What is Options Trading and How Does it Work?

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Roger Wohlner is a writer and financial advisor with over 20 years of financial services experience. He writes about financial planning for Wealthsimple and for a number of financial advisors. His work has been published in Investopedia, Yahoo! Finance, The Motley Fool, Money.com, US News among other publications. Roger owns his own finance blog called 'The Chicago Financial Planner'. He holds an MBA from Marquette University and a Bachelor’s degree with an emphasis on finance from the University of Wisconsin-Oshkosh.

Andrew Goldman

Andrew Goldman has been writing for over 20 years and investing for the past 10 years. He currently writes about personal finance and investing for Wealthsimple. Andrew's past work has been published in The New York Times Magazine, Bloomberg Businessweek, New York Magazine and Wired. Television appearances include NBC's Today show as well as Fox News. Andrew holds a Bachelor of Arts (English) from the University of Texas. He and his wife Robin live in Westport, Connecticut with their two boys and a Bedlington terrier. In his spare time, he hosts “The Originals" podcast.

Options are a type of financial derivative. Yes, that sounds boring. And complicated. But it’s not — not boring, at least. (Definitely complicated. Get ready!) With options, you aren’t limited to simply buying or selling a stock. Instead, you can take a position (and possibly earn returns) on very specific expectations, like how much a stock will move and by when. Options provide more … options.

What are options?

Options are contracts. They give you the right (but not the obligation) to buy or sell a specific stock at a specific price by a specific date. 

But there's so much that can happen before that date. Options trade on markets just like securities do. Which means, along with the right to buy or sell a particular stock, options holders also have the right to sell the option itself at any point until it expires. Here are a few scenarios:

Say Apple is trading at $150, and you think it’s going to go up. You could buy an option that gives you the right to buy AAPL stock for $170 a share within two months (by the expiration date), no matter its price at that time. 

If you waited two months and Apple was at $180, you could “exercise” your option, which just means you’d buy the stock at your locked-in rate of $170 and could immediately sell it (at the going rate of $180) for a profit of $10/share. An option contract usually represents 100 shares of the underlying stock, but the price (called the premium) is quoted per share. So in this example, with a $5 premium, those Apple options would cost $500 per contract. After subtracting your $500 premium from the $1,000 you earned, you’d end up with $500 in profit, minus some fees. For comparison’s sake, had you invested that $500 in Apple shares, you’d be up 20%, or $100.

You could also sell the option before it expires. A lot of people do. Say AAPL got to $165 a month after you bought the option. You could sell the option for more than you bought it for, since it’s closer to the $170 — and closer to making a profit when exercised at the expiry date.

In a less rosy scenario, say AAPL traded well below $170 for those two months. You could sell the option at any point for a loss — someone might be willing to take on the risk. If you held on to it till expiration, though, there’d be no point in exercising your option and you’d lose your $500. 

Why would you buy an option?

1. You want to hedge your risk. Say you own a lot of Apple stock and you're worried the price could fall. The right options could limit losses if that prediction comes true.

2. You want to get more exposure without spending a lot of money. Buying Options can be a lot cheaper than buying corresponding stock outright, and the leverage provides a much higher potential upside. 

3. You have studied the market and want to play your hunches. Instead of simply choosing between whether a stock will go up or down, options can be used to profit off of predictions of how much a stock will move and by when.

What are the different types of options?

Call options let you buy a stock at a certain price (called the strike price) on or before the expiry date. They’re useful if you think a stock is going up, because they let you buy shares for what could be less than the market price. (There’s a handy glossary of terms at the bottom of this page.)

Put options let you sell a stock at a certain price on or before the expiry date. They’re useful if you think a stock is going down, because they let you sell shares for what could be more than the market price. 

Of the more common options, you’ll also see single stock options, which are (surprise!) that relate to a single stock (e.g Apple, Google, Amazon), and ETF options — options that relate to … ETFs (groups of stocks). 

What happens with an option after you buy it?

Let’s go back to the Apple example. You could sell that option up until the day it expires. What you could sell it for depends primarily on the price of the underlying stock. 

