before trying more complex multi-leg strategies.
Why Trade Options? (Advantages)
Options trading has unique benefits that attract both new and experienced traders. Here are the main reasons to consider adding options to your trading strategy:
Flexibility in Market Conditions
Options allow you to profit whether the market is rising, falling, or moving sideways. You can use call options to benefit from upward trends or put options to protect your portfolio when the market is declining.
Leverage with Lower Capital
Options let you control 100 shares of stock with a relatively small upfront cost (the premium). This leverage means you can participate in price movements without needing to buy the actual shares.
Risk Management and Hedging
These contracts can serve as a protective measure for your investments. For example, buying a put option can protect your stock holdings from unexpected price drops.
Income Generation
Selling (or “writing”) options, such as covered calls, can create income from premiums even if you never exercise the option. Many investors use this method to generate consistent cash flow.
Strategic Variety
From simple trades to advanced multi-leg strategies, options provide endless flexibility. Whether you want to speculate, hedge risk, or generate passive income, options can help you achieve your goals.
These advantages make options an appealing tool for traders seeking diversification and flexibility beyond traditional equity trading. However, it’s important to understand the risks involved, which we’ll discuss next.
Risks of Options Trading
While these contracts offer flexibility and the potential for profit, they also come with specific risks that every trader should understand.
Time Decay
These instruments lose value as their expiration date approaches, a concept known as time decay. If the underlying asset doesn’t move as you expected before the option expires, you might forfeit the entire amount spent.
Market Volatility
Large and unexpected price changes can work for or against you. While volatility can create opportunities, it also raises the risk of quick losses.
Leverage Risk
Leverage can increase both gains and losses. While you control a large position with a small premium, a small unfavorable price movement can wipe out your entire investment.
Complexity
These contracts involve more details than just buying or selling shares. Beginners who don’t fully understand strike prices, expiration dates, and pricing models may take on unnecessary risks.
Assignment Risk
If you write contracts (calls or puts), you may have to buy or sell the underlying asset if the buyer exercises the option, even if this is not favorable for you.
Important: Only trade options with money you can afford to lose. Start with simple strategies, use stop-loss rules, and avoid taking on too much leverage until you gain experience.
Who Trades Options?
The options market attracts a wide variety of participants, from individual retail traders to large institutions. Each group has different reasons for trading options:
Retail Traders
These are everyday individuals who use online platforms to speculate, protect their portfolios, or generate income. With the rise of easy-to-use brokers, more retail traders are participating in options trading than ever before.
Institutional Investors
Hedge funds, mutual funds, and large financial institutions use options to protect large portfolios, manage risks, or implement complex trading strategies. They make up a significant portion of the options market activity.
Professional Traders and Market Makers
Market makers help ensure there is enough buying and selling activity by continuously trading options. Professional traders often use advanced strategies to capture small price movements or manage risks.
Corporations
Companies sometimes use options to protect against changes in currency values, interest rates, or to manage employee stock options.
While institutions and professional traders dominate the trading volume, retail traders now have more access to the options market thanks to online brokers and educational resources.
How to Start Trading Options
Starting to trade options can be straightforward if you follow these steps:
Step 1 – Choose a Regulated Broker
Select an online brokerage that allows trading these instruments, such as TD Ameritrade, E*TRADE, or Robinhood. Make sure the broker is regulated and offers educational tools, real-time data, and competitive fees.
Step 2 – Apply for Options Approval
Unlike equity trading, brokers require you to apply for permission to trade these financial instruments. You’ll answer questions about your financial background, investing experience, and risk tolerance to determine your trading level.
Step 3 – Learn the Basics
Understand key terms such as calls, puts, strike prices, expiration, costs, and time decay. Many brokers offer free courses and demo accounts for you to practice before using real money.
Step 4 – Fund Your Account
Deposit money into your trading account. Some brokers have no minimum deposit requirement, but it’s wise to start with an amount you can afford to risk, typically at least $500 to $1,000 for basic options trading.
Step 5 – Start with Simple Strategies
For beginners, focus on basic trades involving these contracts like:
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Buying calls when you expect a price increase.
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Buying puts when you expect a price decrease.
Step 6 – Manage Your Risk
Options can expire worthless, making risk management crucial:
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Only invest money you can afford to lose.
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Set a trading plan with stop-loss limits.
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Start with small trades and gradually increase the size as you gain confidence.
Tip for beginners: Maintain a trading journal to track each transaction, including your reasons, strategies, and outcomes. This will help you learn from both your successes and mistakes.
Quick Glossary of Options Trading Terms
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Call Option: A contract that gives the buyer the right (but not the obligation) to buy an underlying asset at a specific price before the expiration date.
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Put Option: A contract that gives the buyer the right (but not the obligation) to sell an underlying asset at a specific price before the expiration date.
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Strike Price: The set price at which the underlying asset can be bought (for calls) or sold (for puts).
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Expiration Date: The last day an option can be exercised or traded.
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Premium: The cost you pay to buy an option contract.
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In the Money (ITM): A call option where the market price is above the strike price, or a put option where the market price is below the strike price.
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Out of the Money (OTM): A call option where the market price is below the strike price, or a put option where the market price is above the strike price.
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At the Money (ATM): When the option’s strike price is equal to the current market price of the underlying shares.
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Time Decay: The decrease in a contract’s value as it approaches its expiration date.
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Intrinsic Value: The amount an option is “in the money,” or how much immediate value it holds if exercised.
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Extrinsic Value: The part of the cost based on factors like time remaining until expiration and market volatility.
