Investing > Options Trading Basics

Options Trading Basics

When it comes to options trading, there's nothing more important than the basics.

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Updated January 12, 2021

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Someone recently turned $600k into $4.4 million with a single call option. We do not know exactly who because this was a Bitcoin option—but this trade is indicative of the times we’re in.

Not much has changed in the world of online trading in 2020 except just about everything. Broker commissions are down, the markets are very lively, and the number of options traders is higher than ever—however, not all of these new traders are experts.

Trading volumes have gone up by 50% lately and countless young traders approach their investing like sports betting—very high-risk and high-reward. Needless to say, most of these traders do not fare too well and lose a lot, if not everything they put in.

If you want to be an effective trader in these opportune times, first you absolutely need to learn how to trade options—and where better to start than with the basics? Don’t worry, options might seem complicated but just knowing the fundamentals will separate you from the competition, which is why we made this guide for you.

In the following paragraphs, we will explain the logic behind options, how they work, and we’ll talk about some low-risk strategies that you can implement as soon as today as a complete beginner. Time is money, so let’s go through this quickly, shall we?

What you’ll learn
  • What are Options?
  • Types of Options
  • How Options Work
  • Benefits of Options
  • Disadvantages of Options
  • Beginner Strategies
  • Trade Options in 4 Steps
  • Options Trading Tips

What are Options? 📖

Options are contracts that allow you to buy securities at a later date at a predetermined price. For example, if XYZ stock costs $100 today, someone might sell you an options contract that says you can buy XYZ one month from now at $100 per share. 

If you buy this options contract and XYZ’s price jumps to $140 in a month, you can buy the stock for a low price of $100—this means your profit is $40. Of course, this is an oversimplification, but this is essentially how options work—you predict where the price is going and buy a contract that allows you to sell high or buy low in the future.

Types of Options 🗂

There are two main kinds of options contracts—a bullish one and a bearish one. Essentially, put and call options allow you to either sell or buy the underlying security at a later date at a predetermined price.

What are Puts and Calls?

As one of the two major types of options, put options give you the right to sell the underlying asset at a predetermined price during an agreed-upon timeframe. If you think a stock that’s worth $100 now will drop to $50 in the future, you can get a put option for $90, and if your prediction is correct, you will be at a $40 profit.

On the other hand, call options allow you to buy an asset at a predetermined price during a certain period—you can use a call option if you think a price is going up. Essentially if you get an option for a stock today and the company goes up in value before the contract expires, you will be at a profit.

Binary Options

Unlike calls and puts, binary options are far more straightforward and risky. As the name implies, these options have two possible outcomes, which are “yes” or “no”. Basically, you can use binary options to make a bet like “XYZ stock is going to jump to $120+ per share”—if your prediction is true at the expiry date, you get paid, whereas you lose your investment if you guess wrong.

Binary options trading is known to be very risky. An added element of risk is the multitude of unregulated brokers that facilitate options trading. If you’re interested in binary options trading, be sure to use one of the top regulated brokers for binary options trading.

How Options Work 🏗

Every option has a period during which it can be exercised—this is referred to as the option’s expiry date. Now, here’s how options work: If the option expires, and you haven’t done anything with it, it will become worthless and unusable, which is why it is necessary to plan ahead.

To buy an option, you need to pay the premium which is the price of the contract. Premiums are always dramatically cheaper than the price on the underlying security, but you have to pay them upfront. Then, if you want to exercise your options, you can buy the asset in question for the strike price—this is the price that has been agreed upon.

Complicated? It won’t be for long—here’s an example. Let’s say you buy a call option for XYZ stock which allows you to buy the asset at today’s price of $100 (this is the strike price) one month from now. For this options contract, you need to pay $5 upfront (this is the premium).

So, if XYZ stock price has gone up to $140 one month later and you want to exercise your contract, here’s what happens. You paid $5 upfront for the premium and now you can pay $100 for the stock—that’s a total expense of $105. But if XYZ is now worth $140, that means your net profit would look like this:

$140-$105=$35

Essentially, there are 3 main numbers you need to think about when making calculations about options trades. These are the strike price, premium, and the asset price on the day you want to exercise the option.

