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How to Trade Options Explained

Options are contracts that represents the right to buy or sell an underlying asset before an expiration date once certain price conditions are met.[1][2][3][4][5][6][7][8]

There are two basic ways to participate in the options market:

  1. You can buy an option contract
  2. You can sell (AKA write) an option contract.

There are two types of options contracts

  1. A contract that represents the right to buy an underlying asset is a “call.”
  2. A contract that represents the right to sell is a “put.

All options contracts have an expiration date (generally weekly, monthly, and yearly) and “strike price” (price at which the owner of the contract has the right to buy or sell and the writer the obligation to buy or sell).

Contracts can be closed at any time before expiration date (both buyers and sellers can close a contract by trading it back into the market), or contracts can be exercised at any time before or on the expiration date by the owner of the contract.

Even though there are only two things you can do with a contract and two types of contracts, in total there are actually 10 different actions you can take in terms of any contract:

  1. Buy call to open (Buy a call; the right to buy a stock at the strike price) BULLISH POSITION (a bet the price goes up)
  2. Sell call to close (close a call you bought)
  3. Sell call to open (Write a call; the obligation to sell at stock at the strike price) BEARISH POSITION (a bet the price goes down)
  4. Buy call to close (close a call you sold)
  5. Buy put to open (Buy a put; the right to sell a stock at the strike price) BEARISH POSITION (a bet the price goes down)
  6. Sell put to close (close a put you bought)
  7. Sell put to open (Write a put; the obligation to buy at the strike price) BULLISH POSITION (a bet the price goes up)
  8. Buy put to close (close a put you wrote)
  9. Exercise a call (exercise your right to buy an underlying asset at the strike price).
  10. Exercise a put (exercise your right to sell an underlying asset at the strike price).

Lastly the duration of a contract, the distance the current price of an asset is from the strike price, the volatility of the asset in terms of price, and general supply and demand all play into the value of a given option.

Don’t worry if you don’t understand that all right now, the rest of the page is designed to walk you through the logic.

DISCLAIMER: This page is meant to introduce you to the concept of options, this is not investing advice, please consult a professional (a fiduciary or at least your broker) before trading options.

FACT: Options are a very old type of derivative of a futures contract. Futures contracts span back to the origins of banking and were commonly used in agriculture due to unknown factors like future crop yields. Check out a history of writing options.

TIP: This page focuses on US options which work slightly differently than options in some other countries. American-style contracts allow you to exercise options at any time before the date of expiration. European ones can only be done right around the time the contract is set to expire.

Everything You Need to Know About Calls and Puts

Above we covered the bare bones basics of options. Now let’s go into every aspect with a little more detail. This will on one hand help go reinforce what we just covered, and on the other will probably help to fill in a few gaps that didn’t fit in the condensed version.

Here we go:

You can use options to bet on the price of a stock going up or down (either to speculate or as a hedge).

You can buy, sell, and write option contracts (each traditionally representing 100 shares of the underlying stock; although there are mini options which are 10 shares).

Options contracts gives the buyer of the contract the right to buy/sell the underlying asset at a specific price called a “strike price,” regardless of the current price, at any time before the expiration date of the contract.

The amount paid for the contract is called a “premium.”

As the buyer of the option contract, an option contract that bets on the price going up is a “call,” and a contract that bets on the price going down is a “put.” To open these orders you “buy call to open” or “buy put to open.”

As the writer (aka “seller”) of a contract you are selling that contract to the buyer, so your bet is somewhat different than the buyers. To open these orders you “sell call to open” or “sell put to open” (although depending on the platform you use, the terms might simply be “write call” and “write put”).

For both the buyer and “writer” of a contract, with a put, the further below the strike price, the more the contract is worth (and the higher above, the less). Meanwhile, with a call, the further above the strike price, the more the contract is worth (and the lower, the less).

