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Options Trading: What It Is and How to Do It

Master the fundamentals and strategies of options trading to maximize profits and manage risks effectively.

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Shane Neagle

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Matt Miczulski

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Options trading offers a flexible and potentially lucrative way to navigate the stock market. Whether you’re a beginner curious about the basics or a seasoned trader seeking advanced strategies, understanding the mechanics and risks is essential.

In this guide, we’ll cover everything from key terms and strategies to placing trades and monitoring positions, providing you with a comprehensive roadmap to options trading success.

Key takeaways

  • Options trading involves buying and selling contracts that give the right to buy or sell an asset at a set price by a certain date.
  • To buy options, select a contract through your broker, choose the underlying asset, expiration date and strike price and place an order to purchase either a call or put option.
  • Options trading fees can include commissions, per-contract fee, pass-through fees and exercise and assignment fees.

What is options trading?

Options trading is a financial strategy where investors buy and sell contracts that give them the right, but not the obligation, to buy (call) or sell (put) an underlying asset at a predetermined price within a specific time frame.

Unlike directly purchasing shares of stock, options trading offers flexibility and allows traders to capitalize on market movements with less capital. This leverage can lead to significant profits if the trade goes in the trader’s favor, but it can also result in substantial losses if the trade moves against them.

How to trade options

Below are key steps to help you get started in options trading, from mastering the basics to placing your first trade.

Understand the basics of options

Before diving into trading, it’s essential to understand how options work. An option is a contract that gives you the right to buy or sell an asset at a specific price, known as the strike price, before or on the contract’s expiration date.(1)

There are two main types of options: call options, which give the right to buy an asset, and put options, which give the right to sell. Here are the other key terms which you should familiarize yourself with:

  • Strike price. The price at which you can buy or sell the underlying asset.
  • Premium. The fee you pay to purchase the option contract.
  • Expiration date. The date on which the option expires and is no longer valid.(2)
  • In-the-money (ITM). When the current market price is favorable for exercising the option. A call option is in-the-money if the strike price is below the underlying security’s market price. A put option is in-the-money if the strike price is above the underlying security’s market price.(3)
  • Out-of-the-money (OTM). When the current market price is not favorable for exercising the option. A call option is OTM if its strike price is greater than the underlying asset’s market price, while a put option is OTM if its strike price is less than the security’s market price.(3)
  • Intrinsic value. The real, measurable value of an option if it were exercised immediately.

Select an options trading strategy

Once you’ve grasped the basics, the next step is to choose an options trading strategy that aligns with your financial goals and risk tolerance. Some popular strategies include:

  • Buying calls. This strategy allows you to profit from a rising asset price by giving you the right to purchase the asset at the strike price. You stand to gain if the market price exceeds the strike price before the option expires.
  • Buying puts. A put option lets you benefit from a decline in the asset’s price. By securing the right to sell at the strike price, you can profit if the market value drops below that level before expiration.
  • Covered calls. If you already own the underlying asset, you can sell a call option to generate additional income. However, this limits your potential gains, as you may be forced to sell your asset at the strike price if the option is exercised.
  • Protective puts. This hedging strategy involves buying a put option on an asset you own to protect against a potential drop in its price. If the asset’s price falls, the put option helps offset losses by allowing you to sell at the higher strike price.(4)

Choose a broker and apply for options trading permission

To start trading options, you’ll need a brokerage account that supports options trading. Popular platforms like Charles Schwab, E*TRADE and Robinhood are well-suited for both beginners and advanced traders.

Once you’ve opened your account, you’ll need to apply for options trading permission, as brokers assess your trading experience, financial background and risk tolerance before granting access to trade options.

The approval process usually involves assigning a trading level, which dictates the types of options trades you’re eligible to make.(5) These levels range from beginner options trading strategies, like covered calls, to more complex strategies, such as spreads or naked options. Here’s a general breakdown:

  • Level 1: Covered calls, cash-secured puts.
  • Level 2: Buying calls and puts.
  • Level 3: More advanced strategies, such as spreads.
  • Level 4: High-risk strategies, such as selling uncovered (naked) options.