However, you don’t have to cash in your option, you can just sell the contract altogether. If it seems like your price predictions were wrong and that you’re going to lose money, you can sell your option before expiration to a willing buyer and mitigate some of your losses—however, you will likely sell it for a much lower premium than the one you bought it at.

In the Money vs. Out of the Money 💸

If a stock price is $100 right now and someone is selling a call option on it for $90, we say that option is “In the money”—this simply means that the option is immediately profitable. However, in-the-money options have very high premiums, so they aren’t something you can use to make an instant profit.

Opposite to them, an “out-of-the-money” option’s strike price is higher than the current price of the underlying asset. If you think the underlying stock is going up in value in the future, an out-of-the-money option is a good thing to have—these options have very low premiums to make up for the high strike price.

Smack-bang in the middle are the appropriately-called “At-the-money” options. Here, the strike price is the same as the price of the underlying security at this moment. The premiums are neither cheap nor expensive in this case, so you can never go wrong with an at-the-money option.

Long Options and Short Options ⚖️

This is another term you’ll run across very often when learning about options. In investing, holding a long position means buying an asset and betting it will go up in value over time. Therefore, a call option could be a long option—if you’re hoping for a stock to go up in the future, you can get a call option now so that you can buy that stock cheap later on.

On the other hand, a short position is when you’re betting on a security to go down in price. If you get a put option that allows you to sell a stock at today’s price of $100 and the stock drops to $90, you can then buy the stock for $90 and sell it for $100 making a profit—this is a short option.

What is a Spread in Options Trading?

Put simply, a spread is the difference between your profits and expenses. To make money, you need to make sure your spread is positive, that is to say, that your profits are bigger than your expenses. 

Benefits of Options 🔎

Why not just buy stocks, ETFs, and other securities directly instead of using options? Trading via options can be a bit more complicated, but it comes with a few very important benefits over stock trading that can make your life a lot easier.

The first benefit is hedging risk. For example, many popular strategies for trading options involve buying a call and a put option together—this way, even if your long bet fails miserably and you can’t cash in on your call option, you can sell the put option and get most of your money back. 

Excited african american woman celebrating success with laptop while sitting on couch and learning about options trading.
Many traders use options to hedge risk as part of their larger investing strategy.

The second, and maybe the most prominent advantage of options is the high liquidity. If you hold an options contract, you have the right to sell it immediately whenever you want. On the other hand, selling a stock means you have to find a willing buyer first—the ability to get out of your positions quickly is one of the reasons why trading options is still so popular

The third, but just as important benefit of using options is leverage. If you have an options account on a popular platform like Robinhood, you have access to leveraged trades with options. This means you can make trades with amounts that exceed your account balance up to 2 or more times—basically, you can make safe trades with borrowed money to increase your profits, which is great for traders with small portfolios.

Is Trading Options a Bad Idea? ⚠️

Every option has an expiration date which means you have to exercise them in a limited (often short) time frame. Opposite to that, when you buy a stock, it can go up and down and up and down for 5 years before you sell it—and it might reach an all-time high by then. 

Also, options have premiums, so if you’re making a very sure long-term bet on a stock, it makes little sense to buy an option instead of the actual stock. That way, you need not worry about the premium, and you can sell the stock for the same amount.

Also, since options are a more flexible investment tool, they might lure you into making rash, imprudent decisions, especially nowadays. The markets are volatile, yet they are driven by options traders making risky moves.

If you’ve got a sweet tooth for high-risk, high-reward trades, be very careful before taking an options investing app in your hands—compulsive gamblers make for poor options traders.

Options Trading Strategies for Beginners 📈

Strategies for trading options range from super-simple to fairly complicated—and the more complex the strategy, the more you can hedge risk using it. However, if you stick to stocks that are somewhat popular and predictable, the more basic options strategies will do wonders for your portfolio.

Here are some commonly-used strategies that beginners should have no problem learning and implementing.

Bull Call Spread 🐂

This strategy works for upward-trending stocks and is fairly simple to do. To perform a bull call spread, you need to buy one option and sell another. Here is how in an example.

