How to trade options

Puts, calls, strike prices, premiums, derivatives, bear put spreads and bull call spreads — options investors have a colorful language to describe what they do.

And what, exactly, is it that they do?

In a nutshell, options trading involves buying a contract that says you are allowed — but not obligated — to buy or sell an asset (usually a stock or exchange-traded fund) at a fixed price (the strike price) on or before a particular date (the expiration date). The value of an option is based on — or derived from — the underlying asset, which makes options a type of derivative.

Again, in English — stocks vs. options

Let’s try that again using real-people words and a made-up scenario to illustrate the difference between buying a stock and buying a stock option. The setting: a chic modern art gallery. (The fact that it requires a contrived analogy to explain options trading hints at why most investors are better off keeping things simple and sticking with a long-term buy-and-hold investing strategy.)

You, a learned and thoughtful aesthete, spot “Blue Dot on Black Velvet #48” being sold for $500 in a gallery. (We’ll use this painting as a stand-in for a stock in this article for a while. Bear with us.) You predict that collectors will soon be clamoring for this artist’s work and drive up the price of paintings in the series. To profit from this investing thesis, you can …

1. Buy the painting (the stock) outright for $500 (minus trading commissions, in the Wall Street version of this metaphor). Now you own “Blue Dot on Black Velvet #48” (or, say, a stock). If demand does indeed soar and drive up prices, score! Clearly you have an eye for good art and good investments.

Then there’s the flip side: If the hoi polloi pan the “Blue Dot on Black Velvet” series, you’ll be stuck with a reminder of your losing investment hanging above the sofa until a) you sell the painting at a loss, or b) move it to the attic to gather dust. Who knows, maybe someday the art world will confirm your discerning eye and your great-great-grand-nephew will make a killing when he sells it. (As long as your heirs haven’t ruined the painting using it as a surface to play beer pong.)

Or, you can …

2. Buy an “option” — a contract to purchase the painting at a later date. In this scenario you pay the gallery owner, say, $100 to reserve “Blue Dot” for a set period of time (usually a month or so) before the contract expires.

Here you own the contract — not the actual painting (or stock) — and the contract’s worth is based on what happens to the value of the underlying asset. But no matter what, you’ve locked in the purchase price (aka the “strike price”) at $500 in our example.

The advantages of buying an option versus the asset itself:

• Buying an option requires a smaller initial capital outlay.
• An option locks in an equity at a specific price without the obligation to buy the asset.
• Options can limit an investor’s exposure to risk on stock positions they already have. (More details on this later.)
• An option buys an investor time to see if their investing thesis plays out.
• Options offer investors several ways to cash in.

Let’s say a big-shot collector sees the “Dot” series and puts each painting’s value at $1,000. That option contract — which, quick refresher, is based on the value of the underlying asset — is now worth a lot more than the $100 you paid for it.

Remember, your contract obligates the gallery owner to sell you the painting for $500, even though everyone else now has to pay $1,000 for it.

Naturally, investors would love to get their hands on your half-off coupon. It’s like scoring front-row tickets to a sold-out show; your tickets are worth a lot more than face value. In technical money-speak, the intrinsic value of the contract has gone up and your option is “in the money” (also a technical term, but it sounds a lot cooler than “increased intrinsic value”).

Now you’re sittin’ pretty and you’ve got several ways you can choose to cash in before your option expires (the contract ends).

3 things you can do with an options contract

An options contract enables an investor to lock in the price of an asset for a set period of time. That, you already know. But wait, there’s more! During that period an investor can:

• Purchase the asset.
• Sell the contract to another investor.
• Let the option expire and walk away from the deal without further financial obligation.

Here’s how each of these option options work in practice.

1. Purchase the asset (“exercise the option”) at the pre-set price. In our art-world example, when you “exercise your option,” you’ll pay just $500 (the strike price) to buy the painting. That makes your all-in cost basis $600; that is, $500 plus the $100 cost of the contract you paid.

Now you own the asset free and clear, and you can do owner-like things such hang it in your portfolio for a while and bask in the bargain you got. You can also turn around and sell the painting for the $1,000 going rate to another investor and pocket the $400 profit.

But, remember, you are not obligated to buy the asset. When the option is in the money — its value has gone up — you can also choose to …

2. Sell the option contract to another investor. This is called closing out your position. Instead of buying the painting (or shares of a stock) you can sell the contract — not the painting or the shares, because you don’t actually own them — to another investor who wants to speculate on the future of “Blue Dots” or that stock. Since the value of the underlying asset has gone up, so has the “premium” — the per-share value of the option — and you’ll get more than the $100 you paid for the contract.

3. Let the option expire. If the price of the underlying asset remains the same as when the option was purchased (which makes the option “at the money”) or the price drops (making your option “out of the money”), your contract allows you to simply let the option contract expire without further financial obligation.

Exercising or selling the option in this instance would make no sense, since no one will be willing to pay $100 to buy a painting at $500 when they can simply purchase the painting directly from the gallery for $500 or less. So your gamble doesn’t pay off and the option then expires, worthless. You’re out the $100 you paid for the contract and have nothing to hang above your mantel. But that’s the price you pay for your noncommittal ways.

Holders and writers, puts and calls: basic options strategies

In our “Blue Dot” example you are what’s called a “call holder.” In options-speak a “holder” refers to a buyer and a seller is called a “writer.”

Just like you can buy a stock because you think the price is going up or short a stock when you think its price is going to drop, options transactions are a standoff between two rivals betting on which direction they think the price of an asset is going to go. Typically, a holder (buyer) is an investor who is taking a long position on the stock (betting the price will rise) and a writer (seller) is taking a short position (betting the price will fall).