Make sure to select a broker that aligns with your needs, offers competitive fees and provides educational resources to guide you through the options trading process.

Research the underlying asset

Successful options trading begins with thorough research of the underlying asset, whether it’s a stock, exchange-traded fund (ETF) or index.

Traders should use fundamental analysis to evaluate the asset’s financial health, considering factors like earnings reports, revenue growth and industry trends. However, most options traders rely more on technical analysis, which focuses on price patterns, volume and momentum indicators to forecast future price movements.

It’s also important to keep an eye on market conditions, as volatility, interest rates and geopolitical events can all influence asset prices.

Combining these research methods allows you to make informed decisions when selecting the right asset to trade options on. Pay close attention to relevant news that could impact the asset’s performance and the overall market sentiment.

Choose the right option contract

Once you’ve selected an underlying asset, the next step is choosing the right option contract. Consider the following factors when making your decision:

  • Call or put. Decide if you want the right to buy (call) or sell (put) the asset.
  • Strike price. Choose a strike price that reflects your expectation of where the asset’s price will move.
  • Expiration date. Select an expiration date that matches your investment timeline and market outlook.
  • In-the-money, at-the-money or out-of-the-money. Determine the option’s moneyness based on the underlying asset’s current price relative to the strike price.(6)

Place the trade

With your strategy and option contract in place, you’re ready to execute the trade. Start by navigating to the options trading section of your broker’s platform.

Then, select the option contract you’ve chosen — whether it’s a call or put — input the number of contracts you wish to trade and confirm the order details, including the limit price or market price at which you want to execute the trade.

Review the order carefully before submitting it. Once you place the trade, you’ll be able to see your open position in the brokerage platform, along with key details like the option’s expiration date and current market value.

Monitor the trade

After placing the trade, it’s important to monitor your open position. Keep an eye on the underlying asset’s price movements and the performance of your options contract. You have three primary choices depending on how the trade progresses:

  • Sell the option before expiration to lock in profits or minimize losses.
  • Exercise the option if it’s in-the-money, allowing you to buy or sell the asset at the strike price.
  • Let the option expire if it’s out-of-the-money, resulting in the loss of the premium paid but no further obligations.

Review and refine your strategy

Once you’ve closed the trade, take the time to review its outcome. Analyze what worked and what didn’t — this will help you improve your options trading strategies.

Factors to consider include the timing of your trade, the accuracy of your market analysis and whether the chosen strategy aligns with your goals. Keep track of your trades, note patterns in your performance and always be ready to adapt based on market conditions and your evolving financial objectives.

Options trading examples

Understanding options trading becomes clearer with real-world examples. Below are two common strategies — buying calls and buying puts — and how they work in practice.

Buying calls

Imagine you believe XYZ stock, currently priced at $50, will rise in the coming weeks. You purchase a call option with a strike price of $55, expiring in one month, for a premium of $2 per share. Each contract represents 100 shares, so the total cost of the trade is $200.

If the stock price rises to $60 before expiration, your option is in-the-money. You can now exercise the option to buy 100 shares at $55 and immediately sell them at $60, netting a profit of $500 ($5 per share x 100 shares), minus the $200 premium you paid, for a total profit of $300.

Buying puts

Suppose you expect ABC stock, currently trading at $70, to drop in price. You buy a put option with a strike price of $65, expiring in two months, for a premium of $3 per share. As with all options contracts, this one covers 100 shares, costing you $300 in total.

If the stock price falls to $60 before the option expires, your option is in-the-money. You can now exercise the option to sell 100 shares at $65, even though the market price is $60, giving you a profit of $500 ($5 per share x 100 shares). After deducting the $300 premium, your total profit is $200.

