What Is Options Trading & How Does It Work?

Options Trading in 2021: Key Takeaways

See what exactly options trading is…
Discover top options trading styles…
Learn everything you need to get started…

Plus, the ‘$100K Shortcut’ strategy every small account trader MUST see!

Learning new trading strategies can be fun. Yeah, that’s a little nerdy. But you may end up liking something new more than you think…

So here’s something new for you: options trading! Today I’ll take you into the world of options trading and how it all works. Let’s dive in!

A Quick Explanation of Options Trading

Options are different from buying and selling stocks.

Instead of directly buying and selling shares, you stake a claim on shares at a specific price — but without the obligation to complete the purchase.

Options are a type of derivative. A derivative takes its value based on either a single asset or a group of underlying assets. These assets could include bonds, commodities, currencies, stocks, etc.

You can trade derivatives like stocks, either OTC or on stock exchanges. The price fluctuates based on the underlying asset’s value.

Options as Derivatives

You could think of options as calling dibs on something.

Options are contracts that give you the option to purchase or sell an underlying asset at an agreed-upon price on or before a specified date.

The word option is key. You have permission to buy or sell, but you don’t have to go through with the purchase.

How Does Options Trading Work?

Options trading has similarities to trading stocks and some important differences, too…

Long vs. Short Options

Like with trading stocks, options traders can go long or short. Let’s cover the two key types of options.

Call Option: Definition

With a call option, you’re banking the asset’s price will go up.

For example, say you want to purchase an asset. You might want to lock in the trade at $10 per share but believe it could go much higher.

In this case, you’d buy a call option that allows you to purchase within a specified period.

This would lock you into that desired amount. So even if it rises exponentially in value, you could still go through with the purchase at that price.

Of course, the owner wants something in return. That’s why options buyers put down a premium. It’s like a down payment on the contract.

With the call option, you make the call. You can go through with the purchase at any point in the duration of the contract. But if you don’t exercise the option, you don’t get the premium back.

Put Option: Definition

Put options are bearish. You hope the asset’s price will drop.

By buying a put option, you’re granted the right to sell the asset in question at any time within a predetermined period.

With a put option, a “strike price” is set. So, say you set the price at $10. With a put option, you can sell that asset at $10 at any point before the expiration date.

The idea is that if the value drops dramatically and dips below the strike price, you still get the agreed-upon price and keep the difference in profits.

This also requires a premium that you lose should you choose not to go through with the option.

Reading Options Tables

Options tables can be confusing at first. But it’s not all so bad. Here’s a guide to some common columns on an options table and what they mean…

OpSym: Short for option symbol. This is where you’ll find the ticker, the date of contract maturity, strike price, and whether it’s a call or put option (specified with a C or P).

Last: The option’s current trading price.

Net change: The price change since the close of the last trading day.

Bid: The current price offered to buy the option.

Ask: The current price offered to sell the option.

Extrinsic Ask: The time premium built into the option price.

Implied Volatility Bid/Ask (IV Bid/Ask): Potential future volatility, based on factors like the option’s current price and time until expiration. The higher the IV bid/ask, the bigger the amount of time premium built into the option’s price.

Volume: How many contracts are changing hands. Options with larger movement and volume tend to have a tighter bid/ask spread since there’s more competition to buy and sell them.

Open Interest (OI): Here, you can find how many contracts have been opened but not yet cashed in or sold.

Delta: Potential exposure of the underlying asset to price shifts, measured in values from 1.0 to -1.0 or 100 to -100.

Gamma: A monitor of the rate at which delta changes, expressed as a percentage.

Vega: How much the option contract’s price reacts to a percent change in the I/V.

Theta: This tracks the degrading value of options based on approaching expiration dates. It’s a negative number and shows how much the option’s value will decrease over time.

Strike: Strike price, or the price that’s been set to buy or sell the security.

Types of Options Trading

One of the most appealing things about options trading is that it offers lots of flexibility.

Yes, you’ve got to pay that premium, but this style of trading opens up … well, plenty of options for you.

If you decide not to go through with the call or put option, it will expire without any further action. All you lose is the premium.

There’s also flexibility in terms of what you trade. Options can be used for stocks, but also for bonds, commodities, and foreign currencies, to name a few.

Options Trading Strategies

There are several different strategies for trading options. Ready to learn more?

Options Trading Examples

These are some examples of some common options trading strategies that traders use.

What’s a Long Call?

This is a common strategy with call options.

As the buyer, you believe the asset will rise in value.
You believe the call option will be exceeded by a certain date.
Set an expiration date for when you think this will reasonably happen.

You get some leverage here because while you have the potential for the value to go up dramatically, you only have to pay the premium right now.

