Options trading may sound confusing and overwhelming if you're a new investor. But learning how to trade options offers investors many advantages to their portfolios, specifically flexibility and leverage.
Options have become increasingly popular for individual investors because of the benefits, plus online brokerages have made options trading more accessible and affordable than ever before.
If you’re interested in adding options to your investment strategy, you need to start with the basics, like learning what options are and key terminology used when trading. It’s also essential to learn about the different types of options trades, and the steps you’ll take to start trading options.
How to Trade Options for Beginners - A Quick-Start Guide
What are options?
Let’s start with the basics first: an option is a contract that allows an investor to buy or sell an underlying asset, like a stock or ETF, at a predetermined price over a certain period. The options trader doesn’t have to exercise their contract and buy the option, but they have the right to.
There are a few more words we need to define to understand options trading:
- Premium: The price of buying or selling an option contract
- Strike price: The agreed-upon price of the security as outlined by the option contract
- Expiration: Date and time when the contract ends
Besides buying or selling the asset on the expiration date, you can let the contract expire or sell the option contract to another investor.
Here’s an analogy to understanding options:
Pretend you’re at an art gallery and see this incredible painting, but it’s $2,000. You don’t have the cash now, but you will in a couple of months. The gallery owner agrees to sell it to you at that price (strike price) in two months, and you decide on a date (expiration). And to put the contract on the painting, you have to pay $100 (premium).
While you’re waiting to get the money to buy the painting, it turns out this painting is a long-lost Picasso, so it’s worth a lot more. Let’s say $100 million. Your contract still lets you purchase the newly discovered Picasso for $2,000.
You can do a couple of things here: either buy the Picasso for $2,000, or you can sell your contract to another person. Either scenario would be incredibly lucrative to you as an investor.
Now, if it’s discovered the painting is worth less than $2,000 for some reason, you don’t have to buy it for $2,000 once the two months are up. You let the contract expire, and you’re only out $100.
That’s a simple analogy, because there are different kinds of options (I’ll explain more shortly). Still, the idea is the same: an option is a contract that allows — but doesn’t require — the investor to purchase an underlying asset.
What is options trading?
Now you know what an option is — the ability to buy or sell an asset at a pre-negotiated price — but what is options trading?
Trading options is similar to the way you trade stocks, ETFs, bonds, etc. You can trade options contracts in the same way you trade stocks, except buying an option isn’t buying an asset. You are trading the contract that allows for potential ownership.
Why trade options?
In the example above with the painting, the option gave the art collector some serious advantages. They profited if the painting was worth more, but they also didn’t lose a ton of money if the price of the painting went down. They could even sell the option contract to another collector.
There are a lot of advantages there, but I want to explain those advantages even more:
Basic stock trading is financially beneficial when the price of the stock (or other asset) goes up, but options trading gives you flexibility if the price falls. You can purchase the asset if the price goes up and walk away if it goes down.
Speaking of stock prices going down — hedging reduces risk. Options can protect your trades and portfolio if stock prices fall. Again, that’s because you have the option to purchase the shares at the agreed upon price or not. It’s worth mentioning that options trading can be risky, even riskier than stock trading in some scenarios, but they can also reduce risk.
Leverage is all about cost-efficiency. Options trading gives you exposure to the market without as large of a financial commitment. There’s always the risk of losing money, but being able to put less money towards an investment can give you more flexibility in your overall portfolio.
#4 Higher potential returns
Options trading may allow you to spend less money to make the same profit. That’s always good math. Look at the example of the painting, you’ve
There are even types of options strategies that can earn you income on your future stock positions.
Types of options trading
Before I explain how to trade options, you need to understand different types of option trading. There are several strategies, and they boil down to two broad categories: puts and calls.
- A call option gives you the ability to buy an asset at a specific price. Remember, you’re not obligated, though.
- A put option gives you the ability, not the obligation, to sell an asset at a specific price.
Now we can break down puts and calls into more specific options trades.
The long call
This is the most straightforward options trading strategy. A long call is betting that the strike price of the asset’s underlying value will increase by the expiration date.
