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Options Trading: What Are They and How Do They Work?

What is options trading
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updated: July 4, 2024
edited by Jill Cornfield

Options trading has grown in popularity in recent years, with retail traders’ involvement in the options market jumping from around 34% at the end of 2019 to 42% as of September 2023, according to New York Stock Exchange data. Retail traders invest in their own accounts, as opposed to institutional traders, who invest for others.

But while options trading has the potential for high returns, income generation, and hedging your portfolio, it can also come with risk.

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How options trading works

You can trade options similarly to how you trade stocks and bonds in your online brokerage account. However, when you trade options, you’re not actually buying or selling an underlying financial asset—you’re buying or selling the right to buy or sell the underlying financial asset before the contract’s expiration date.

The options contract also outlines how many shares of the underlying asset—whether a stock, exchange-traded fund (ETF), or other asset—can be bought or sold.

Options traders base investments on expectations that the underlying asset’s price will rise or fall during a certain period. For example, if investor A thinks that a stock will jump in price in the next month, they may buy an options contract that gives them the right, without obligation, to buy the stock from investor B if it hits a certain price (this is known as the strike price) before the expiration date.

Investor A would pay Investor B a premium in exchange for that right. Standard stock options contracts generally cover 100 shares of the underlying stock. Say the premium is $2. The total amount the buyer of the option would pay is $200 ($2 multiplied by 100 shares), plus any transaction fees. If the stock hits the strike price before the expiration date, investor B is contractually obligated to sell their stock to Investor A if Investor A chooses to exercise their right to buy.

If the expiration date comes without the stock hitting the strike price, the options contract expires. Investor B is no longer obligated to sell the stock to Investor A.

Different types of options contracts

Options contracts come in two basic types: call and puts.

Call options, like in the example above, give the option buyer the right, but not any obligation, to purchase an underlying asset if it hits the agreed-upon strike price by the agreed-upon date. They obligate the seller to sell if the buyer exercises their right.

Put options, on the other hand, give the owner of the option the right, without obligation, to sell an underlying asset if it hits the strike price by the expiration date.

In short, the buyer of a call option is betting that the price of the underlying asset will jump above the strike price before the expiration date, and the seller of a call option is betting the price of the underlying financial asset will stay below the strike price before the expiration date.

The buyer of a put option bets that the underlying asset's price will fall below the strike price before the expiration date, and the seller of a put option bets that the underlying asset's price will stay above the strike price before the expiration date.

How to trade options

Trading options can be risky, and financial advisors typically recommend only experienced investors try it. But if you’ve decided you want to trade options, follow these steps:

1. Choose a trading platform

Many popular trading apps allow investors to trade options, though you’ll likely need to fill out an application with information about your financial trading experience to be allowed to start trading options. (Again, this isn’t a recommended strategy for beginners).

Brokerages may also require you to have a margin account, which is an account in which the brokerage lends you money to buy securities.

2. Select your options contract

You will need to choose an underlying asset, such as a stock or ETF, and decide whether to buy or sell a call or put option.

Option chains allow traders to view contracts’ pricing and activity—and it’s much more detailed than the metrics you see when buying or selling a stock. According to Fidelity, options contracts are structured as follows: Ticker symbol + Year of expiration + Month of expiration + Day of expiration + C for call or P for put + the strike price.

Review your options, including the available options’ strike prices and expiration dates, and pick one that fits your objectives.

3. Execute your trade

When you place your options trade, you’ll pay your premium, if applicable. You may also owe your brokerage transaction costs. If you decide to exercise your option, you can contact your broker, though some brokers will automatically exercise your right upon expiration if you are in-the-money.

Benefits of options trading

For experienced investors, trading options can be more appealing than trading other financial assets, like stocks and bonds. The benefits of trading options include:

Ability to reduce risk in your portfolio

Traders can use options to hedge other financial assets, like stocks, in their portfolios. The strategy can lower the portfolio's risk, though keep in mind that options trading itself comes with plenty of risk.

Less financial requirement than stocks

When you buy an options contract, you pay a premium—and that premium can be much lower than the cost of actually buying a stock.

Flexibility

When you trade stocks, you can either buy or sell the stock. While traders can certainly implement various strategies when trading stocks, there are even more strategic trading moves available to options traders.

Buyers only risk their premiums

Options buyers only risk losing the premium they pay to the seller. But sellers take on a lot more risk (more on that below).

