Options Trading Basics

Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a specific price before or on a specific date. Investors use options to speculate on price moves, generate income or hedge existing positions.

This page explains the core building blocks: calls and puts, essential terminology, how option pricing works at a high level, simple strategies and the main risks to understand before trading options. Treat it as education, not a signal to rush into highly leveraged trades.

What is an option?

An option is a financial contract between two parties:

• The option buyer pays a premium for a specific right.
• The option seller (writer) receives the premium and takes on an obligation.

Each standard stock option contract typically controls 100 shares of the underlying stock or ETF (contract size can vary in some markets or after corporate actions). This creates leverage: a relatively small amount of capital can control a larger notional position.

Options can be based on stocks, ETFs, indices, currencies and more. On this page we focus on stock and ETF options, since these are what most individual investors encounter first.

Calls and puts: the two basic option types

Every standard option is either a call or a put:

• Call option: gives the buyer the right (but not the obligation) to buy the underlying asset at the strike price before expiration.
• Put option: gives the buyer the right (but not the obligation) to sell the underlying asset at the strike price before expiration.

The price you pay to buy an option is called the premium. This is the most you can lose as an option buyer, but sellers (writers) of options can face much larger potential losses depending on the strategy.

Long vs. short options

When people say they are “long” an option, they have bought it and paid the premium. When they are “short” an option, they have sold (written) it and collected the premium.

• Long call: bullish; you want the underlying to rise.
• Long put: bearish; you want the underlying to fall.
• Short call: you received premium and may be obligated to sell shares.
• Short put: you received premium and may be obligated to buy shares.

Key terms in options trading

When you read about or trade options, you will often see:

• Underlying: the stock, ETF, index or other asset the option is based on.
• Strike price: the price at which the option buyer can buy or sell the underlying.
• Expiration date: the last day the option can be exercised (or last trading day, depending on the contract).
• Premium: the price of the option, quoted per share (usually multiplied by 100 per contract).
• In the money (ITM): an option that currently has intrinsic value.
• At the money (ATM): an option with a strike price close to the current underlying price.
• Out of the money (OTM): an option that would not be worth exercising at current prices.
• American vs. European style: American-style options can typically be exercised any time up to expiration; European-style options are exercised only at expiration.

Simple options examples

Suppose a stock trades at $50. You buy a call option with a strike price of $55 that expires in two months, paying a premium of $2 per share (or $200 per contract, before costs). A few possibilities:

• If the stock rises to $65 before expiry, the call is worth at least $10 (intrinsic value) per share. Ignoring time value, that’s $1,000, minus your original $200 premium.
• If the stock stays below $55, the option expires worthless and you lose the entire $200 premium.
• If the stock drifts to around $56–$57, the option may have some value, but you may not fully recover the premium paid.

A put option works in the opposite direction: it gains value as the underlying price falls below the strike. For example, a $50 strike put becomes more valuable if the stock falls to $45 or $40.

Why investors use options

Options are flexible tools that can be used in several ways:

• Speculation: betting on a rise or fall in the price of a stock, ETF or index with limited capital.
• Income: collecting option premiums by writing covered calls or cash-secured puts.
• Hedging: buying puts to limit downside risk on an existing position or portfolio.

Because options can be combined into many different structures, they are sometimes described as “financial building blocks” that can shape a payoff diagram in many ways.

Basic “Greeks”: how options react to the market

Options pricing models use several risk measures often called the “Greeks”. For beginners, the most important are:

• Delta: estimates how much the option price moves when the underlying moves by $1.
• Theta: measures time decay – how much value an option loses as each day passes, all else equal.
• Vega: measures sensitivity to changes in implied volatility.

You do not need to master every Greek on day one, but you should understand that option prices respond not just to direction, but also to time and volatility.

Common beginner strategies

Some options strategies are simpler and easier to understand than others. Examples include:

• Covered call: you own the stock and sell a call option against it, collecting premium in exchange for potentially selling your shares at the strike price.
• Cash-secured put: you set aside enough cash to buy shares and sell a put option, collecting premium while agreeing to buy if the price falls to the strike.
• Protective put: you own the stock and buy a put option to limit downside risk, similar to an insurance policy.
• Vertical spreads (debit spread): buying one option and selling another at a different strike in the same expiration to limit both potential gain and loss.

More complex strategies involve combinations of multiple options (straddles, strangles, iron condors and so on) and should only be used once you have a solid grasp of the basics and fully understand the payoff diagrams.

Risks in options trading

Options are often described as “leveraged” instruments. Small moves in the underlying price can lead to large percentage changes in the option's value, especially as expiration approaches. Major risks include:

• Time decay (theta): the value of many options falls as expiration nears, even if the underlying does not move much.
• Volatility risk (vega): changes in implied volatility can increase or decrease premiums, sometimes in ways that surprise beginners.
• Assignment risk: option sellers can be assigned and must fulfill the contract, potentially buying or selling shares at an unfavourable price.
• Leverage risk: overusing leverage can lead to rapid losses, especially in short-term speculation.
• Liquidity risk: thinly traded options with wide bid-ask spreads can be expensive to get in and out of.
• Complexity: it is easy to misunderstand payoff diagrams or underestimate risk in multi-leg strategies.

Because of these factors, options are usually better suited to experienced investors who fully understand the potential outcomes of each position and who limit options to a reasonable portion of their overall portfolio.

How options can fit into an investing plan

For many long-term investors, options – if used at all – play a small, supporting role. A few ways relatively conservative investors may use them include:

• Writing covered calls on long-term stock holdings to generate extra income.
• Selling cash-secured puts on stocks they are willing to own at a lower price.
• Buying protective puts during periods of unusual uncertainty as a form of portfolio insurance.

Speculative, highly leveraged options trades should only be done with money you can afford to lose, and only after practising with paper trades. For many investors, core holdings in mutual funds, index funds and bonds form the foundation, with options used tactically on top.

Getting started with options (if you decide to)

If, after understanding the risks, you still want to explore options trading:

1. Build a foundation first: make sure your emergency fund and core long-term investments (for example, retirement accounts) are in place before committing money to options.
2. Start with education: learn basic option terminology, payoff diagrams and how your broker handles margin, assignment and exercise.
3. Use simple strategies: begin with covered calls, cash-secured puts or protective puts before moving into spreads or multi-leg strategies.
4. Limit position size: keep individual option positions small relative to your total portfolio, especially when starting out.
5. Review and learn: track each options trade and review results over time, just as you would with day trading or other active strategies.

Important: nothing here is personalised advice. Always consider your own financial situation, goals and risk tolerance before using options. Long-term planning and retirement investing often deserve priority over short-term speculation.

Options trading FAQ

To see options in the context of other markets, you can also review our pages on futures, forex, mutual funds, bonds and day trading. For quick definitions of option terms, visit our Dictionary Index.