If you’ve found yourself here, chances are you’ve come across discussions about options trading and its potential for profit—whether from someone you know or online conversations. This article serves as an introduction to the options trading basics you should know before starting. We’ll cover understanding options, their uses, and the basics of options trading.
Key takeaways
- Options trading basics consist of understanding what options are, their purpose, and how they can be used for hedging or speculative purposes.
- Options are derivative contracts and can be either “calls” or “puts.” They can function as insurance against price changes or as opportunities to leverage market movements.
- The option premium is the cost paid by the buyer, influenced by factors such as intrinsic value, time value, and volatility.
Options Trading Basics – Understanding Options and Their Purpose
Options trading basics consist of understanding that these contracts give the buyer the right—but not the obligation—to buy or sell an asset at a specific price within a certain time. Options come in two types (calls and puts) as this simple infographic tells you:
We’re talking about options trading basics, so think of these contracts as a form of insurance. For instance, if you own a car, you buy insurance to protect against potential damage. Similarly, traders use options to protect their investments from sudden price changes. This protective use of options, also known as hedging, was their original purpose. They allow you to lock in a price for buying or selling something, which helps manage risks in volatile markets.
Call Options
Let’s begin with calls. Call options are a part of options trading basics, giving the buyer the right—but not the obligation—to buy an asset at a set price (strike price) within a specified time. They’re ideal for those anticipating a price increase in the underlying asset.
The P&L profile for buying a call option is straightforward:
The chart above, which looks just like those you may find on our screener for options, is what you should get from the chart above:
- Profit: When the asset’s price rises above the strike price + premium paid.
- Loss: Limited to the premium paid if the asset’s price doesn’t rise as expected.
Put Options
Let’s now move to puts. Put options, part of options trading basics, give the buyer the right—but not the obligation—to sell an asset at a set price (strike price) within a specific timeframe. These are useful when you expect the asset’s price to fall.
The P&L profile for buying a put is simple:
Here’s what the chart above highlights, in terms of options trading basics:
- Profit: When the asset’s price drops below the strike price minus the premium paid.
- Loss: Limited to the premium paid if the price doesn’t fall as anticipated.
The Premium of an Option (and Its Implications)
While you may have a general understanding of how a stock is priced, options work a bit differently (which is probably one of the main factors that brought you to look for an options trading basics article).
When you purchase an options contract, you pay something called a premium. This is the cost to acquire the right to buy or sell an asset at the strike price. For the buyer, the premium represents the maximum potential loss, while for the seller, it’s the potential profit upfront.
What Influences the Option Premium?
The price of an option, or its premium, depends on several factors, such as:
- Intrinsic Value: This is the difference between the current market price of the asset and the strike price (only for in-the-money options).
- Time Value: The amount of time left until the option expires. More time equals a higher premium as it increases the chance of the option becoming profitable.
- Volatility: High asset price volatility means more potential movement, which makes the option more valuable—and pricier.
Breaking Down the Formula
When you buy an option, you’re paying a price called the option premium. This premium isn’t just a random number—it’s made up of three main components:
- Intrinsic Value: This is the part of the premium that reflects the option’s real, current value based on how far “in the money” it is. For a call option (the right to buy a stock at a set price), intrinsic value is how much higher the stock price is compared to the option’s strike price. For instance, If the stock is trading at $55 and your call option’s strike price is $50, the intrinsic value is $5. Why? Because if you exercised the option, you’d pay $50 for something worth $55, giving you $5 of immediate profit.
- Time Value: This is the part of the premium you’re paying for the possibility that the stock might move in your favor before the option expires. Options with more time left until expiration tend to have higher time value because there’s more opportunity for the stock price to change. Think of this like a “what could happen” fee—more time means more chances for big changes.
- Impact of Volatility: This is the part of the premium that reflects how much the stock’s price tends to move (up or down). Stocks that are more volatile make options more expensive because big price swings increase the chances that the option could end up “in the money.”
A Simple Example
Imagine you spend $4 per share on a call option for 100 shares of a stock with a $60 strike price. This costs you $400 (premium). If the stock rises to $70 before expiration, your profit calculation looks like this:
- Stock price of $70 minus the $60 strike price equals $10 in profit per share.
- Subtract the $4 premium, giving you $6 per share in profit ($600 total).
The premium shapes whether the trade is worth your investment based on the risk and potential reward. This is why understanding options and how premiums operate is a key part of learning the basics of options trading.
Options Trading Basics – The Different Ways to Trade Options
With all the concepts introduced above in mind, you should now know that you can trade options in a more or less creative way to achieve different goals. Options trading basics revolve around two main approaches—simple single-leg trades and more complex multi-leg strategies. Each has its purpose, risk levels, and ideal use cases.
The table below gives you a general single-leg and multi-leg options strategies:
| Options Trading Basics | Single-Leg Strategies | Multi-Leg Strategies |
| Complexity | Simple and straightforward | More complex, designed for experienced traders. |
| Number of Options | Involves a single option contract (call or put) | Combines two or more options in a single trade. |
| Risk Level | If you are an option buyer, you always have capped risk. If you sell an option, however, you will face unlimited risk. | Can manage or increase risk depending on the strategy used. |
| Ideal User | Beginners or traders with simple market expectations. | Advanced traders with knowledge of market behavior. |
Single-Leg Trades
Single-leg trades are the simplest form of options trading, making them a great starting point for beginners. This type of trade involves just one option contract. Let’s focus, for instance, on a long call or a long put (you could also count the naked call and naked put strategies, but let’s keep this in mind for a more advanced article):
- Long Calls: Buying a call option means you’re betting the price of the underlying asset will increase. For example, if you believe a stock currently priced at $50 will rise to $70, you might buy a call with a $60 strike price. If the stock price surpasses $60 plus the premium you paid, the trade becomes profitable.
- Long Puts: On the flip side, a put option allows you to profit if a stock’s price falls. For instance, if a stock is trading at $80, and you expect it to drop to $60, buying a put with a $70 strike price could yield gains if the price dips below that level minus the premium.
These single-leg trades are easy to execute and involve straightforward strategies that align with your market outlook—bullish for calls and bearish for puts.
Multi-Leg Strategies
For more experienced traders, multi-leg strategies offer advanced ways to leverage options. These involve combining two or more options in a single trade. While these strategies are more complex, they are designed to manage risk and maximize returns in volatile or neutral markets. Some popular multi-leg strategies include:
- Spreads: This involves buying and selling options with the same expiration date but different strike prices. Spreads limit potential losses but also cap profits.
- Straddles: A straddle combines buying a call and a put with the same strike price and expiration date, making it ideal for betting on big price swings without knowing the direction.
While multi-leg strategies might sound appealing, they require deeper understanding and carry higher risks due to their complexity. Beginners should focus on learning and perfecting single-leg trades before moving on to these advanced methods. We won’t tell you more about this set of strategies as we’re only looking for the options trading basics here, but our blog is filled with examples of more complex strategies.
