How Do Options Work? [Complete Guide for 2022]

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When it comes to investing, there are so many different types of options to keep track of that the broad term of “options” might make your head spin. But, don’t worry—we’re here to clear things up and explain exactly how do options work. By the end of this article, you’ll have a much better understanding of what options are, how they work, and how you can include them in your investing strategy.

What Are Options?

An option is a contract giving the holder the right to buy or sell an underlying asset at a specified price within a certain time period. Options are traded on exchanges all over the world and can be used to speculate on the future direction of a wide variety of underlying assets. Options are derivative contracts, meaning their value is derived from the underlying asset. The most common underlying assets are stocks, ETFs, indexes, bonds, commodities, currencies, and other options.

There are two types of options: call and put options. The main difference between put options and call options is that a call option gives the holder the right to buy an asset, while a put option gives them the right to sell an asset.

  • Call Options

Call options are a type of derivative instrument allowing the buyer to buy stock at a particular price by a certain date. There’s no requirement to acquire them if the stock’s value doesn’t meet the holder’s expectations before the contract’s expiry date.

  • Put Options

Selling call options equals put options, which are another form of leverage—it’s a contract that gives the holder the right to sell shares at a specific price on a certain date. You may see that put options have lower risk than other derivatives, as the writer (seller) faces a different level of risk than the buyer (holder).

DID YOU KNOW: 75% of options trades are profitable.

How Do Options Work?

Now that you know the basics of what an option is, let’s take a closer look at how they work through this call and put options examples:

When you buy a call option, you’re buying the right to buy an asset at a certain price. Let’s say you buy a call option on ABC stock with a strike price of $50. This means you have the right to buy 100 shares of ABC stock for $50 per share within the specified time period. If the stock price rises above $50, you can exercise your option and buy the stock at $50 even though it’s worth more, allowing you to lock in a lower price and sell the stock for a profit. If the stock price falls below $50, you can choose not to exercise your option—in this options trading example, you’d lose the premium you paid for the option, but you’d avoid taking a loss on the stock.

Put options work in the opposite way—when you buy a put option, you’re buying the right to sell an asset at a certain price. Let’s say you buy a put option on XYZ stock with a strike price of $60. This means you have the right to sell 100 shares of XYZ stock for $60 per share within the specified time period. Within this options trading example,if the stock price falls below $60, you can still sell the stock at $60 even though it’s worthless, having locked in a higher price to avoid taking a loss on the stock. If the stock price rises above $60, you can choose not to exercise your option, in which case you’d lose the premium you paid for it, but you’d avoid taking a loss on the stock.

How Do Trade Options?

Now that you know the basics of options, here’s a quick overview of how to trade them. Keep in mind that this is a very simplified explanation, and there are more nuanced strategies to use when trading options.

Step One

Decide which underlying asset you want to trade—a stock, index, commodity, or currency.

Step Two

Choose whether you want to buy or sell an option. If you think the price of the asset will go up, buy a call option, and if you think it will go down, buy a put option.

Step Three

Select the strike price and expiration date. The strike price is the price at which the option will be exercised, and the expiration date is the date when the option expires.

Step Four

Place your order with a broker. You’ll need to have a margin account to exchange options.

And that’s it! These are the basics of how options work and how to trade them. If you’re thinking of getting into options trading, make sure you do your research and understand the risks involved first. If you’re interested in swapping options, talk to your broker about getting started, as they’ll be able to offer some tips on the best stock broker for beginners.

Key Takeaways

There are two types of options: call options and put options. The main difference between call vs put option is that a call option gives the holder the right to buy an asset, while a put option gives them the right to sell an asset.
The most common underlying assets are stocks, ETFs, indexes, bonds, commodities and currencies.
Speculation, hedging, and flexibility are some of the advantages of option trading.
Once you enter into an options contract, you’re obligated to fulfill your side of the deal, whether that means buying or selling the underlying asset when the time comes.

Benefits and Downsides of Trading Options

Now that you know how options operate, let’s take a look at the benefits and downsides of an options trade.

Benefits:

There are a few key benefits of options trade that make them an attractive investment for many people:

  • Speculation

Its main appeal is that you may generate money simply by engaging in the activity without having a large sum of money on hand. The use of leverage makes for substantial profits from small investments, allowing you to make the most of your leverage by gaining greater trading power with a modest investment. This makes options perfect for beginners with little funds, and easy to get into for individuals with bigger amounts of cash.

  • Hedging

For those who make a living by taking advantage of short-term and medium-term price fluctuations and maintaining a large number of open positions, hedging is an excellent technique to reduce risks. If a trader has taken a highly speculative position that can result either in large profits or significant losses, they can reduce the risk of potential losses by using another investment or trade to hedge the position.