First, let’s say you bought a call option with a premium of $10 and a strike price of $130. Then, let’s say you wrote and sold another call option but with an unrealistic strike price of $200—the over-the-top strike price means this option has little chance of being profitable, so the premium on this is only $4.

In summary, you bought one option for $10 and sold another for $4 which leaves you with a $6 total expense. The idea here is to lower your cost of premiums by selling an option with an unrealistic strike price that the underlying asset has little chance of reaching.

  • Profit: If the price of the stock at the expiry date is higher than the stock price and the premium combined, you will profit. For example, if the stock costs $150 today, your strike price is $130, and the premium was $10, you will earn $10 from the trade.
  • Break-even: If the price of the stock at the expiry date is equal to the strike price plus the premium, then you will break even and will earn nothing (the spread will equal $0)—but on the bright side, you won’t lose anything either. 
  • Lose money: As long as the price of the stock at the expiry date is lower than the strike price plus the premium, you will lose some money. However, this loss will likely be small as it will be mitigated by the premium of the option you sold.

Pros

  • Very low risk
  • Works great on upward-trending assets
  • Reduces cost of investment

Cons

  • Limited max profit
  • Can lose money if the underlying asset unexpectedly skyrockets in value

Bear Put Spread 🐻

The bear put spread is the direct opposite to the bull call spread—it is a safe strategy used for downward-trending assets that don’t seem like they will drop too dramatically in the future. Basically, if a company nearing bankruptcy, like the dozens of retailers and restaurant chains that went out of business in 2020, don’t bet against them using this strategy.

This works similarly to the previous strategy, but instead, you need to buy a realistic put option and sell a less-realistic put option—doing this means you will spend less on premiums. Then, you need to wait until the underlying stock is between the two strike prices and cash in.

Be careful when writing your put option—if the stock price drops to the level where someone can exercise the option they bought from you, it will incur losses. To profit, you need to make sure that the price of the underlying asset at expiry is lower than the strike price and the premium combined—if it isn’t, you will likely incur a small loss.

Pros

  • Very low-risk strategy
  • Works great on downward-trending assets
  • Reduces premium cost

Cons

  • Limited profits
  • Can lose money if underlying asset drops exponentially

Long Call and Put ☎️

This one is so simple and intuitive that it can hardly be called a strategy, but it has its benefits nonetheless. In short, if you think a stock is going up in value, buy a call option, and if you think it is going down, buy a put option.

Where this simple approach has an edge over the two aforementioned strategies is there is no profit limit. If you bet short on a stock and its price falls to oblivion, you can make a huge amount of money. 

Similarly, if you want to invest in a risky startup safely while accounting for the possibility that it grows exponentially, it is better to buy a long call option and wait.

If you simply buy the stock, you will be at a large loss should the said startup go bankrupt and its stock goes up in flames—the biggest loss you can suffer is equal to the price of the premium you paid, which is much cheaper than the underlying asset.

Pros

  • No max profit limit
  • The simplest strategy
  • Less risky than directly buying stocks

Cons

  • Premium cost is not offset by anything and can be high
  • Requires you to make a correct price prediction to be profitable

How to Trade Options in 4 Steps

Trading options means trading the underlying assets through options contracts. Therefore, you need to know what these underlying securities are—for example, you can only trade stock options effectively if you know how to analyze stocks.

The next step is to decide on a specialization—you can either trade rising, falling, or stagnant assets, and trading strategies for each of these vary. To make the best of your trades, it’s best to focus on one type of asset rather than doing everything sporadically, especially if you are a new trader that’s just learning to trade options.

Young millennial male sitting at a table in his house with a window in the background, smile at the camera with a laptop in front of him use to trade options
Online options brokers have made options trading available from anywhere with an internet connection.

Once your basic skill set is there, you need to find a trading platform—luckily, due to the huge increase in retail traders world-across, online brokerages have become more accommodating than ever. Even the top stock brokers are very cheap with low commissions and a plethora of great features overall.

Lastly, you need some starting capital. Minimum account requirements for most top stock brokerages range between $0 and $100 nowadays but the amount of money you can make depends on your investment.

Your broker’s leverage can help with this but you still need an adequate sum if you want to make a living by trading—however, having just a couple of hundred dollars is completely fine for practicing.