If AAPL tanked way below the strike price a few weeks after you bought your option, you could sell it, but you’ll likely get less than the $500 you paid, since the option would be less likely to pay off. If AAPL is way above the strike price and there’s only a week left till the option expires, however, the option has a high chance of making money, and you likely could sell it for a lot more than $500. 

You could also wait till the expiration date. (Another also? You could exercise the option early. We’ll get to that in a second.) If AAPL is above $170 that day, you could exercise your option and pocket the difference. If you get to the expiration date and the stock is below $170, however, you lose your $500.

A lot of traders don’t get that far. Not because they’re lazy but because they may not have the cash. Exercising that Apple option would cost $170 x 100, or $17,000. So instead they “sell to close,” which just means they sell the contract to someone else. In the case where APPL tanked, you’d likely sell for a loss (but potentially recoup part of what you originally paid). In the case where APPL rose, you’d likely sell for a profit. In either case, it’s a way of seeing similar returns without needing bags of cash lying around.

When can you exercise an option?

Assuming you have enough money to buy the underlying stocks (for a call) or enough stock to sell (for a put), options can be exercised at any time. But often it's in an investor’s best interest to wait till the expiration date.

If your option isn’t "in the money" (when the stock’s current price means you would profit if you bought or sold at the strike price), exercising it means locking in your losses. Even if it is in the money, if you exercise an option early you are losing out on the time value. What’s that mean? The closer an in-the-money option gets to expiring, the more it’s worth. 

If your option expires “out of the money" — you’re out of luck. You lose whatever you paid for it.

What drives the price of an option contract?

Like any other market, it depends what people are willing to pay. Figuring that out is complicated and abstract, but it’s essentially driven by three things: 

1. how much the underlying stock price needs to move for the option to be in the money.  In the Apple example above, you have a call option that would let you buy 100 shares of AAPL at $170. If AAPL is at $120, the option is worth a lot less than if AAPL is at $168. And if the stock is already at $175, the option is worth even more. 

2. how much the stock price tends to change (its volatility) AAPL doesn’t have much volatility; it’s been a steady mountain climber, with a few dips here and there. If it’s at $120 and you need it to get to $170, there’s not much chance of that happening before the option expires. A stock like DraftKings, however, has a price chart that might as well track a bumblebee on speed. Even if the strike price is still far away, a stock like that has a much better chance of getting in the money. Which means the option will cost more.

3. how much time until the option expires The more time you have, the more time there is for the underlying stock price to change — and the more valuable an options contract is. 

The specific metrics for pricing options are called "the Greeks." They have nothing to do with that (actually-not-completely-horrible) Russell Brand movie. You’ll see them listed with every option contract, and how they are calculated is pretty 🤓. To learn more about the Greeks, check out our glossary below.

What are the risks of options?

🛑 This is important, because the risks are big: if the stock underlying your option doesn't hit its strike price and you can't convince someone to take it off your hands before it expires, you lose whatever you paid for it. That’s 100% loss, which is an incredibly rare occurrence in typical stock trading. 

Here are some the reasons options can be riskier than stocks: 

Compound volatility. Since options are derivatives of stocks, you’re stacking one layer of volatility on top of another (a stock price is loosely based on predicting a company’s future performance, and an options price is loosely based on predicting a stock’s future performance). That makes it very hard to predict what will happen with the price of an option. For example, if you buy an option with high volatility, something could happen that makes investors’ perception of the underlying asset’s volatility drop. Then, the value of your option can drop, too — even if the underlying asset price stays the same. This happens because the lower implied volatility means the stock’s future movement is more certain. And not a lot of people want to bet against something certain. You may have paid $100 for that option a week ago, but now it could be worth $5.

Time sensitivity. You can hold a stock forever. An option, not so much. As an option’s expiration date approaches, its value can change really quickly. If you’re in the money or close to it, the value shoots up. But if you’re still a long way off, that value can fall off a cliff. Why? The shorter an option’s duration, the less time there is to recover from sudden movements — and the riskier that option is. So pay close attention to timing. 

Confusion. Options are complicated. In a world where it’s normal to hear things like “vol crush” and “the modal outcome is zero,” it’s also normal to get confused. There are a lot of different strategies and techniques to learn, especially when you’re starting out. As you learn, you’re going to make mistakes, and those mistakes can cost you. That’s especially true in the fast-paced world of short-duration trading.