It’s a gamble in that way, but not as much as if you bought shares outright.

What’s a Long Put?

This is the equivalent strategy of the long call, but for put options. You…

Believe the underlying asset will lose value over time.
Bet on the price dropping past a certain point by buying a put option with a strike price above that point.
Try your best to choose a reasonable date range in which you think it will go down in value.

This practice can be less risky than short selling. You don’t have to find shares to borrow and the losses are limited.

What’s a Call Backspread?

Also referred to as a “reverse call ratio spread,” this is a more bullish strategy.

The trader intends to sell a certain number of call options, then buys more call options of the same asset with a higher strike price.

This aggressive approach works best when you believe that the asset will experience huge growth very soon.

A sharp price increase can make this strategy very profitable.

What’s a Put Backspread

This is the opposite equivalent to the call backspread. This is a bearish method for put options that’s also referred to as a “reverse put ratio spread.”

The trader sells a certain number of put options then buys more put options of the same underlying asset with a lower strike price.

This strategy is best suited to when you think the asset will crash in value and is profitable when the price experiences a big drop.

How to Make Money Trading Options

There are no guarantees in ANY trading. That said, here’s how it could work out…

Say your contract offers the option to purchase a stock at $20 per share. If that stock went up to $50 per share, you’d still be able to execute your order at the lower price. Good on you!

In addition, options can help you maximize potential profits while also controlling your losses. That can make it sound easy. Rest assured, it’s not.

In and Out of the Money

An options trade might be referred to as “in the money” or “out of the money” depending on whether it’s profitable.

In the Money

In the money, or ITM, refers to an options trade that’s profitable:

For a call option, this is when the strike price is below the current market price.
For a put option, the strike price is above the current market price.

Out of the Money

Out of the Money, or OTM, refers to an options trade that’s not profitable:

For a call option, this is when the strike price is higher than the current market price.
For a put option, the strike price is below the current market price.

Common Options Trading Mistakes

Unrealistic goals. Just because an options trading strategy is profitable for some traders doesn’t mean it’s right for you. It’s important to choose a strategy that matches you.

Wrong expiration date. Picking an expiration date for options contracts is tough. Here are some questions to ask:

How long will it reasonably take for the trade to play out favorably?
Are you prepared to hold this trade through earnings season … or other events?
Is there enough liquidity in the market for this trade to be viable?

Wrong position size. Where’s the middle ground for your position size? That depends on you and your account. Some traders choose a position size based on a percentage of their account. Others stick to a sum for every trade. Ultimately, never trade more than you can lose.

Best Options Trading Platform

At this time, StocksToTrade doesn’t offer options trading. So where should you go if you’re interested in exploring this type of trading?

If you have a broker you love, the first step might be to see if they offer options trading. Be sure to check fee schedules.

A variety of trading platforms offer options trading.

Be sure to do thorough research before committing. Our post on how to choose a stockbroker offers tips that can help you choose an options broker, too.

Options Trading Risk

When trading options, if the asset doesn’t move in the direction you’re hoping, you won’t lose the entire amount of the trade. That’s because you don’t have to exercise the option.

But that doesn’t mean that options trading is without its fair share of risk.

If the trade doesn’t go your way, you don’t have to exercise the option, BUT you won’t get your premium back. Over time, these losses can add up!

Options Trading Calculator

An options trading calculator lets you input various criteria like price, number of contracts, and anticipated price to help you calculate potential returns.

Depending on your broker, they may offer such a calculator built into their trading platform. There are also online calculators that you can use for this purpose.

StocksToTrade

StocksToTrade isn’t an options trading platform/screener, but it still has plenty of amazing tools for traders…

Educational tools. The SteadyTrade Team is an extensive trading mentorship program where you can pursue a trading education with like-minded traders. Mentorship is so important … This community is a great place to find it and get up to speed!
Amazing scanning tools. Yeah, you should scan the markets every day, but you don’t need to sacrifice your life. STT has awesome scanning software that helps you maintain a strong watchlist.
Paper trading. Test strategies before you put your cash on the line! Our paper trading module is the perfect way to test out new methods and theories.
Tech tools. Be sure to check out StocksToTrade’s awesome service powered by Oracle! Find great trades faster with the power of technology.

Try it today with our 14-day trial for just $7!

Conclusion

As the name implies, options trading gives you the benefit of options.

It’s a trading method that offers flexibility, risk management, and more. Is it right for you? That depends on YOUR needs.

Just like any trading style, it’s important to educate yourself. Learn the market mechanics and how options trading works before risking your hard-earned cash.

What about options trading appeals to you — and why? Leave us a comment, we love hearing from you!

Last update: November 2021