Options Trading Tips ⭐️

Getting the basic terminology and strategies is very important but all traders should also gain some fundamental options trading wisdom. Successful traders are more than knowledgeable—they are disciplined and careful.

Here are some things that every new trader should know before investing.

1. Hedging risk is paramount ✅

This means being good with numbers. When making a trade, always calculate how much you can lose at most, and devise your strategies accordingly. In the long term, it’s better to rely on low-risk, low-profit tactics because your portfolio will never be hurt like this—it will only go up.

What’s more, do not put all your eggs in one basket and don’t invest all your money into one industry or stock. If you diversify your portfolio across multiple industries you are familiar with, you will be damaged less if one of your investments fail.

2. Don’t follow the herd 🐃

The worst thing to do in times of turmoil and volatility (which is right now) is to do what everyone else is doing impulsively. Most traders often display bullish naivete when markets are going up, and sell like crazy when a recession strikes—do not make the same mistake. Stick to your plan and think long term—rationality and a cool head are the best tools you have to make good trades and stay ahead of the competition.

3. Keep an eye on the news 👀

The stock market isn’t something you can analyze through ticker numbers and price charts alone—one important event can make or break a company and consequently, its stock. For example, anyone following the video game industry would not have missed the release of Cyberpunk 2077.

Just a few days after the release, it was clear that the game isn’t working properly on gaming consoles, and the developer, CD Projekt Red, saw its stock plummet over 29% in just a couple of days. Just imagine if you bought a few put options before this happened—you would’ve hit the jackpot just by paying close attention to what’s going on.

4. Always keep learning 🎓

The stock market is ever-changing and the laws of yesterday might not count for much tomorrow. Moreover, the more strategies, tips, and tricks you have in your arsenal, the more effective you will be—learning to invest is a never-ending process.

Trading Options During COVID-19

With all the economic damage that’s been done to the world during 2020, it would make sense for stock trading to slow down too—but the exact opposite is true. There are more options traders than ever and they are bullishly betting on the market to go up

But the markets aren’t going up that decisively. Not long ago, NASDAQ reached its all-time high, but it also has drastic regular drops which should be of some concern. This unsteady market means high volatility, which means risk. However, a risky environment can also yield very high rewards, like it has for numerous Bitcoin investors who doubled their wealth over the past few months.

That’s why trading Bitcoin options is also quite popular and profitable nowadays. All in all, COVID-19 has brought a lot of volatility to the markets, and traders like nothing more than to use this opportunity to make a profit—and some have.

However, beginner options traders with big dreams tend to risk too much too early and fail at those goals. Remember to exercise caution in today’s market and only take big bites when you’re more experienced.

Options Trading Basics FAQs

  • Is Trading Options Considered Gambling?

    Not gambling, but options trading can be considered betting to a degree. This is because the buyer of a contract will only profit if they correctly predict where the price of the option’s underlying security is going. Therefore, the trader is betting on the stock price, but this can hardly be called gambling considering how much research and forethought can go into making a prudent trade.

  • Are Options Riskier Than Stocks?

    This depends on the situation. Options require less commitment—you only need to pay the premium and that’s all you can ever lose. However, if you want to bet very long and cannot predict how quickly a stock is going to grow, buying a stock might be preferable as you don’t have to worry about any expiry dates.

  • What Do I Need to Trade Options?

    To trade options you need knowledge, a starting capital, and an account with a top-notch online brokerage. The amount of money needed depends on your goals, but it is good to have between $5,000 and $10,000—with this amount, you can buy individual options for all stocks without risking a large percentage of your portfolio.

  • How Long Does it Take to Learn How to Trade Options?

    The usual learning curve is 2 years. In a professional environment, a beginner will go to a junior trader and then to a pro in this period—however, this can vary tremendously. The amount of money and attention you devote to your craft will determine how quickly you improve, and it is certainly possible to become well-versed in under 2 years.

Get Started with a Broker

Congrats on making it this far! 🚀

The next step is choosing a reliable, trustworthy broker to get started:

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Huge discounts for high-volume trading

Low fees

Promotion

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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