Options trading fees to consider

When trading options, there are several fees to take into account, as they can impact your overall profitability. Here are the most common fees associated with options trading:

  • Commissions. Some brokers charge a commission for each options trade, though many platforms have eliminated this fee for basic trades. Always check your broker’s fee schedule.
  • Contract fees. Brokers typically charge a per-contract fee, which can range from $0.50 to $1 or more per contract. These fees can add up, especially if you’re trading multiple contracts.
  • Pass-through fees. Some brokers pass along fees from exchanges or clearinghouses, such as the Options Regulatory Fee (ORF), which typically ranges from $0.03 to $0.05 per contract.
  • Assignment fees. If your option is exercised and results in an assignment, some brokers may charge a fee for this. The exact fee will depend on your platform of choice.
  • Exercise fees. If you choose to exercise an option rather than sell it, some brokers charge an exercise fee. The exact fee will depend on your platform of choice, adding to the trade’s overall cost.

Options trading advantages and risks

Options trading can be highly rewarding, but it also comes with risks. Below are some of the advantages and risks to consider.

Advantages

  • Flexibility and variety of strategies. Options offer a broad range of strategies to suit different market conditions, enabling traders to profit in bullish, bearish or even flat markets. This versatility makes options attractive for both speculative and conservative investors who want to tailor trades to specific goals and risk tolerance.
  • Income generation. Certain strategies, such as covered calls, allow investors to generate additional income from assets they already hold by collecting premiums. This strategy can be particularly useful in a sideways or stable market, where price appreciation is limited, but options can still provide consistent returns.
  • Hedging. Options serve as an effective risk management tool, allowing investors to protect their portfolios against potential losses in other investments. By purchasing put options, for example, traders can offset declines in stock prices, acting as a form of insurance in volatile markets.

Risks

  • Total loss of premium. If your option expires out-of-the-money, the entire premium you paid for the contract is lost, which can result in a complete loss on that trade. This makes options riskier than buying stocks, where the asset typically retains some value even in a downturn.
  • Complexity. Options strategies can be challenging to understand, especially for beginners, due to the numerous factors affecting their pricing and performance. Without a clear grasp of concepts like time decay and implied volatility, inexperienced traders may struggle to execute profitable trades and manage their risks. Time decay is the reduction in value of an options contract as it approaches its expiration date.(7) Implied volatility refers to the market’s forecast of the likely movement of the underlying asset’s price over the life of the option.(8)
  • Volatility risk. Options are highly sensitive to market volatility, which can cause sudden and significant changes in an option contract’s value. While volatility can create profit opportunities, it can also increase the risk of loss, especially for traders who misjudge market movements or don’t adjust positions accordingly.

Bottom line

Options trading offers unique opportunities to profit in a variety of market conditions, but it requires careful planning and risk management. If you’re ready to start, compare the best options trading platform to find robust tools and educational resources to help you along the way.

Frequently asked questions

What are the available options trading hours?

Options trading generally follows regular market hours, weekdays from 9:30 a.m. to 4 p.m. ET. Some brokers may offer extended trading hours, but liquidity can be lower during these times.

Is options trading gambling?

While options trading involves risk, it’s not gambling if approached with a well-thought-out strategy. Traders who understand market movements, carefully select strategies and manage their risk are investing, not gambling. However, without proper knowledge, trading options recklessly can resemble gambling.

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To make sure you get accurate and helpful information, this guide has been edited by Matt Miczulski as part of our fact-checking process.
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Shane's career started with the US Department of Defense where he performed research for 8 years. He then studied philosophy and became fascinated by the ways in which technology and finance can consolidate to impact the world's socio-economic order. To date, he has written hundreds of articles with various insights into digital assets, trading, investing, and the ways in which technology can be used to further optimize the stock trading and settlement processes. His work has been featured in Yahoo Finance, Nasdaq, Bitcoin Magazine, Investing.com, Tokenist, and others. See full bio

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