How to Trade Stock Options: A Step-by-Step Guide

Stock options offer individuals a versatile tool to engage with financial markets, providing the right, but not the obligation, to buy or sell an underlying asset at a predetermined price. These financial contracts can be used for various purposes, from speculating on price movements to managing risk within an investment portfolio. This article guides readers through fundamental concepts, necessary preparations, trade mechanics, and strategies for managing and closing positions.

Fundamental Concepts of Stock Options

Stock options are financial contracts that derive their value from an underlying asset, typically shares of a company’s stock or an exchange-traded fund (ETF). These contracts come in two primary forms: call options, granting the holder the right to purchase the underlying asset at a specified price, and put options, providing the holder the right to sell the underlying asset at a specified price.

The predetermined price at which the underlying asset can be bought or sold is known as the strike price. Each option contract also has an expiration date, the last day the option can be exercised. The cost to purchase an option contract is called the premium, paid by the buyer to the seller. This premium represents the maximum loss for the option buyer if the option expires worthless.

Options are categorized by their relationship between the underlying asset’s current market price and the option’s strike price. An option is considered in-the-money (ITM) if it has intrinsic value, meaning exercising it would be profitable. For a call option, this occurs when the underlying asset’s price is above the strike price; for a put option, it means the underlying asset’s price is below the strike price.

Conversely, an option is out-of-the-money (OTM) if it holds no intrinsic value. A call option is OTM when the underlying asset’s price is below the strike price, and a put option is OTM when the underlying asset’s price is above the strike price. When the underlying asset’s price is exactly equal to the strike price, the option is referred to as at-the-money (ATM).

An option chain presents a comprehensive list of available options contracts for an underlying asset. This chain typically displays various strike prices, expiration dates, and the premiums for both call and put options. Most options contracts are standardized, with one contract generally representing 100 shares of the underlying stock.

The value of an option changes based on the movement of the underlying asset’s price relative to the strike price and the time remaining until expiration. For a call option, its value generally increases as the underlying stock price rises above the strike price, and decreases as the stock price falls. A put option’s value typically increases when the underlying stock price drops below the strike price and decreases as the stock price rises.

Preparing to Trade Options

Before engaging in options trading, individuals must establish a brokerage account approved for options trading. Most brokerage firms require a separate application and approval process, reviewing an applicant’s financial experience, net worth, and investment objectives to determine the appropriate options trading approval level.

Brokerage firms categorize options trading permissions into several levels, each allowing for progressively more complex strategies:
Level 1 usually permits covered calls, which involve selling call options against shares of stock already owned.
Level 2 often expands to include buying long calls and puts, allowing for directional speculation.
Higher levels, such as Level 3, might allow for spread strategies, which involve simultaneously buying and selling different options contracts.
The highest levels, sometimes Level 4, may permit the selling of naked options, which carry unlimited risk.

A fundamental aspect of preparing for options trading involves allocating capital one can comfortably afford to lose. Options trading involves substantial risk; it is possible to lose the entire premium paid for an option contract if it expires out-of-the-money. For option sellers, particularly those engaged in uncovered or naked options, potential losses can significantly exceed the initial premium received, sometimes even being theoretically unlimited.

For instance, buying a call or put option means the maximum loss is limited to the premium paid. However, selling an uncovered call option could expose the seller to significant losses if the underlying stock price rises sharply, as they would be obligated to sell shares they do not own at the strike price.

Accessing reliable information sources is another preparatory step. Traders should utilize credible platforms for real-time market data, company news, and financial statements. Staying informed about factors that can influence the underlying asset’s price, such as earnings reports, industry developments, and broader economic trends, is important for making informed trading decisions.

Placing an Options Trade

Placing a trade through a brokerage platform involves navigating to the options chain for a specific stock. This chain displays all available options contracts, organized by expiration date and strike price, for both call and put options.

From the option chain, individuals select the specific contract they wish to trade, choosing between a call or a put, a desired strike price, and an expiration date. After selecting the contract, the trading platform will prompt for the order details, including the number of contracts, keeping in mind that one contract usually represents 100 shares of the underlying stock.

Selecting an appropriate order type is an important decision when placing an options trade. A market order is executed immediately at the best available price, offering speed but with potential price uncertainty, especially in fast-moving markets. A limit order allows a trader to specify the maximum price they are willing to pay when buying or the minimum price they are willing to receive when selling. While a limit order offers price control, there is no guarantee that the order will be filled if the market price does not reach the specified limit.

Another order type is the stop-limit order, which combines features of a stop order and a limit order. For a buy stop-limit order, a stop price is set to activate a limit order once the underlying asset reaches that price. For a sell stop-limit order, a stop price is set below the current market price, triggering a limit order once that price is hit, aiming to limit potential losses or protect profits.

After inputting the number of contracts, the price (if using a limit order), and the order type, it is important to thoroughly review all order details before submission. Brokerage platforms typically provide a summary screen for confirmation, displaying the chosen option, quantity, price, and estimated commission or fees. Confirming these details helps prevent unintended trades or errors.

Managing and Closing Options Positions

After an options trade has been successfully placed and executed, monitoring the position becomes an ongoing process. Brokerage platforms provide tools to track the performance of open options positions, displaying the current profit or loss and the fluctuating premium of the contract. Regularly checking these metrics helps traders assess whether the position is moving as anticipated or if adjustments are necessary.

Closing an options position before its expiration date is a common practice for many traders, allowing them to realize profits or limit losses. If an individual bought an option (a long option), they would typically sell to close the position. This involves placing an order to sell the exact same option contract they initially purchased, effectively offsetting the original trade.

For individuals who initially sold an option (a short option), closing the position involves buying to close. This means repurchasing the same option contract they previously sold, which cancels out their obligation. This action is important for short options to mitigate potential further losses or to secure profits.

When an option contract reaches its expiration date, different outcomes occur based on whether it is in-the-money or out-of-the-money. If an option is in-the-money at expiration, it will typically undergo automatic exercise for call options (meaning the holder buys the underlying stock) or automatic assignment for put options (meaning the holder sells the underlying stock). Some options, particularly those based on indexes, may be cash-settled, meaning the difference in value is paid in cash rather than through stock delivery.

Conversely, if an option is out-of-the-money at expiration, it simply expires worthless. In this scenario, the option buyer loses the entire premium paid, and the option seller retains the premium received. Most retail traders prefer to close their options positions before expiration to avoid the complexities of exercise or assignment, which can involve taking delivery of or delivering the underlying shares.