There are downsides to trading options, too, including:

Sellers face unlimited downside risk

Unlike options buyers, options sellers are obligated to buy or sell the underlying asset if the option is exercised. That means they may be obligated to buy a stock even if its price soars or sell it even if it plummets. There’s no cap on how high or low those prices can move, meaning sellers can experience huge losses.

Traders need to be right twice to benefit

When you invest for the long term, you can rely on the power of the financial markets to help your balance grow, especially if you employ a set-it-and-forget-it strategy. The same can’t be said for options trading, which requires short-term betting on asset prices. Options traders need to choose a strike price that the asset will hit; they also need to choose an expiration date by which the stock price will hit to be successful.

It’s complicated and requires more from investors

Investing can be intimidating, especially for beginners. Options trading comes with more complexities than simply buying assets in a 401(k) or taxable brokerage account, so much so that investors usually must apply to trade options before they can get started. Options traders may also need to open a margin account, which can come with higher fees than a typical brokerage account.

What are options trading levels?

Brokerage firms offer different levels of options trading, and your application to trade options helps determine the levels you’re eligible for. Firms typically offer five levels, with the first requiring the lowest amount of risk and the fifth requiring the most, but that can vary.

For example, the trading platform moomoo offers four levels, while SoFi currently only offers two.

The lowest level may offer the ability to buy and sell basic call and put options, while the highest level will tack on more advanced (and risky) strategies, like selling uncovered calls and puts where the writer doesn’t own the underlying asset.

Options trading strategies

Options traders can use various strategies to hedge their portfolios, generate income, and more. Some examples include:

Long call

A trader may buy a long call if they expect the price of the underlying asset to rise above the strike price before the expiration date. It’s a way to speculate and benefit from the short-term price jump of an underlying financial asset.

Short call

Similar to a long call, a short call is a strategy a trader might use if they believe the price of an underlying asset will fall. The trader would buy the right to sell the underlying asset if the price falls below the strike price.

Short put

Also known as an uncovered put or naked put, a short put is a strategy a trader employs if they hope to pocket the premium without exercising the option.

Covered calls

Options traders sell covered calls as a way to generate income. The strategy involves selling an options contract on an underlying asset you already own.

Married put

A trader who implements the married put strategy buys a put contract while holding a position in the underlying asset. If done correctly, the strategy can offer downside protection on a financial asset you hold.

How options are priced

The premiums, or options prices, are the sum of two factors: the intrinsic value and the time value.

Intrinsic value

The intrinsic value is the amount an option is worth at any given time. It is based on the difference between the price of the underlying asset and the strike price.

Time value

The time value is based on the amount of time left before an option's expiration date. The longer the time period until the expiration date, the higher the time value.

Why do people buy or sell options?

One reason people buy and sell options is to protect their overall portfolio by using contracts to lower their risk. If an investor is concerned that the price of a stock in their portfolio will fall, they can buy an options contract that gives them the right to sell the stock to another investor if the stock hits a certain strike price.

Another appeal of options is the ability to generate income. To do this, an options seller may sell a call option—which gives the buyer the right to buy an underlying asset—of an underlying asset that the seller already owns and pocket the premium. The contract may expire without the seller having to sell, but if the underlying asset reaches the strike price, the seller already has the asset on hand to sell.

TIME Stamp: Trading options can come with benefits, but it’s also risky

Options trading can be a way for investors to speculate (and profit) from short-term price moves, protect their portfolios from risks, and generate income. But it also comes with risk, so it’s not recommended for new and inexperienced investors.

Trading options requires a more hands-on, strategic approach than investing in the stock market for the long term. You can trade options via a brokerage account like you can other financial assets, but you’ll likely have to apply and demonstrate that you have the appropriate investing experience.

Frequently asked questions (FAQs)

Can anyone trade options, or do you need special qualifications?

In most cases, you need to apply to trade options. Based on your application and the information you input about your trading experience, you’ll be designated a certain options trading level. Those levels allow for different kinds of options trading, with lower levels offering less risky strategies and higher levels offering higher-risk strategies.

How much money do you need to start trading options?

Brokerage firms vary in how much they require you to start trading options. Some may require you to have a margin account to begin trading options, with a minimum of $2,000 or more to open the account.

Is option trading better than stocks?

Options trading has different pros and cons than stock trading. Buying stocks likely makes more sense for most long-term investors than trading options.

Is option trading for beginners?

Options trading can be risky and is therefore not for beginners.

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