The benefit is that if the price of the stock increases, you’ve locked in a lower price, sometimes much lower. Theoretically, there’s infinite potential. The downside is that if the value decreases, you’ve lost what you’ve paid for the premium, but not more than that.
The long put
A long put is an options trade that bets the value of the stock will decline by the expiration date. Put options give you the ability to sell at the strike price, which is hopefully higher than the market price on or by the time the contract expires.
The benefit is that if the stock price declines, you can still sell the asset at the strike price. The risk is losing your premium if the price stays flat or increases.
The short put
A short put is the opposite of a long put and has the investor selling their put and “going short.” The investor is betting that the value will either stay flat or increase until the expiration date. In that case, the option becomes worthless, and the put seller keeps the premium.
The benefit is that you can receive the full premium, but the risk is much higher. There’s the potential to lose the difference between the strike price and underlying asset multiplied by the number of shares covered in the contract.
Those three strategies will help you learn options trading, and there are a few more advanced strategies once you get the basics of options trading. Covered call and married put are two more sophisticated trades you can research and try once you feel more confident.
How to trade options in 4 steps
You’ve learned the basics, from definitions to different types of options trading. Now it’s time to learn how to trade options.
Here’s a step-by-step guide to options trading for beginners:
Step #1: Open an options trading account
Not all brokerages offer options trading, so the first step is to find a brokerage that does and open an account with them. Webull, Robinhood, Charles Schwab, and E-Trade are a few of the most well-known brokerages for options trading.
Opening an options account takes a little more work than a basic brokerage account. The brokerage needs to know more about you, including your investment objectives, trading experience, personal financial information, and the kinds of options you want to trade.
Based on the information you provide, most brokerages will assign a trading level based on risk. Your rating gains you access to different kinds of options trades.
It’s worth mentioning that options trading requires a higher minimum investment because options typically trade in blocks of 100. Brokerages may want to see anywhere from $1,000 - $10,000 to fund your trading account.
Related: How Does Robinhood Make Money?
Step #2: Decide what options to buy or sell
The two broad types of options are calls and puts. Call options allow you to buy an asset at a predetermined price on or by the expiration date. Remember, it’s a right, not an obligation. Puts allow you to sell shares on or by the time the contract expires.
Which type of options contract you choose is based on whether you think the asset’s value will increase, decrease, or stay stable.
- Price increases: Buy a call option or sell a put option
- Price decreases: Buy a put option or sell a call option
- Price remains stable: Sell a call option or sell a put option
Step #3: Set the option strike price
Setting the strike price is predicting the best price to buy or sell. But you’re not just shooting in the dark and picking whatever price you want — options quotes, which are technically called an option chain or matrix, contain a range of strike prices you can choose trom. Strike prices are standardized across the industry and are based on the stock price.
The strike price affects the premium you pay for the option. The premium factors in the intrinsic value, or difference between strike price and share price. Time value is also included in the premium, and that includes factors like volatility, interest rates, time to expire, etc.
Step #4: Select your option time frame
The expiration date on your option is the last day you have to exercise that option. Like the strike price, you can’t pick just any date. The option chain gives you choices for the expiration date, which can range from days, months, or years. Shorter time frames are generally riskier, but longer expirations can be a solid choice for long-term investors.
When you select a time frame, there are American and European styles of options, and they determine when you can exercise the options contract. American options can be exercised at any point up to the expiry date, and they’re generally more expensive because of the added flexibility. European options can only be exercised on the expiration date.
The final word on how to trade options
Options trading might seem intimidating, but understanding options trading is as simple as remembering what an option is: you’re buying the right to buy or sell shares of an underlying asset at a predetermined price. This gives investors flexibility and leverage in their portfolio, which are both great things.
There’s still risk (same with any kind of investment) when it comes to options trading, especially when it comes to predicting the price and whether it’s going to go up or down — that’s how you profit.
Make sure you understand the risk and how options trading works, and then find a brokerage and start trading.