Options Trading: What It Is, How It Works & BEST Strategies

Options Trading: Key Takeaways

• See the good and bad about trading options…
• Learn the different ways you can trade options and see examples…
• Discover important options trading terms and lingo…

One of the most remarkable trading strategies I’ve seen in 20+ years of trading…

I don’t trade options, but that doesn’t mean you can’t or shouldn’t. Trading is all about finding out what works for you. Could options be a good fit? Read on to learn more.

What Is Options Trading?

Options are a specific type of security called a derivative.

Derivatives are a type of financial security that’s valued based on underlying assets. That could be bonds, commodities, currencies, stocks, and market indexes.

You can trade derivatives like stocks, either OTC (over the counter) or via an exchange. Their prices fluctuate based on the value of the underlying stock.

Option prices are derivatives of the stocks they represent.

Options Trading Rights and Obligations

With options, you get the right — but not the obligation — to purchase or sell a certain amount of stock (or other securities) at a pre-arranged price and on a specific date. That price is derived from the stock’s price.

Options are contracts, but they give you rights to buy or sell –– not an obligation. They’re different from regular stock plays and futures because you can decide not to go through with the contract.

Options Trading Examples

To succeed as an options trader, education is CRUCIAL. You need to know how it all works and how trades play out.

So let’s review some basics and examples.

How Does Options Trading Work?

Think of how options trading works in terms of selling a car to a private buyer.

• You meet the buyer who looks over the car and gives you a deposit to hold the vehicle.
• You get to keep the deposit even if the buyer decides not to return with the full purchase price by the agreed-upon date.
• The prospective buyer has bought the option to buy the car by whatever deadline you set.
• If the buyer doesn’t, you can sell the car to someone else — maybe even for a higher price — and you already have the deposit in your pocket.

Options trading is more complex than that, but it’s a good analogy for stock market options.

Options Trading Brokers

Just like with stocks, you need a broker to trade options. However, not all brokers offer options trading.

Do your research to see if a specific broker offers options trading and their requirements.

Types of Options

With options, you have … well, options. Let’s look at a few.

Long vs. Short Options

With stocks, you can go long or take a short position. With options, you can trade either call or put options. Here are the basics…

Call Option

A call option is a potential future trade.

Say you want to purchase 1,000 shares of Stock X at $4.20 per share in the future because you believe it’ll go up in price.

You can purchase a call option to make this purchase at any point within a defined period. You’re kind of calling dibs on that price.

But the person selling doesn’t necessarily just want you calling dibs without getting something in return.

As the buyer, you put down a premium — that’s the price of the options contract. 

If the stock goes up in value, you can complete the purchase at the agreed-upon price during the contract period. The premium you pay acts as a down payment.

But if the option’s expiration date passes and you don’t move forward, you don’t get the premium back.

Put Option

A put option is a contract where you’re a contract holder with the right to sell the asset in question at any time within a predetermined period.

Say you want to sell shares of a stock. You set your strike price — $5. With a put option, you can sell your shares for that price at any point before the expiration date.

And even if the stock value drops dramatically, you still get the agreed-upon price.

A put seller receives a premium or down payment in this case. A single put option represents a specific amount of the underlying asset in question. Frequently, it’s one put option to 100 shares of the underlying asset.

In other words, the “down payment” is 1/100th of the total purchase price.

Trading Call vs. Put Options

To review…

• A call option is for when you believe the price of a stock will rise.
• A put option is for when you believe the price of a stock will fall. 

Benefits and Advantages of Trading Options

Why do some successful traders love options trading? Here are some advantages.

Flexibility

Options can give you a ton of flexibility.

Yes, you have to plunk down that premium, but it can give you the flexibility of whether to exercise the option.

You don’t have to exercise the option. When the expiration date comes, the option becomes null and void.

Yes, you lose the premium you pay, but there are no additional losses.

Also, you can use options to trade a number of securities like commodities and foreign currencies. It’s not just for stocks.

Limited Risk for Buyers

I’m all about cutting losses and limiting risk. Options can let you limit risk, which is a good thing.

Yes, you can lose the premium. So there’s a risk.

But that risk can be minimal compared to the losses you’d take if you traded without an options contract.

Speculation

Yep … There’s a certain level of speculation in options trading.

For instance, if you purchase a call option, you probably have a strong belief that its value will go up in time and that you’ll be able to buy in at a low price. Employing a call option versus simply buying the asset or stock allows you additional time.

But remember the car sale scenario. The buyer puts down a deposit against the agreed-upon price. OK. But the seller holds the cards here. If the buyer doesn’t come back, the seller keeps the cash.

It works the same with options trading.

Hedging

One of the biggest draws of options is hedging your bets — aka reducing risk.

I hate risk. You should, too.

An options premium creates a stopgap. It basically says, “This is the most I’ll lose on this deal if it goes south.”

Options can help limit losses, while potentially making the most of gains. In theory, anyway.

How to Read an Options Table

Options tables can be confusing.

So let’s break it down and you’ll see it’s not that complex. Here are common columns you’ll see in a table and what they mean.

OpSym

This is short for Option Symbol. This column offers the basics — stock symbol, contract date of maturity, and strike price. It also defines whether it’s a call (C) or a put (P) option.

Bid

Referred to in points, the bid price is the most current price offered to buy the option in question.