Variable liquidity. There are a lot of stocks out there, but there are exponentially more stock options. Each stock or ETF could have dozens of different options, with different strike prices and durations. This array of different options can lead to low supply and demand for any particular one. This could mean being forced to pay a higher price for an option than you might want to. It can also mean having trouble finding buyers when you go to sell, and having to drop your price to do so. In some cases, you could even be forced to hold the contract to expiry and eat the loss. 

Terms you might come across

Options come with their own specific language, and before you start trading, you'll want to make sure you can speak it. (If you already know that an Iron Condor is not a member of the Marvel Cinematic Universe and is in fact a complicated way to trade options, you can skip this part. For anyone else, read on.)

Strike price: The agreed upon future purchase or sell price of the option’s underlying asset.

Put options: These give you the right to sell an asset at a particular price. You buy a put option when you think a stock price is going to fall. It’s similar to short selling

Call options: The opposite of a put. These options give you the right to buy an asset at a particular price. It’s used by investors who think a stock price is going to go up.

Expiry date: The date by which you can exercise or sell to close option contracts. The time before expiry can range from a single week to as many as three years.

In the money: In the money — or “ITM” if you’re texting with someone in a Patagonia vest — means that an investor would profit from exercising an option. 

Out of the money: This one’s easy: the opposite of in the money. 

Premium: How much an option will cost you to purchase. Though premiums are quoted per share, they are generally bundled and sold in increments of 100 shares per contract. So if the premium is $5.50, those options will cost you $550 per contract.

Breakeven: The amount the underlying stock needs to move for you to break even on an options trade.  

Time value: How much time there is between now and the expiry date. 

Volatility: A measure of an underlying asset’s price swings.  

Bid, Ask, and Spread: A bid is how much traders are currently willing to spend on an asset (in this case an option), an ask is how much sellers are willing to spend on it, and the spread is the difference between the two. The spread can sometimes be wider for options than for stocks, which may make it harder for you to sell an option than a stock. 

Mark: That college friend you really should call. Those were fun times. Also: the midpoint between the bid and the ask. It’s often quoted as the best measure of value.

High: The highest price at which a given security has traded over the current or last trading day. 

Low: The lowest price at which a given security has traded over the current or last trading day. 

Last trade: The price at which an asset was bought or sold in its most recent transaction. 

Volume: The total number of options contracts being traded over the current or last trading day. 

Open interest: The total number of option contracts that are currently active.

Implied volatility: An estimate of how much a stock will fluctuate over the life of an option. The number is reflected as a percentage. The higher it is, the more movement is expected — meaning there’s a higher chance of profit (or loss) — and the more the option will be worth. Implied volatility typically increases with market expectations for risk and general demand for options.  

What are the Greeks in options?

The Greeks are calculations that help investors estimate the price of an options contract.

Delta: An estimate of how much an option's value is likely to change when the price of the underlying stock changes. Delta values range from -1.0 to 1.0. A delta of 0.25, for example, tells you that for every $1 increase in the value of the underlying stock, the value of the option should increase by about $0.25. A negative delta means that an increase in stock price results in a decrease in option value.

Gamma: How much an option’s delta changes in response to changes in the price of the underlying asset. When someone buys an option, it has positive gamma between 0 and 1. The closer an option is to expiry or the strike price, the higher that number goes; the farther it is from either, the lower the number goes. For investors hedging their options positions by also holding the underlying stock, Gamma is often used to determine how much of the stock to buy/sell after the stock price changes in order to remain hedged against future moves.

Theta: An estimate of an option’s decline in value over time. Also known as “time decay,” theta is expressed as a negative number, and it grows as an option gets closer to expiring. 

Vega: An estimate of how much the price of an options contract will change in response to a change in the implied volatility of the underlying asset. The higher the vega, the more sensitive an option is to big events like earnings.

Rho: An estimate of how sensitive the value of an option is to changes in the interest rate of (because these are USD options) a U.S. Treasury bill. Call options tend to have a positive rho and put options have a negative one. Rho tends to be less of a factor than the other Greeks, but can still be useful if you expect interest range to change.

Last Updated April 19, 2023

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