The technique of this options trading example allows the trader to combine one position with another to offset any losses incurred by either, recovering at least some (if not all) losses if the original position ends up making a lot of money. If the initial position loses money, the trader might be able to recoup at least part of their losses.

  • Flexibility

By having multiple possibilities available regardless of market conditions, options trading provides greater flexibility and range to investors. Apart from the possibility of buying options and selling options based on a number of underlying assets, traders can also gamble on the price fluctuations of equities as well as other investment choices such as indices, commodities, and foreign currencies. This implies that any interested investor has a large number of viable leads for a potential profit.

There are also a plethora of actual trading techniques available—spreads, for example, give true adaptability in trading. Their usage is quite broad: you may use them to reduce the risk of taking a position, minimize the upfront expenditure of doing so, or profit from several price trajectories. Spreads offer freedom in various ways on how to buy options.

Disadvantages:

While there are some definite benefits to option trading, there are also some disadvantages you should be aware of:

  • High Losses

As options are highly leveraged investments, don’t be surprised if their prices change rapidly. Unlike stocks, which can fluctuate only by several dollars in a few minutes or seconds, option pricing changes dramatically in the same time span. Leverage is a double-edged sword—while it can magnify your profits, it can do the same for your losses, which is why many investors stay away from options and other derivatives, scared off by the potential for large losses.

  • Complexity

Options trading is a highly intricate field, and some might even say that option trading for beginners is not the best choice. In order to look for potential profits, an investor must monitor the transactions constantly as they occur throughout the market’s rise and fall, which may be confusing for inexperienced individuals, who should refrain from trying different activities. They must be conversant with a variety of strategies to adapt, and acclimating to them takes time. As they’re a complex investment tool not suitable for everyone, before deciding to trade options, you should carefully consider your investment objectives, level of experience, and risk appetite to avoid losing money due to not understanding them.

  • Limited Time Frame

An options contract is a binding agreement that gives the holder the right to buy or sell an underlying asset at a specified price within a certain period of time. This means that once you enter into an options contract, you’re obligated to fulfill your side of the deal—whether that means buying or selling the underlying asset—when the time comes. And how does options trading work if you don’t keep your side of the agreement? Well, you may be subject to penalties or fees.

There are also limitations on how long you can hold onto an options contract before you’re required to act on it. For example, let’s say you buy a call option with a strike price of $50 and an expiration date of one year—this means you have the right to buy shares of the underlying asset at $50 per share at any time before the expiration date. But, if the stock price never reaches $50 during that one-year period, your option will expire worthlessly and you’ll lose the money you paid for it.

  • Additional Costs

When buying or selling call options, investors can also face additional costs impacting their profit and loss results, including broker commissions, fees for exercise and/or assignment, and state or federal taxes. Also, certain options trading methods require investors to open a margin account, which is basically a line of credit that serves as security when the trade goes against them.The requirements for starting a margin account vary from firm to firm, and the interest rates are determined based on the amount of cash and securities in the account, although they’re commonly in the low single digits to lower double digits.

How does options trading work if an investor isn’t able to repay the loan, or if a brokerage account balance falls below a certain threshold due to daily market fluctuations? Well, the lender may issue a margin call and liquidate an account if the investor doesn’t replenish it with more money or shares.

DID YOU KNOW: If you’re a beginner at trading and want a passive income, there are some great robo advisors to get you started. 

A Word Before You Go

So, there you have it— a quick overview of how options work. As you can see, they’re not suitable for everyone, but if you’re an experienced investor who understands the risks involved, they can be a valuable tool in your investment arsenal, although you should research the finest investment tools for additional help. If you’re interested in selling and purchasing options, talk to your broker about getting started. Happy trading!

FAQ

How many shares are there in an options contract?

An options contract is typically for 100 shares of the underlying asset. However, some brokerages offer trade call options contracts for less than 100 shares.

How do options actually work?

The buyer of an options contract pays a premium to the seller for the right to buy or sell the underlying asset at a certain price. If the stock price falls below the strike price, the buyer can exercise their option and sell the stock at the strike price, and if it rises above the strike price, the buyer can choose not to exercise their option. In this case, they’d lose the premium they paid for the option, but they’d avoid taking a loss on the stock.

Are options safer than stocks?

Options are not necessarily safer than stocks. Buying options is a tool that can be used to protect your portfolio from losses or speculate on the future price of an asset, but it has its own risks and benefits you need to understand beforehand.

Why is trading options a bad idea?

Options exchange is not necessarily a bad idea, as they‘re a tool that can be used to protect your portfolio from losses or speculate on the future price of an asset. However, before dealing options, make sure you understand the risk and the benefits, and ask yourself if you really know how do options work.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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