How to Buy and Sell Options: A Step-by-Step Guide

Options contracts are financial agreements that can be bought and sold, offering a way to engage with markets beyond direct stock ownership. These contracts derive value from an underlying asset, such as a stock, exchange-traded fund (ETF), or index.

Core Concepts of Options

An option is a contract granting the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) on or before a specified date (the expiration date). The seller of the option assumes the obligation to fulfill the contract if the buyer exercises this right.

There are two types of options: call options and put options. A call option gives the buyer the right to purchase the underlying asset at the strike price. A put option grants the buyer the right to sell the underlying asset at the strike price. Buyers of call options expect the underlying asset’s price to increase, while buyers of put options expect a price decrease.

For the seller (also known as the writer), the perspective is reversed. Selling a call option implies the seller believes the underlying asset’s price will stay the same or decrease, as they are obligated to sell if the price rises above the strike. Selling a put option suggests the seller believes the price will remain stable or increase, as they are obligated to buy if the price falls below the strike. The price paid for an option contract is called the premium.

The premium consists of two components: intrinsic value and time value. Intrinsic value is the immediate profit an option would have if exercised. For a call, intrinsic value exists if the underlying asset’s price is above the strike price. For a put, it exists if the underlying price is below the strike price. If an option has no intrinsic value, its intrinsic value is zero.

Time value represents the portion of the premium reflecting the possibility of an option gaining intrinsic value before expiration. This value erodes as the expiration date approaches, a phenomenon known as time decay. The further away the expiration date, the higher the time value, as there is more time for the underlying asset’s price to move favorably.

Options are categorized by their relationship between the underlying asset’s price and the strike price. An option is “in-the-money” (ITM) if it has intrinsic value. For a call, this means the underlying price is above the strike; for a put, it is below the strike. An option is “at-the-money” (ATM) when the underlying asset’s price is exactly or very close to the strike price. An option is “out-of-the-money” (OTM) if it has no intrinsic value. For a call, this means the underlying price is below the strike; for a put, it is above the strike. OTM options consist entirely of time value.

Profit and loss calculations depend on whether you are buying or selling and the option type. For a long call buyer, profit occurs if the underlying asset’s price at expiration is above the strike price plus the premium paid. Maximum loss is limited to the premium paid. For a long put buyer, profit occurs if the underlying asset’s price at expiration is below the strike price minus the premium paid, with maximum loss limited to the premium. For a short call seller, profit is limited to the premium received if the underlying asset’s price stays below the strike price at expiration, but potential losses are unlimited if the price rises significantly. For a short put seller, profit is limited to the premium received if the underlying asset’s price stays above the strike price at expiration, while potential losses can be substantial if the price drops significantly. Options involve leverage, meaning a small change in the underlying asset’s price can lead to a proportionally larger change in the option’s value, amplifying both gains and losses.

Setting Up for Options Trading

Engaging in options trading requires establishing an account with a brokerage firm. This process begins by opening a standard brokerage account, providing personal identification details like name, address, date of birth, and Social Security number. Brokerage firms also require financial information, including employment status, annual income, net worth, and liquid assets, to assess suitability. Investment objectives, such as capital preservation, income generation, or growth, are also requested to understand your financial goals.

After opening a standard brokerage account, a separate application for options trading approval is necessary. Brokerage firms require this due to options’ leveraged nature and potential for significant financial implications. The application asks for detailed information about your investment experience, including trading history, knowledge of financial products, and understanding of options risks. Firms categorize options trading permissions into different levels, from basic strategies like buying calls and puts to complex strategies involving selling uncovered options. Each level permits different types of options transactions, with higher levels requiring greater financial sophistication and risk tolerance. For instance, a basic level might allow only the purchase of long calls and puts, while advanced levels could permit selling naked options or engaging in complex multi-leg strategies. The brokerage firm reviews submitted information to determine the appropriate approval level based on regulatory guidelines and internal risk management policies. This assessment ensures individuals are aware of and can manage the risks associated with the options strategies they wish to employ.

Once the brokerage account is opened and options trading approval granted, the next step involves funding the account. Brokerage firms offer various methods for depositing funds, including electronic funds transfers (ACH), wire transfers, or mailing a check. The time for funds to become available varies; electronic transfers are often quickest, clearing within one to three business days. Some firms allow instant funding up to a certain amount using a linked bank account. Sufficient funds are a prerequisite for placing options trades, as premiums must be paid upfront for purchased options and collateral may be required for sold options positions.

