What Is Options Trading & How Does It Work?

Curious about options trading … but unclear about how it works or how to get started? 

As a trader, it’s important to learn about a variety of different financial instruments and trading strategies. This can help you decide what trading styles are right for you. 

If the idea of a security that features built-in flexibility and risk management sounds appealing, it may be worth considering options trading. 

Options trading isn’t currently available on StocksToTrade … but it’s still well worth exploring.

Ready to get educated? In this post, you’ll get a comprehensive overview of options trading: what it means, how it works, and several options trading examples. Here’s your chance to see if options trading suits you!  

Options Trading Explained

Options are a little different from buying and selling stocks. 

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

Options are a type of derivative, so before we go any deeper, let’s talk about what they are.

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. 

Derivatives can be traded like stocks, either OTC or on stock exchanges. The price will fluctuate based on the value of the underlying asset. 

Options as Derivatives

Options are a type of derivative since their price depends on the price of an underlying asset. 

On a simplistic level, 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, though. You have permission to buy or sell, but you don’t have to go through with the purchase. 

This is what differentiates them from another type of security called futures. In the case of futures contracts, you’re obligated to buy or sell if certain criteria are met during the transaction. 

How Does Options Trading Work?

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

Long vs. Short Options

Like with trading stocks, options offer up the chance to go long or short. To better help you understand, let’s go over the two key types of options.

Call Option

With a call option, the future’s looking bright. With this type of option, you’re banking on the price of the asset going up. 

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

In this case, you’d buy a call option on the asset, allowing you to make a purchase within a specified time period. This would lock you into that desired amount, so even if it went up exponentially in value, you could still go through with the purchase at that price.

However, the asset’s owner isn’t necessarily inclined to let you call dibs without getting something in return. So as the option buyer, you put down a premium, or a sort of down payment on the contract. 

With the call option, you can make the call. You have the ability to go through with the purchase at any point in the duration of the contract, and the premium acts as a down payment. However, if you don’t exercise the option, that premium won’t be returned. 

Put Option 

With a put option, you’re hoping for the price of an asset to go down. 

By buying a put option, you’ll be 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 that 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 here is that if the value goes down dramatically and dips below the strike price, you can still get this agreed-upon price and keep the difference in profits. 

Once again, a put option also requires a premium. If you choose not to go through with the option, you’ll be out this amount. 

Reading Options Tables

The first time you look at an options table, it’ll look pretty strange. The rows and rows of columns can be confusing at first. But once you break it down, it’s really not all that bad.

Here’s a little guide to some of the common columns you’ll see on an options table and what they mean… 

OpSym: Short for “Option Symbol.” This is where you’ll find the basics: 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 most recent trading price for the option. 

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

Bid: The most up-to-date price offered to buy the option. If you were to submit a market order, this would be the price commanded.  

Ask: The most up-to-date price offered to sell the option. If you were to enter a market order, this would be the price commanded.  

Extrinsic Ask: This column shows you the time premium built into the option price. All options will lose their time premium when they expire, so this column shows you the amount of time premium currently playing into the option’s price. 

Implied Volatility Bid/Ask: Also known as “IV Bid/Ask.” Here, you can see the potential future volatility, based on factors like the option’s current price, the amount of time until the option expires. It’s determined by a model like the Black-Scholes Model. 

Per “The Economic Times,” Black-Scholes is “a pricing model used to determine the fair price or theoretical value for a call or a put option based on six variables such as volatility, type of option, underlying stock price, time, strike price, and risk-free rate.”

The higher the IV Bid/Ask, the bigger the amount of time premium built into the price of the option. 

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

Open Interest: Also called “OI.” Here, you can find out how many contracts have been opened but not yet cashed in or sold.  

Delta: This column helps you figure out the 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. It’s expressed as a percentage, and follows the delta based on the underlying asset’s movements. 

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 shown as a negative number and demonstrates how much the option’s value will decrease as time goes on. 

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 a number of different strategies that traders use to trade options. Curious to learn more?  

Options Trading Examples

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

Long Call

This is a common strategy with call options.

It starts with you as the buyer believing that the asset will rise in value. You buy a call option that you believe will be exceeded within the duration you’ve set. This means you have to 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. So yes, it’s a gamble in that way, but not as much as if you bought shares outright.  

Long Put

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

It starts with you as the buyer believing that the underlying asset will lose value over time. With that in mind, you buy a put option with a strike price that you believe the price will dip below over time. 

Like with a long call, you’ve got to determine an expiration date. You have to try your best to choose a reasonable date range where you think it will go down in value. 

Compared to short selling a stock, this is a little easier on the wallet and helps reduce risk. You don’t have to find shares to borrow, and the losses are limited. 

Call Backspread

Things get a little more complicated here.

Also referred to as a “reverse call ratio spread,” this is a strategy that’s more bullish. Here, you intend to sell a certain number of call options, then buy more call options of the same asset with a higher strike price.

This is an aggressive approach, and it’s best when you believe that the asset will experience huge growth very soon. 

This strategy is profitable when there’s a sharp price increase. 

Put Backspread

This is the opposite equivalent to the call backspread. Also referred to as a “reverse put ratio spread,” this is a bearish mode of pursuing put options. 

Here, you sell a certain number of put options, then buy more put options of the same underlying asset with a lower strike price. 

Once again, this is an aggressive approach, and it’s best suited to when you think the asset will crash in value. 

The “put backspread” is profitable when the price experiences a big drop.

How to Make Money Trading Options

There are no guarantees in trading… regardless of what you’re trading. However, that being said, here’s how it could work out in a positive scenario.

Say that your contract offers the option to purchase a stock at $20 per share. If, during the duration of the options contract, 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 make the most of a potential trade … they help you maximize potential profits while also controlling your losses. 

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, this is when 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, this is when 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 an options trading strategy that matches your constitution and outlook. 

Inappropriate expiration date. It can be agonizing trying to pick an expiration date for options contracts. Here are some questions to ask yourself:

• 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? 

Too big or too small position size. Don’t be timid, but don’t be greedy … Where’s the middle ground for your position size? That will depend on you and your account. Some traders will choose a position size based on a percentage of their account. Others will stick to certain sized chunks of money for trades. 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, and if so, what it entails. 

There are a variety of trading platforms out there that offer options trading, but it doesn’t mean you should just go with the first one. 

Be sure to do thorough research before committing. Our post on how to choose a stock broker offers plenty of tips that can be helpful for choosing 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 because you don’t have to exercise the option. 

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

Remember: if the trade doesn’t go your way, even though you don’t have to exercise the option, 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, the 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. StocksToTrade Pro is an extensive trading community that lets you pursue a trading education with an ever-growing community of 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 with ease.  
• 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.

Give it a try 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 the potential to maximize profits without putting too much of your account on the line.

But just because options trading can be profitable doesn’t mean there are any guarantees. Every trading style comes with risk. 

And just like any other trading style, it’s extremely 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!