With those two terms learned, it’s on to the next two important ones: puts and calls. A put — simply put — is the right to sell a stock, and a call is the right to buy. There are many ways to mix and match put and call buys, sells, spreads and other exotic-sounding terms depending on your investing strategy and risk/reward tolerance. We’ll cover two main ones:

Calls are used by investors who think the stock price will go up. Call holders have the right to buy an asset at a certain price within a set period. The downside is limited to the amount of money paid for the contract and any trading commissions.

Ideal outcome: The stock price rises before the contract expires so an investor can buy shares at the cheaper price (to hold or sell), or sell the options contract for a higher price than originally paid, pocketing the difference.

Puts are used by investors who think the stock price will go down. Put holders have a contract that states they are able to sell an asset at a certain price within a particular time period. Options investors also use puts as a hedge against short-term dips on stocks they already own outright. Unlike shorting a stock, where losses are unlimited, the downside risk for buying a put is contained — if the trade doesn’t go your way, you’re only out the premium.

Ideal outcome: Holders of puts celebrate when the price of an asset falls below the strike price because they can either exercise the put and buy at the cheaper price (the difference between the strike price and the current market price) or sell the put to another investor for a higher price.

Option spreads, covered calls and more. The options for options investors don’t stop with buying puts and calls. You can also sell puts and calls, cover them, do both at the same time, and get into options spreads of the bull and bear variety.

As you can imagine, the more sophisticated strategies get very complex and require the experience, assets and time to deploy them properly. So let’s see if you’re up to it.

4 skills every options investor needs

Flexibility? Leverage? Hedge-ability? Unlimited upside and limited downside? Insert your preferred “no free lunch” metaphor here because, well, there’s never a free lunch, is there?

Yes, options give investors more leeway than buying a stock in terms of time (to see how the asset performs) as well as things you can do with them (the three things outlined above). This is also what makes successfully investing in options more difficult.

In order for the investment to pay off, options investors need:

1. A short-term time horizon. Because every option has an expiration date after which it becomes worthless, the very nature of options is short-term. Options investors are looking to capitalize on a near-term price movement — within months. Long-term buy-and-hold investors buy stocks that they think will increase in value over years, even decades. If you have a long time horizon and your investing objective is to build long-term wealth for retirement or big purchases like homes and college educations, options investing may add needless complexity to your financial life.

2. Analytical chops. Deciding whether to simply buy, sell or hold a stock for the long term requires knowing the company’s business inside-out and predicting the direction the asset is heading. Options investors need to be hyper-aware of these things and more. Success requires not only a good grasp of the company’s intrinsic value, but also a solid thesis about ways the business has been and will be affected by near-term factors (within-company operations, the sector/competition, macroeconomic impact). Beyond that tall order, success also depends on …

3. Good timing. Options investors have to make two correct assumptions during a well-defined time frame for the trade to pay off: picking the right time to buy the option, and deciding exactly when before the option expires to exercise, sell or walk away.

4. An understanding of the risks. The most important requirement of all is grasping the risks inherent to options trading. With the basic strategies outlined above, an option investor’s downside is limited. But you still must have the willingness to risk losing the money you paid to trade — which, depending on the size of your trades, can easily run into triple digits and higher.

For these reasons and more, investing in options is best left to those who are experienced, have short-term investment objectives, and have the constitution and capital to withstand potential losses.

The cost of trading options

Option contracts are typically sold in 100-share increments, for which a broker charges a trading commission (or base rate) and a fee for the contract.

Options trading commissions can range from a low $3 per trade to the standard stock trading commission charged by a broker (e.g., $4.95 to $9.99). On top of the trading commission, investors also pay an additional per-share fee (typically about $0.75).

So if you’re buying two contracts that contain 100 shares each, the trade will cost $150 ($0.75 times 200) plus the broker’s standard trading commission.

Pricing based on volume or frequency of trades is common among discount brokers that offer options trading. For example, an investor who qualifies as an “active trader” will pay a flat $12.95 for one to 10 contracts at OptionsXpress, and $1.25 per contract for 11 and up. The base rate at TradeStation (a broker for sophisticated options investors) ranges from $4.99 to $9.99 and $0.20 to $0.70 per contract, depending on volume. (The definition of “high volume” or “active trader” varies by brokerage. We’ve included the details in our options broker reviews.)

Additionally, some brokers charge extra to access their more sophisticated trading platforms and other extras that active options traders like, such as real-time data, modeling tools, customization and research.

Many brokers, like OptionsHouse, TradeKing and TD Ameritrade’s thinkorswim, charge a set-price commission-plus-contract fee no matter how much a customer trades. This setup is good for investors who use options sparingly in their investing strategy or are trying out options for the first time.

Even if you can afford to trade options, you can’t begin until you meet a broker’s minimum account balance requirements (anywhere from $2,000 to $10,000) and you answer questions to show that you’re an experienced investor who understands the inherent risks. And if you want to enter into some of the more sophisticated option trades you may be required to fund a margin account and/or maintain a minimum account balance to pay your tab in case the whole “wheeling-dealing options trading” thing goes south.

The best broker for options trading

A lot of discount brokers support options trading, and choosing the best discount broker shouldn’t be based solely on trading costs. Look also at which brokers offer the research and trading tools that will help you develop and execute your options trading strategy.

Based on costs, trading tools, research and reliability, here are NerdWallet’s picks for the best brokers for options trading.

For even more customized guidance and to compare option investing costs based on your trading activity, use our free online brokerage comparison tool to find the best account to trade options with the features you need.

Dayana Yochim is a staff writer at NerdWallet, a personal finance website. Email: dyochim@nerdwallet.com. Twitter: @DayanaYochim. This article first appeared in NerdWallet.