Placing and Executing Options Trades

Once a brokerage account is established and approved for options trading, navigate the trading platform to select and execute an options trade. Begin by locating the options chain for the desired underlying asset, such as a specific stock. An options chain displays all available call and put options for that asset, organized by expiration date and strike price. It also shows real-time bid and ask prices, volume, and open interest data for each contract.

When selecting an option, identify the underlying asset, choose an expiration month, and pick a strike price aligning with your strategy. For example, if you anticipate a stock to rise, select a call option with an expiration several months out and a strike price slightly above the current stock price. If you expect a decline, a put option with similar characteristics might be chosen. The bid price is the highest price a buyer will pay, while the ask price is the lowest a seller will accept. The difference is the bid/ask spread. This spread impacts your trade’s execution price; when buying, you generally pay the ask price, and when selling, you receive the bid price. A wider spread indicates less liquidity and potentially higher trading costs.

After selecting the option contract, choose the order type. Common order types include:
Buy to Open: Initiates a new long position (purchasing a call or put).
Sell to Open: Initiates a new short position (writing/selling a call or put).
Buy to Close: Covers a previously sold option to exit a short position.
Sell to Close: Liquidates a previously purchased option to exit a long position.

For instance, if you bought a call option (Buy to Open) and wish to sell it, place a Sell to Close order. If you sold a put option (Sell to Open) and want to eliminate your obligation, place a Buy to Close order.

When placing an order, specify whether it is a market order or a limit order. A market order instructs the brokerage to execute the trade immediately at the best available current price. While offering quick execution, a market order may result in a price differing from the last quote, especially in fast-moving markets or for options with wide bid/ask spreads. Many traders prefer limit orders for options. A limit order allows you to specify the maximum price you will pay when buying or the minimum price you will accept when selling. Your order executes only if the market price reaches your specified limit or a better price. This provides greater control over the execution price but carries the risk that the order may not be filled. Once parameters are set (quantity, order type, price), review and submit the order through the trading platform. Upon submission, the brokerage system processes the order. If executed, you will receive an order confirmation, detailing the filled price and transaction specifics. The executed trade will then appear in your account’s positions tab for monitoring.

Managing and Exiting Options Positions

After placing an options trade, continuous monitoring of the position is important. Track the price movements of the underlying asset, as the option’s value derives directly from it. Observe changes in the option’s premium value, which fluctuates with the underlying asset’s price, time decay, and implied volatility. Regularly check the remaining time until expiration, as time decay accelerates in the final weeks and days.

The most common method for exiting an options position before expiration is by executing an offsetting trade. If you bought an option (a long call or put), sell it to close the position (a “Sell to Close” order). Profit or loss is realized based on the difference between premium paid and received, minus commissions. If you sold an option (a short call or put), buy it back to close the position (a “Buy to Close” order). Closing a short option position removes your obligation as the seller, capping potential loss or locking in profit. This allows traders to realize gains or limit losses without waiting for expiration. Many options traders prefer to close positions before expiration to avoid the complexities of exercise and assignment, especially for short options where assignment can lead to unexpected obligations.

If an option is held until its expiration date, outcomes depend on whether it is in-the-money or out-of-the-money. For option buyers, if the option is in-the-money at expiration, it is typically automatically exercised by the brokerage firm. This means a long call holder purchases the underlying shares at the strike price, and a long put holder sells the underlying shares at the strike price. Automatic exercise usually occurs if the option is in-the-money by a small threshold, often one cent.

For option sellers, if the option sold is in-the-money at expiration, they face the risk of assignment. Assignment is the obligation to fulfill the contract terms: a short call seller is obligated to sell the underlying shares at the strike price, and a short put seller is obligated to buy the underlying shares at the strike price. This can lead to significant financial obligations if the underlying asset’s price moves substantially against the seller’s position. Brokerage firms typically notify clients of potential exercise or assignment.

Most options traded on exchanges in the United States are settled through physical delivery of the underlying asset, meaning shares of stock are exchanged. However, certain options, particularly those on broad market indices, may be cash-settled. Cash settlement means the difference between the strike price and the underlying price at expiration is settled in cash, instead of exchanging the underlying asset.