What Is Options Trading?

Options trading allows investors to speculate on a stock's directional move, but there are some key concepts to learn before jumping in.

closeup of person with pen buying and selling stocks online
(Image credit: Getty Images)

By definition, options are contracts that entitle the holder to buy or sell shares of the underlying asset at a specific price by a specific date.

However, many active options traders never plan to touch the underlying shares themselves. Instead, they buy and sell options – sometimes in various combinations known as "spreads" – with the intent of profiting from changes in the premiums of the option contracts.

In fact, while the well-timed purchase of a call option would grant the holder the right to buy those shares at a discount to market prices, the impressive fungibility of options means there are actually strategies better-suited to acquiring stock than a straightforward call purchase – such as the cash-secured put.

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How does options trading work?

Traders looking to capture a quick directional move in the underlying stock would be best suited to straightforward call and put buying strategies. In this scenario, the trader would "buy to open" a call or put contract, and then "sell to close" the contract once the profit target or stop-loss was triggered.

Equally important is to understand the multi-pronged factors that influence the price of a derivative as compared to its underlying asset. There are three primary components that impact an option's price, or premium: 

  1. The share price of the underlying asset
  2. Time until expiration
  3. Implied volatility (IV)

Other factors, like dividends and interest rates, also play a role – though in many short-term and day-trading options strategies, these are effectively incidentals.

First, the share price of the underlying asset determines the so-called "moneyness" of the option. Options can be in-the-money, at-the-money or out-of-the-money, depending upon their strike price's relationship to the underlying asset's price. Only in-the-money options (call strike < stock price or put strike > stock price) carry what's known as intrinsic value, which is all the contract has left at expiration.

Extrinsic value, more broadly known as time value, includes the amount of time until expiration – whether that's two hours or two years. Time value decays at a nonlinear pace that accelerates as expiration draws closer, eventually zeroing out as the contract expires.

Implied volatility (IV) is perhaps the hardest to quantify, but it's critical to understand for options traders. IV reflects the amount of price movement the stock is expected to realize over the option's life span, and this metric can occasionally spark drastic changes in an option's price single-handedly – particularly around known events, such as earnings reports and product launches.

So in order to win at this kind of speculative options trading, the trader must successfully anticipate the underlying asset's direction – and that price forecast has to play out prior to the contract's expiration date, and the magnitude of the move has to outstrip what the options market priced in via implied volatility.

Is options trading better than stocks?

While there may be a few additional degrees of difficulty relative to stock trading, the reward for options traders is leverage. Each option contract offers control of 100 shares for just a fraction of what it would cost to buy those shares outright, which means the percentage gains on a winning options trade can be relatively massive compared to a corresponding stock trade.

Traders who prefer higher probability outcomes can take up the selling end of the transaction, which generally flips the risk/reward equation into the investor's favor.  

For example, an investor anticipating relatively flat price action might opt to collect the premium on a trade upfront by "selling to open" a call or put option near the asset's current price, and then "buying to close" the contract close to expiration, once its value has eroded almost completely. 

The usage of "sell to open" and "buy to close" verbiage can be confusing for those new to options trading, so it’s important to be clear on the jargon before entering those first trade orders.

Bought and sold options – both calls and puts – can also be combined in multiple different ways to create strategies known as "spreads." A wide variety of spreads exist, and they're tailored to capitalize on nearly every imaginable chart scenario – high volatility to low volatility, explosive price action to negligible price movement, and some designed to capitalize on the simple passage of time. 

Just as with equity options, calls and puts on indexes and exchange-traded funds (ETFs) can be used to speculate on directional moves. The most popular ETFs, such as the Invesco QQQ Trust (QQQ) and the SPDR S&P 500 ETF Trust (SPY), list options that expire every day of the week – making them popular targets for day traders.

How do I start trading options? 

Unlike traditional stock trading, brokerage firms require clients to meet various levels of approval before they're permitted to trade options. Depending upon the investor's experience, account size, trading goals and various other factors, options clearance can range from the lowest risk level (covered calls and cash-secured puts) to the highest risk level (selling "naked," or uncovered, calls and naked puts).

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Elizabeth Volk
Contributing Writer, Kiplinger.com

Elizabeth Volk has been writing about the stock and options markets since 2007. Her analysis has been featured on CNBC, published in Forbes and SFO Magazine, syndicated to Yahoo Finance and MSN, and quoted in Barron's, The Wall Street Journal, and USA Today.