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Covered Call: A strategy where you sell a call contract on shares you already own to generate income.
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Naked Option: Selling a call or put contract without owning the underlying asset carries higher risk.
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Assignment: When a seller is required to fulfill the contract by either selling or purchasing the underlying asset.
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Implied Volatility (IV): The market’s expectation of how much the underlying asset’s price is likely to fluctuate during the life of the contract.
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Greeks: A set of metrics (Delta, Gamma, Theta, Vega, Rho) that measure a contract’s sensitivity to price changes, volatility, and time decay.
Options Trading Examples
To illustrate how options trading works, let’s look at two simple examples.
Example 1: A Winning Trade (Call Option)
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Entry: You purchase a call contract on Apple (AAPL) with a strike price of $150, paying a cost of $3 per share (total $300 for one contract controlling 100 shares).
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Outcome: Before expiration, Apple’s stock price rises to $165.
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Result: The contract is now worth at least $15 per share ($165 – $150), totaling $1,500.
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Profit: $1,500 − $300 premium = $1,200 profit.
Example 2: A Losing Trade (Put Option)
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Entry: You purchase a put contract on Tesla (TSLA) with a strike price of $250, paying a $4 cost ($400 total).
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Outcome: Tesla’s price rises to $260 instead of falling.
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Result: The contract expires worthless.
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Loss: You lose the $400 premium paid.
These examples illustrate that your maximum loss when purchasing contracts is limited to the cost you paid, while your potential profit can be substantial, especially with strong market movements.
Final Thoughts / Next Steps
Trading options is a flexible and powerful way to engage with the markets. This approach provides opportunities to hedge against risks, generate income, or speculate on price fluctuations. With the ability to profit in rising, falling, or even sideways markets, options can complement both long-term investing and short-term trading strategies.
If you’re new to this, consider these steps to build a solid foundation:
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Learn the basics: Understand key terms like calls, puts, strike prices, and expiration dates before making a trade.
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Start small: Utilize a demo account or trade with small amounts to build confidence while minimizing risk.
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Focus on simple strategies: Start by purchasing calls or puts rather than jumping into complex multi-leg strategies.
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Choose a regulated broker: Choose a platform that provides security, transparent pricing, and valuable educational resources.
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Use risk management: Limit the size of your positions, establish a budget for costs, and avoid trading with funds you cannot afford to lose.
Successful trading in this arena is not solely about quick profits; it demands discipline, planning, and continuous learning. As you become more experienced, you can delve into advanced strategies like spreads, straddles, and covered contracts to enhance your trading approach.
With the right preparation and risk management, options can be an exciting way to expand your trading toolkit and take advantage of various market opportunities.
Continue Your Trading Journey
If you’re interested in learning about other growing markets, check out our next guide, “What Is CFD Trading – A Beginner’s Guide,” which explains how contract for difference trading works, the risks to consider, and how to start safely.
When you’re prepared to start trading contracts, ensure you collaborate with reputable brokers. Our “Best Broker for Option Trading” page compares trusted brokers side by side to help you choose one that aligns with your goals.
Legal Disclaimer
This content is for educational purposes only. Nothing on this page is financial advice or a solicitation to buy or sell any security or derivative. Trading involves risk. Past performance does not guarantee future results. Always verify broker licensing on official regulator registers.
Beginner FAQ
What is options trading in simple terms?
Options trading involves buying and selling contracts called options that give you the right, but not the obligation, to buy or sell an underlying asset (like a stock or ETF) at a set price before a certain date.
What is option trading and how does it work?
Options trading works by purchasing calls (to bet on a price rise) or puts (to bet on a price drop). You pay a premium for each contract, which gives you the right to buy or sell 100 shares of the underlying asset at the strike price before expiration. You can close the trade at any time by selling the option itself or exercising it if it’s profitable.
What is an example of an option trade?
Suppose you buy a call option on Tesla with a strike price of $200, paying a $5 premium ($500 for one contract). If Tesla rises to $220 before expiration, the option is worth at least $20 per share ($2,000 total). Your profit would be $2,000 − $500 = $1,500.
Can I trade options with $100?
Yes, but your options will be limited. Some options contracts have premiums under $1 per share ($100 per contract), allowing you to start small. However, with only $100, your trades will likely be basic and high-risk. Starting with more capital is recommended for better flexibility and risk management.
Is option trading really risky?
Yes, options are riskier than simply purchasing shares. While purchasing options limits your maximum loss to the premium you pay, selling or writing options can carry unlimited risk. Time decay, market volatility, and leverage can all lead to losses if not managed carefully.
What is a call option?
A call option gives you the right to acquire an underlying asset at a set strike price before expiration, typically used when you expect the asset’s price to rise.
What is a put option?
A put option gives you the right to liquidate an underlying asset at a set strike price before expiration, typically used when you expect the asset’s price to fall.
Can beginners trade options?
Yes. Many brokers provide beginner-friendly tools and paper trading accounts. Start with executing simple trades like calls or puts and avoid complex multi-leg strategies until you gain experience.
What is the minimum amount needed to trade options?
Most brokers don’t require a high minimum deposit, and you can sometimes acquire a single option contract for under $100. Still, starting with at least $500–$1,000 is recommended for proper diversification and to manage risk effectively.
Are options better than stocks?
Neither is “better” universally; they serve different purposes. Options provide flexibility and leverage; however, they also involve higher risk. Stocks are simpler and better for long-term investing, while options are ideal for traders seeking hedging, income generation, or short-term opportunities.
This article was written by Itai Levitan at investinglive.com.