To put that all together, the basics of calls and puts from the perspective of a buyer are:

  1. A call option contract gives the buyer the right to buy the stock at a specific price called a “strike price” for the duration of the contract (before the “expiry date” or before the contract reaches “maturation”). The higher the price of the stock is above the strike price, the more the contract is worth (and the lower below, the less). A buyer can use this to bet on a stock going up.
  2. A put option contract gives the buyer the right to sell the stock at the strike price for the duration of the contract.The further the price of the stock is below the strike price, the more the contract is worth (and the higher above, the less). A buyer of this contract can use this to bet on a stock going down.

Meanwhile, from the perspective of the writer:

  1. A call option contract gives the seller the obligation to sell the stock at a specific price called a “strike price” for the duration of the contract.
  2. A put option contract gives the seller the obligation to buy the stock at the strike price for the duration of the contract.

So what is the difference between a buyer and writer (AKA seller) of an option? The main difference is the option writer is obligating themselves to a trade while the option buyer is buying the right to exercise the contract.

Ok, so let’s break that down:

  1. The writer (seller) of a call option is selling the right for someone else to buy their shares and getting a premium (the money made from selling the contract) in return. Generally you would write a call with the strike price above the current price of the stock. This is useful if you know you would sell at a certain price.
  2. The buyer of a call option is buying the right to buy shares at the strike price. That means no matter how high the stock goes, you can still buy at that price if you hold the contract. By buying calls you can control many shares for only the price of the premium of the contract. This is a way to bet on the price of a stock going up without having to tie up a lot of funds.
  3. The writer (seller) of a put option is selling someone else the right to make them buy shares and getting a premium in return. Generally you would write a put with the strike price below the current price of the stock. This is useful if you know you would buy at a certain lower price no matter what.
  4. The buyer of a put option is buying the right to sell shares at the strike price. Puts can be used to short a stock. When you exercise a put contract you are selling a, so the lower the stock price goes compared to the strike price, the more the put is worth.

With that covered, there are a few ways to make money from options contracts:

  1. You can write calls and puts and “sell to open” contracts; i.e. you can sell options. Here you make money from collecting premiums (and ideally from your underlying trades). You can even “buy to close” later when it is profitable, trading back some of your premium for some profit and the ability to write another contract.
  2. You can “buy to open” call and put contracts and then “sell to close” at a profit i.e. you can trade options.
  3. You can “buy to open” a call or put and then exercise the contract, ideally when it is profitable (that means you buy / sell the shares at the strike price).

With all of that in mind, here are some examples of how calls and puts work from the perspective of both the buyer and the writer.

  1. Writing a Call: a stock is at $5, you can sell someone else a contract that gives them the “option” to buy X shares of your stock at $5.50 a share by Y date regardless of what the price is. The closer the price is to $5.50, the more volatile the stock, and the further away from the date, generally speaking the more someone will pay. If the price is above the $5.50 strike price, they will pay even more for the contract. But remember, no matter how high it goes, you have to sell it for $5.50 for the length of the contract once the premium is paid. So ideally, the stock never goes to $5.50 and you just collect your premium… but of course, if it goes down while you are waiting for the contract to expire, you are stuck unless you buy out the contract.
  2. Buying a Call: I think the stock is going to $10. The stock is currently $5. I buy the $5.50 call above and then when it goes up I either sell the contract on the market for a profit or exercise the contract and then sell the shares. If I’m wrong, at worst I lose the premium I paid for the call.
  3. Writing a Put: A stock is $5. You want to buy this stock at $4 if it ever goes there, like you would just set a buy limit there anyways, so instead you write a put contract and obligate yourself to buy at $4 for the duration of the contract regardless of the price if the contract is exercised. So if it crashes to zero, you’ll still have to buy at $4 no matter what if the contract is exercised. Secretly though you hope it never goes to $4 so you can just collect your premium.
  4. Buying a Put: a stock is at $5, you think the stock is going to go down, you buy an options contract to sell at $5 within 1 month. The stock goes to $4.50, you exercise the contract and sell at $5 (meaning you make $0.50 cents x 100 per contract – the premium). At worst you lose the premium paid if the stock goes up. Of course, you can also trade this contract at any time (for example when the stock price is $4.75, as it’ll likely have a higher price tag than when you bought it when the stock price was higher).

