How to Trade Options: The Basics and Key Strategies

Options are financial derivatives that derive their value from an underlying asset, such as a stock, exchange-traded fund (ETF), or index. These contracts allow investors to potentially profit from price movements with less capital outlay than directly purchasing the asset. Understanding options requires foundational knowledge of their structure and markets. This article covers essential options trading concepts, from basic terminology to placing orders and tax implications.

Understanding Options Fundamentals

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. The seller takes on the obligation to fulfill the contract if the buyer exercises their right. This agreement allows for speculative and hedging strategies.

There are two types of options: call options and put options. A call option grants the holder the right to buy the underlying asset at a specified price, suitable for anticipating an increase in value. A put option gives the holder the right to sell the underlying asset at a specified price, favored by those expecting value to decline.

Option contracts are defined by key terms. The underlying asset is the security on which the contract is based, such as shares of a publicly traded company or a broad market index. The strike price, also known as the exercise price, is the fixed price at which the underlying asset can be bought or sold if the option is exercised. Each option contract has an expiration date, the final day it can be exercised; after this date, it becomes worthless if not exercised or sold.

The premium is the price paid by the option buyer to the seller for the rights conveyed by the contract. It is determined by factors including the underlying asset’s price, strike price, time remaining until expiration, and volatility. One option contract represents 100 shares of the underlying asset, so the premium quoted per share must be multiplied by 100 to determine the total cost.

Moneyness describes an option’s relationship between the underlying asset’s current price and its strike price. An option is in-the-money (ITM) if exercising it would result in a profit. For a call, this occurs when the underlying asset’s price is above the strike price; for a put, it means the underlying asset’s price is below the strike price. An option is at-the-money (ATM) when the underlying asset’s price is equal or very close to the strike price.

Conversely, an option is out-of-the-money (OTM) if exercising it would not be profitable. For a call, this happens when the underlying asset’s price is below the strike price; for a put, it means the underlying asset’s price is above the strike price. OTM options risk expiring worthless, requiring significant price movement to become profitable.

Option chains help understand available option contracts for an underlying asset. These tables display strike prices, expiration dates, and current bid and ask prices for call and put options. Traders use option chains to identify suitable contracts, assess liquidity, and gauge market sentiment for different strike prices and expiries.

Preparing for Options Trading

Before engaging in options trading, individuals must complete preparatory steps. The initial requirement is to open a brokerage account that supports options trading. Most online brokerages offer this; confirm the platform provides access to the options market.

Once a brokerage account is established, investors must apply for options trading approval. Brokerages categorize permissions into levels, allowing for progressively more complex strategies. Level 1 might permit only covered calls, while higher levels allow for buying calls and puts, spreads, and uncovered options strategies.

The approval process involves providing information about one’s financial history, investment experience, and risk tolerance. Brokerages assess these details to determine the appropriate trading level, ensuring investors understand the risks of their intended strategies. This assessment protects both the investor and the brokerage.

After obtaining options trading approval, funding the brokerage account is the next step. Common deposit methods include electronic transfers, wire transfers, or mailing a check. Electronic transfers are the quickest, often clearing within one to three business days, while wire transfers can be same-day but may incur higher fees.

To trade options effectively, access to research tools and resources is beneficial. Many brokerages offer charting software, real-time quotes, and analytical tools. Utilizing reputable financial news sources, market analysis websites, and educational materials can provide insights into market trends and trading opportunities.

Common Options Trading Strategies

Options trading encompasses a wide range of strategies, each designed to capitalize on different market outlooks. Understanding fundamental strategies is important for new options traders. These strategies leverage the characteristics of call and put options to achieve specific financial objectives.

Buying call options is a common strategy for investors with a bullish outlook, expecting the underlying asset’s price to increase before expiration. This strategy provides leverage, as a small premium payment can control a larger value of the underlying asset. Potential profit is substantial as the price rises; maximum loss is limited to the premium paid.

Conversely, buying put options is used by investors with a bearish outlook, anticipating a decline in the underlying asset’s price. This strategy can serve as a speculative bet or a hedge against a declining stock portfolio. The maximum loss is capped at the premium paid, while potential profit increases as the underlying asset’s price falls towards zero.