Ask

Also referred to in points, the ask price is the most current price offered to sell the option in question.

Extrinsic Ask

This shows the premium of time built into the option price. All options lose their time premium when the option expires, and this value showcases the amount of time premium currently playing into the option’s price.

Implied Volatility Bid/Ask

Also referred to as the IV Bid/Ask, this column shows the potential level of future volatility. This is based on factors including the option’s current price and the amount of time until the option expires.

Ultimately, with a higher IV Bid/Ask, there’s more time premium included in the option’s price.

Historical vs. Implied Volatility

Not sure about the difference between historical and implied volatility? Let’s talk it out.

• Historical volatility is based on historical data –– like actual past price action.
• Implied volatility looks at the past but is forward-thinking. It uses the past to predict what might happen with volatility in the future.

Volume

This column displays how many contracts were traded during the last market session. Often, options with larger movement and volume have a tight bid/ask spread, since the competition to buy and sell these options is higher.

Open Interest

This column tells you how many contracts of a given option have been opened but not yet cashed in or sold.

Strike

This shows the strike price. This is the price that the buyer has set to buy or sell the underlying security.

Assessing Risks in Options Trading

On an options table, you may also see columns with Greek letter headings  — the infamous “Greeks.”

These measure factors that can affect an options contract’s price. Let’s break down what they mean for an option’s risk/reward potential.

Delta

Delta represents the “stock equivalent position” for an option. The delta for a call option can range from 0–100 (and for a put option, from 0 to -100 … yes, negative 100).

In essence, the of-the-moment risk/reward of holding a call option with a delta of 100 is similar to holding the equivalent amount of stock shares.

Gamma

Gamma tells you how many deltas the option will gain or lose if the underlying stock rises by one full point.

Theta

Theta indicates how much value an option will lose in one day based on time decay. This factors in the option’s expiration date.

Vega

Vega indicates the amount by which the option’s price would be affected — up or down — based on a one-point increase in IV.

Rho

Rho measures an option’s sensitivity to a potential change in interest rate. So, for every rho, the percentage point in interest rates will increase the option value.

Options Trading Strategies Explained

There are a ton of different strategies for options trading. Here are some common ones.

Long Call

This is the most basic strategy for a call option…

• You believe the underlying asset will rise in value over time.
• You buy a call option with a strike price that you believe the asset will exceed in value over time.
• Next, determine an expiration date — and be careful. Pick too soon of a date, and you risk losing profits.

Compared to simply buying shares, you could gain leverage because there’s a chance that the value will go up dramatically. Then you can buy in for that predetermined price.

But if the stock doesn’t go up by the expiration date or you decide to not go through with the order, you won’t get that premium back.

Long Put

This is the most basic type of strategy for the put option.

• You either believe that the underlying asset will lose value.
• You buy a put option with a strike price that you believe the asset will sink below over time.
• Like with a long call, you have to agree to an expiration date. Again, it’s a gamble. You have to best determine by what date the asset will drop in value.

Some traders believe that compared to short selling stocks, long puts are easier. For one, you don’t have to find shares to borrow.

And your losses are finite, unlike shorting.

Call Backspread

A call backspread — aka a reverse call ratio spread — is a more bullish strategy.

Here, you sell a certain number of call options, then buy more call options of the same underlying asset with a higher strike price.

This is a little bit more aggressive of an approach for purchasing options.

Put Backspread

The put backspread is the yin to the call backspread’s yang. It’s also referred to as the reverse put ratio spread.

You sell a certain number of put options then buy more put options of the same underlying asset, but with a lower strike price.

Protective Put

The protective put, or put hedge, is a method of hedging.

When you’re worried about a market downturn or crash, or a change in the value of an asset, you may invest in a protective put to protect from limitless losses.

Here, it’s like you have a previous purchase you’re trying to protect. This is what differentiates it from a long put — you’re already in the trade.

Bear Split-Strike Combo

This is one of the most complicated strategies…

You have one long put with a lower strike price and one short call with a higher strike price.

Yup, you have options in both directions with the same underlying asset and expiration date, but with different prices.

You could call this the ultimate in hedging. You’re wagering on whether the asset will go up or down. If it goes up, you profit from the call. And if it goes down, you profit from the put.

Common Options Trading Mistakes

Choosing the wrong strategy. Not all strategies are a perfect fit for all traders. Find the strategy that matches your style.

Wrong expiration date. This is hard … so look at market liquidity, how the price moves, and overall factors like earnings or catalysts.

Going all in. It can be tempting to take a huge position when you only have to pay a premium … Resist the urge. And never trade more than you can afford to lose!

Trading Challenge

I don’t talk about options very often. But I do love discussing stocks.

I’ve helped so many people become self-sufficient traders … Some of which have even become millionaires!

I’d love to help you, too — But only if you’re dedicated.

Ready to take that next step and become the trader you’ve always wanted to become? Apply to join my Trading Challenge today!

The Final Word on Options Trading

Options trading is appealing to many traders … with good reason. It can come with flexibility, limited risk, and the ability to profit.

There are a lot of similarities to trading stocks. Being able to read charts will help you determine where the price could move. Plus, it’s a good idea to have some sort of a trading plan.

It’s not for me. But if it sounds appealing to you, give it a shot!

What do you think about the world of options? What’s your favorite strategy?