Options trading is a way to get involved in the stock market that's a little different from trading or investing in assets (like stocks or ETFs) directly. If you're considering buying and selling options, here's what you should know.
What are options?
An option is a legal contract that gives you the right to buy or sell an asset (think: a stock or ETF) at a specific price by a specific time. They are known in the financial world as "derivatives." They derive their value from the stock or ETF that the contract refers to.
How do options work?
You could buy and sell options through brokerages, much like you could buy stocks, bonds, and fund shares. As you might expect, these contracts aren't free—you as the options buyer (aka options holder) pay what's called a "premium" to gain the right to buy or sell an asset from or to another party, known as the options writer. Why options "writer"? Because they agree to write the contract you hope to buy—and receive the premium you pay.
Depending which side of the transaction you are on, you either pay the "premium" to have the right to buy/sell from or to another party, or you receive the "premium" when you give the right for another party to buy/sell an asset from you. The latter is known as a "writer" of options, and has an obligation to the buyer.
All options contracts list out:
- An expiration date when the contract becomes null and void
- The strike price, or the price you agree to buy or sell the assets
- The quantity of shares of the stock or fund the agreement covers, typically in intervals of 100
- Whether the option is a call or put
- The style of the option (American or European, aka when the option holder can exercise)
Important: Option buyers don't have to exercise their options if they don't want to or hold all the way to expiration. They can simply trade the options before they expire. Keep in mind, though, that if you sell/write, you receive a premium from another party for them to have the right to buy/sell from you at any point.
Being out of the money vs. in the money
Options traders tend to classify each options contract in 1 of 3 ways:
- Out of the money (OTM): That means for a call, the underlying asset (the stock or ETF associated with the options contract) is trading lower than the strike price, and for a put the asset is trading higher than the strike price.
- In the money (ITM): For a call this means that the underlying is trading higher than the strike price, and for a put this means the asset is trading lower than the strike price.
- At the money (ATM): Aka the underlying asset is trading close to or at the strike price.
Types of options
There are 2 main types of basic options contracts: calls and puts. The difference is what each one allows you or another party to do. Call options provides the right of the option buyer to buy the underlying asset and obligates the option seller to sell the underlying asset at a specific price (determined by the strike price) by the expiration date. Put options provide the right of the option buyer to sell the underlying asset and the option seller to buy the underlying asset at a specific price (determined by the strike price) by the expiration date.
The long and short of it
You might also see a couple of other terms when it comes to call and put options contracts. We'll translate:
Long calls vs. short calls
- Long call: You have a long call if you are the option holder with a contract allowing you to buy shares of an asset.
- Short call: Shorting or selling a call is when you are giving another party the right to buy an asset from you at a specific price.
Long puts vs. short puts
- Long put: A long put means you are an option holder who has bought the right to sell shares of an asset at a specific price.
- Short put: Shorting or selling a put means you are giving another party the right to sell an asset to you at a specific price.
Someone buying an options contract is long on something because they expect the asset to perform in the way they want over the length of the options contract. The option writer, meanwhile, doesn't think the asset will perform in the way the option holder expects, so they're short.
Why do people buy or sell options?
There are many reasons people may want to buy or sell options.
To invest with leverage
When you buy options, you pay for a contract that's normally a fraction of the involved share's value. An option holder hopes to benefit from any potential gains an asset makes while minimizing the amount of capital at risk—which could happen if you buy the assets outright. This process, called leverage, gives you the ability to take on more risk and gain more exposure for potential gains with less money upfront. But leverage should not be taken lightly, as that additional risk means you have a higher chance to lose the money you've invested. You also must meet certain requirements to margin trade.
Take this example: You agree to pay $300 for a contract to buy 100 shares of a stock currently worth $100 each. Instead of spending $10,000 to buy 100 shares, you're paying $300, while still positioning yourself to profit if the stock increases in value. If the stock goes up like you think it will, you can exercise your right to buy it for less than its trading price. Then you could potentially profit by selling the stock while it's worth more than you paid.
If the stock value drops, you don't have to buy the stock, and you've only lost the price of the contract—not the change in the stock's value. For instance, if you bought $10,000 worth of shares, and the share price dropped from $100 to $90, the value of your investment drops to $9,000, or a potential loss of $1,000. If you only bought the $300 options contract, your loss would be $700 less.
Help protect against losses
Some investors may buy options to help protect their existing investments. By buying an agreement that lets them sell at a certain price, they create a higher minimum value for the assets they want to offload. For example, if you buy a contract at a strike price of $50 a share, you wouldn't get less than that amount, even if the asset's market value fell to $0 (the option writer is obligated to buy the shares). On the other hand, if the asset's value jumps beyond its current market value, you could choose not to exercise your option to sell and possibly profit by selling the shares outright.
Potentially generate income
Option writers agree to sell options contracts because they don't think the security will perform like the option buyer expects. In return for giving the option holder the right to buy or sell an investment at a certain price, they receive a premium for selling that option. The option writer is provided income from the premium they received for their obligation in that contract.
How to trade options
If you decide you'd like to trade options, follow these steps to get started.
Open and fund a brokerage account with options trading
To trade options, you'll first have to open a brokerage account that allows options trading or allows you to apply for options trading. As you research platforms, check out the platform's fees and research capabilities. You'll also want to transfer money from a linked bank account into your new brokerage account, so you have funds to access when you're ready to trade options.
Apply to trade options
Many brokerages don't enable options trading by default. At Fidelity, you must complete an options application that explains your financial situation and investing experience, and then read and sign an options agreement.
Pick what options you want to trade
Research which stocks or ETFs that you might be interested in trading options. If you want to trade options for a stock that caught your interest, log into your brokerage account, access the option chain and type in the stock symbol. The option chain provides the ability to filter to potentially view several strikes, expirations, quotes of the options, and option strategy views. It will provide the ability to trade right from the option chain but please be aware of the risks involved with the trade that you choose.
Learn how to read an options symbol
Options symbols are like stock tickers—those symbols that represent individual company stocks—for specific types of options contracts. Options symbols appear as a string of letters and numbers and contain the options contract's key info. Here's how they're structured:
TICKER SYMBOL + YEAR OF EXPIRATION + MONTH OF EXPIRATION + DAY OF EXPIRATION + C for call or P for put + the strike price
So if you bought symbol -xyz241231c100 at $1.00, the contract gives you the right to buy typically 100 shares for $1 per share till December 31st, 2024 for a total cost of $100 (price quoted is multiplied typically by 100).
Should I trade options?
Options have unique characteristics and risks and should be carefully considered within the context of your overall investing plan. Read more about who should consider trading options, or consult with a professional to make the best decision for you.