The covered call strategy is an income-generating approach for investors who own shares of the underlying stock. It involves selling call options against shares already held in the portfolio. This collects premium, enhancing returns or partially offsetting losses if the stock price declines modestly. If the stock price rises above the strike price, the shares may be called away at the strike price.

Selling cash-secured puts is another income-generating strategy where the investor sells a put option and sets aside enough cash to purchase the underlying shares if the option is exercised. This strategy is used by investors willing to acquire the underlying stock at a lower price. If the stock price stays above the strike price until expiration, the put option expires worthless, and the seller keeps the premium. If the price falls below the strike, the seller is obligated to buy the shares at the strike price.

A vertical spread involves simultaneously buying and selling options of the same type (both calls or both puts) with the same expiration date but different strike prices. This strategy limits both potential profit and loss, suitable for traders with a defined price target. For example, a bull call spread involves buying a call with a lower strike and selling a call with a higher strike, reducing initial cost while capping potential gains.

Placing an Options Order

Executing an options trade involves steps within a brokerage platform. The process begins by navigating to the trading section and searching for the specific underlying asset. This displays the asset’s current price and an option chain.

From the option chain, the investor selects the desired expiration date and chooses between call or put options. Once the option type is selected, available strike prices for that expiration date are displayed, along with their bid and ask prices. The investor then selects the strike price and premium combination that aligns with their strategy.

When placing an order, various order types can be utilized. A market order attempts immediate execution at the best available price, but the fill price may deviate in fast-moving markets. A limit order allows the investor to specify the maximum price to pay or minimum price to receive, providing control over execution but potentially delaying the trade. A stop-limit order combines features of stop and limit orders, triggered at a specified stop price but executed as a limit order.

After selecting the order type, the investor must input the quantity of contracts they wish to trade. One contract represents 100 shares of the underlying asset. The platform calculates total premium based on quantity and price. Before submitting, review all order details, including the underlying asset, option type (call/put), expiration date, strike price, quantity, and order type.

Upon submission, the order enters the market and is filled, partially filled, or remains pending, depending on market conditions and order type. The brokerage platform provides real-time updates on order status. Once filled, a confirmation is provided, and the trade appears in the investor’s account holdings.

Managing an open options position involves monitoring the underlying asset’s price, the option’s premium, and time remaining until expiration. Investors can set price alerts or establish stop-loss orders to limit downside. To close a position, the investor places an opposing trade; for example, selling a call option previously bought or buying back a put option previously sold.

Taxation of Options Trading

Understanding tax implications of options trading is important for managing an investment portfolio. Gains and losses from options transactions are treated as capital gains or losses for tax purposes. They are subject to capital gains tax rates, which vary based on an individual’s income level and the option’s holding period.

The distinction between short-term and long-term capital gains is important. If an option is held for one year or less before it is sold or expires, any gain or loss is short-term. Short-term capital gains are taxed at an individual’s ordinary income tax rates.

Conversely, if an option is held for more than one year, any gain or loss is long-term. Long-term capital gains receive more favorable tax treatment, with rates generally set at 0%, 15%, or 20%.

Specific options trading scenarios have particular tax treatments. If an option expires worthless, the entire premium paid by the buyer is a capital loss on the expiration date. For the seller, the premium received from a worthless expired option is a short-term capital gain.

When an option is sold before expiration, the difference between the selling price and the original premium paid (for buyers) or received (for sellers) determines the capital gain or loss. It is categorized as short-term or long-term based on the holding period. For example, if a call option bought for $200 is sold for $350 within six months, the $150 profit is a short-term capital gain.

If an option is exercised or assigned, the tax implications tie to the underlying asset. If a call is exercised, the strike price determines the cost basis of acquired shares. If a put is exercised, the strike price determines the sale price of shares. Subsequent sale of these shares generates capital gains or losses, subject to their holding period.

The wash sale rule applies to options. This rule disallows a loss if an investor sells a security at a loss and then buys a “substantially identical” security within 30 days before or after the sale. Options on the same underlying asset can be considered substantially identical, meaning a loss from selling an option may be disallowed if a similar option or the underlying stock is repurchased within the wash sale period. Brokerages report options trading activity on Form 1099-B.