The above I think should summarize everything you need to know about options trading. It isn’t that there isn’t a lot more to it if you want to know every aspect, it is only that the above covers the basics.

On expiration dates: Options contracts can be closed at any point before the expiration date. The owner of the options contract can choose to exercise the contract at any time before the expiration date. However, if at expiration the stock price is at or below the call’s strike price, or at or above the put’s strike price, the call option will lose all of its value. With that in mind, a contract will automatically be exercised if it is profitable at the expiration date.

On closing contracts: Every contract has a buyer and seller, and both the buyer and seller have an option to buy themselves out of the contract. To get out of a contract as a buyer, you “sell call to close” or “sell put to close.” To get out of the contract as a writer (seller), you “buy call to close” or “buy put to close.” You “buy to close” or “sell to close” to avoid losses, to lock in gains, or for any reason. From here you can write another call or simply sell the underlying shares. Check out this article on Closing Covered Calls Early for ideas on why you might close covered calls you write early.

Speculating vs. hedging: Options can be risky when used for speculation. Writing covered calls or hedging with small option plays can be very useful for conservative investors, helping them to hedge their bets and get a bit more out of long term positions… but you can also blow up your account pretty quick trading options on low caps like a gambler. Options markets tend to be less liquid and faster moving than traditional markets. Be careful out there. 😉

Buying, Selling, and Writing Options Contracts

After filling out a form with your broker you can buy options contracts through your broker and/or write calls and puts.

Buying, selling, and writing options contracts are all as easy as filling out a web form (just like when you buy or sell a stock though Charles Schwab or Fidelity, you can trade options through them too).

In general you just have to click over to the tab that says “options” and then select if you want to write a call or put, or buy or sell a put or call to open or close, select the symbol, and select the duration and strike price from the options chain (checking things like bids, asks, last, volume, and open interest to see which contracts make sense).

Putting that all together, as noted above, you can:

  1. Buy call to open (Buy a call; the right to buy a stock at the strike price) BULLISH POSITION (a bet the price goes up)
  2. Sell call to close (close a call you bought)
  3. Sell call to open (Write a call; the obligation to sell at stock at the strike price) BEARISH POSITION (a bet the price goes down)
  4. Buy call to close (close a call you sold)
  5. Buy put to open (Buy a put; the right to sell a stock at the strike price) BEARISH POSITION (a bet the price goes down)
  6. Sell put to close (close a put you bought)
  7. Sell put to open (Write a put; the obligation to buy at the strike price) BULLISH POSITION (a bet the price goes up)
  8. Buy put to close (close a put you wrote)
  9. Exercise a call (exercise your right to buy an underlying asset at the strike price).
  10. Exercise a put (exercise your right to sell an underlying asset at the strike price).

The only note is that your broker may not let you write certain types of calls and puts, or depending on your account type and balance may not let you trade options at all.

TIP: You can buy / sell both calls and puts on a position and/or at different contract dates, this is called a spread. A “straddle” and “strangle” also both involve buying both calls and puts. A strangle has two different strike prices, a straddle has a common strike price. As the buyer, you might do this before earnings if you think you’ll see a big move either way, but aren’t sure which way, or a buyer might do this if they thing a stock will be somewhat range bound and want to capitalize on both the up move and down move.

What Affects Option Prices, How Do Option Chains Work, and Other Options FAQ

Below is just a collection of useful notes on options:

