Options Trading – What are They and How Does it Work?

Options are one of the many financial assets that you can trade on market exchanges. 

Options trading can make a great addition to your trading strategy if you’re looking to diversify your portfolio. 

In this article, we will be discussing options, the different types of options contracts, and the pros and cons of options trading. Lastly, we will provide a brief overview of how to trade options.

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What are Options?

Options are financial derivatives. Options generally derive their value from an underlying asset, for example, commodities or stocks. An options contract gives traders the opportunity to buy and sell the underlying asset. However, this does depend on the type of contract the trader holds. 

By buying an options contract, a trader earns the right to buy and sell the underlying asset at a specific price and within a specific time frame. 

Generally, an options contract represents 100 shares. The seller of the contract generally offers the contract for a premium. The buyer of the contract almost always chooses to pay a premium to be able to have the option of buying or selling the contract for a predetermined ‘strike price’ by or on a specific date. 

For example, if an options contract accounts for 100 shares and the premium on those shares is $3, the contract will be worth $300. If we assume that this is a call options contract, the buyer will now have the freedom to buy stock but they won’t be able to sell it. 

If the strike price for this contract is $50 and the contract matures a month later, at some point before the contract matures, the stock might be valued at $70. This means that the trader is up $20 per share ($70 – $50). So, if you multiply the 100 shares by $20, the trader would have $2000. If you subtract the initial investment of $300, the trader would’ve made $1700 in profits. 

While there are many profit opportunities, there are just as many risks for losses. Before you pick up an options contract, we would advise that you weigh the risks. 

The Pros and Cons of Options Trading

Pros

  • When buying a call option contract, traders are given the freedom to buy assets at a price that is lower than market value if the stock price is rising
  • When buying a put option contract, traders can sell stock at a strike price if the market value is below the strike price. 
  • Traders who sell options contracts receive a premium fee from buyers

Cons

  • If the market is falling, a put option seller might be forced to buy the underlying asset at a higher strike price than usual
  • With call option contracts, the seller takes on a huge risk if the stock price increases significantly. In this case, they would be forced to buy the shares at a high price
  • Options buyers are required to pay a premium for an options contract

Types of Options Contracts

Call Options Contracts

Call options are the most common type of options contract. These contracts give the holder the freedom to buy the underlying asset before the expiration date and at a specific price. 

This options contract allows traders to buy but not sell. 

Buyers opt into these contracts with the hope that once they decide to “call” the option, that the value of the underlying asset will have risen above the strike price. This way, the buyer can make a profit. 

When traders bet that the price of the underlying asset will increase, it is called “going long” on the stock. In this case, traders can either exercise their option and buy the stock or they can decide to hold on to the contract and sell it on the open market. 

Alternatively, the trader could decide to “trade out” of the options contract. This means that the trader offsets the trade by selling the options contract. 

Put Options Contracts

A pull options contract, while not as common as call contracts, functions as the opposite of a call options contract. In other words, it allows the trader the right to sell the underlying asset by the expiration date but doesn’t allow the trader to buy the asset. 

When a trader opts into a put options contract, they do so with the hope that the value of the stock will drop below the strike price. If this happens, the trader can sell the stock at a higher price than its value. 

Betting on the fall in stock value is called “shorting” the stock. 

For example, if a trader has a put option contract with the stock trading at $100. If the value of the stock drops to $50 and it expires in a month, the trader can sell those shares and make a profit. 

However, if the stock price rises above the strike price, the trader might make a loss. 

Trading Options Contracts

Generally, options contracts are traded on major market exchanges. Options trade is strictly regulated by the Securities and Exchange Commission (SEC). 

If you are keen on trading options, I would advise that you stick to the regulated market exchanges and avoid over-the-counter (OTC) markets. Options trading is risky enough without the added risk of trading on an unregulated exchange. 

If you want to trade options, we would advise going to a regulated brokerage firm. This can be either a discount broker or a traditional full-service broker, depending on both your preference and cash on hand. 

A downside to trading options is that, because of the high risks associated with options, you will be required to apply first. This application will ask you very personal questions about your income, level of investing and trade experience, and your knowledge about options. 

In Summary

Options contracts are financial derivatives that trade underlying assets, most often, stocks. 

This type of financial instrument is high risk and traders who opt for options have the opportunity to earn huge profits or make major losses. 

We would recommend options trading to more advanced traders who have extensive experience in trade and investments.