  1. When you own the shares and write a call contract it is called a “covered call.” Covered calls are probably the most basic and conservative thing you can do with options, consider starting here (and remember you can “buy to close”). Your broker will likely require to own shares to write a contract since as a writer you create an obligation and not just a right!
  2. The price of an option is based on the price of a stock, the volatility, the length of the contract (how far away we are from the expiration date; i.e. Time Value), and the supply / demand. The more volatility, demand, and distance from the expiry date, the more the contract is likely to go for. The less volatility, supply, and the closer we are to the expiry date, the less the contract is generally worth.
  3. On that last note, you can write and buy different length contracts. Generally contracts are weekly and monthly.
  4. The table that shows the current bids / asks and other info for options is called an options chain.
  5. In general there isn’t going to be a ton of demand for far away strike prices, or for low volume stocks or low volatility stocks.
  6. Remember, 1 options contract is equal to 100 shares (although there are mini options where a contract is 10). So if you have 1,000 shares of xyz, you are writing 10 contracts and not 1,000 for example… don’t mess this up!
  7. A put or call contract can be exercised at any time before it matures by letting your broker know you want to exercise the contract.
  8. It is common for options not to be exercised and to expire worthless. So there is always a chance you can write a covered call and then not have the option exercised… and then to write another call on the same shares.
  9. Even though many contracts expire worthless, if a contract is worth money upon expiry (if it is “in-the-money”) it will generally be automatically exercised.
  10. When a contract is exercised the deal is automatically executed. So the buyer / seller must buy / sell shares, the contract writer must hand over shares or money, etc.
  11. Basic terms you need to know that describe the current stock price in relation to the strike price. They are in-the-money (the stock price is above the strike price with a call or below with a put), out-of-the-money (the stock price is below the strike price with a call or above with a put), and near-the-money (the stock price is close to the strike price).
  12. Remember, if you wrote an option and are losing money you can buy back the same number of contracts to close your position. This can be helpful if you made a bad bet, just keep in mind the options contracts will cost more as the bet goes against you (because the market is sure to value you them higher).
  13. To see how much demand there is for a certain contract, you can look at “open interest.” Open interest is the number of outstanding long or short option contracts for a given strike price in a given time period.
  14. With puts you want the strike price high and stock price low as an end result. With calls you want a low strike price and high stock price as an end result. The options chain should make things clear, the most expensive contract is typically the most profitable.
  15. You can buy a contract that isn’t super profitable and then hope the price goes your way. This can be useful for example if the current more valuable options are out of your price range…. but be careful, a certain strike price might be below a key support level for example and that could be why demand is low there. In short, you need a rather high level of skill to get clever trading options that are far out-of-the-money.
  16. When you write an options contract you take on the obligation to let the buyer of the contract buy or sell the underlying asset at a specific price if the option is exercised. Thus, you will have to hand over the stock or buy the stock if an option is exercised regardless of the price. Given this, it makes sense to hold any stock you are writing call options on and to have the money to cover put options. Likewise, to ensure you can exercise a contract you want to have the resources to do so. If you write a call and hold the stock, it is called a “covered call,” if you don’t own the stock it is called a “naked call.” A naked call is a risky option that is closer to shorting a stock, as you are betting the price won’t go up (since you don’t want to have to produce shares you don’t own to sell higher). Finally, you can also write a “covered put” where you short a stock and write a put on it or a “naked put” where you short a stock you don’t own (it is illegal to do a naked put in the US). TIP: “Naked” calls and puts are sometimes called “uncovered.”
  17. If you are trading options contracts, call means a bet the price goes up and put means a bet it goes down, and you essentially will always want the stock moving in a way that benefits your option unless you also hold the stock and are using it as a hedge. However, if you are writing contracts, you need to think out your goals before you decide on if you want to sell puts and/or calls and at what strike price. You may want the price to go up so you can sell your stock if you wrote a call for example (i.e. you aren’t exactly taking the opposite bet as the buyer).
  18. You don’t have to exercise a contract that is worthless, however all in-the-money contracts are automatically exercised.
  19. You can write in-the-money options contracts if you choose.
Citations

  1. The Basics of Options Trading. Schwab.com.
  2. How to Trade Options. NerdWallet.com
  3. Option Chain. Investopedia.com
  4. Time Value. Investopedia.com
  5. Pricing Options. Investopedia.com
  6. Call and Put Options With Definitions and Examples Descriptions of Call and Put Options. Investopedia.com
  7. DON’T FORGET, YOU CAN BUY OR SELL AN OPTION CONTRACT, ANALYST SAYS IF YOU SELL BOTH CALLS AND PUT OPTIONS IT’S CALLED A STRANGLE. Agricutlure.com.
  8. Options Quick Facts – Expiration, Exercise and Assignment. Cboe.com.


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