Options Trading: Step-by-Step Guide for Beginners - NerdWallet (2024)

If you've been reading about investing during this time of historical volatility, you've probably heard of options trading.

Options are complex financial instruments which can yield big profits — or big losses. Here's what you need to know about how to trade options cautiously.

What is options trading?

Options trading is when you buy or sell an underlying asset at a pre-negotiated price by a certain future date.

Trading stock options can be complex — even more so than stock trading. When you buy a stock, you just decide how many shares you want, and your broker fills the order at the prevailing market price or a limit price you set. Options trading requires an understanding of advanced strategies, and the process for opening an options trading account includes a few more steps than opening a typical investment account.

In 2022, the stock market saw its share of highs and lows amid concerns about inflation, Russia's invasion of Ukraine and rising oil prices. When the market is volatile, options trading often increases, says Randy Frederick, managing director of trading and derivatives with the Schwab Center for Financial Research.

“You can use options to speculate and to gamble, but the reality is ... the best use of options is to protect your downside,” he says. "Options are one way to generate income when the markets aren’t going up.”

How to trade options in four steps

1. Open an options trading account

Before you can start trading options, you’ll have to prove you know what you’re doing. Compared with opening a brokerage account for stock trading, opening an options trading account requires larger amounts of capital. And, given the complexity of predicting multiple moving parts, brokers need to know a bit more about a potential investor before giving them a permission slip to start trading options. Wendy Moyers, a certified financial planner at Chevy Chase Trust in Bethesda, Maryland, says people who know the market well, and have time to watch it, are better suited to options trading than busy, beginner investors.

"It’s definitely more complicated, and you have to be on top of it all throughout the trading day," she says.

Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks and their financial preparedness. These details will be documented in an options trading agreement used to request approval from your prospective broker.

You’ll need to provide your:

Based on your answers, the broker typically assigns you an initial trading level based on the level of risk (typically 1 to 5, with 1 being the lowest risk and 5 being the highest). This is your key to placing certain types of options trades.

Screening should go both ways. The broker you choose to trade options with is your most important investing partner. Finding the broker that offers the tools, research, guidance and support you need is especially important for investors who are new to options trading.

2. Pick which options to buy or sell

As a refresher, a call option is a contract that gives you the right, but not the obligation, to buy a stock at a predetermined price — called the strike price — within a certain time period. (Learn all about call options.) A put option gives you the right, but not the obligation, to sell shares at a stated price before the contract expires. (Learn all about put options.)

Which direction you expect the underlying stock to move determines what type of options contract you might take on:

If you think the stock price will move up: buy a call option, sell a put option.

If you think the stock price will stay stable: sell a call option or sell a put option.

If you think the stock price will go down: buy a put option, sell a call option.

Frederick says to think of options like an insurance policy: You don’t get car insurance hoping that you crash your car. You get car insurance because no matter how careful you are, sometimes crashes happen.

"You buy options hoping you don’t need them,” he says.

3. Predict the option strike price

When buying an option, it remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for put options, it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.

You can’t choose just any strike price. Option quotes, technically called an option chain or matrix, contain a range of available strike prices. The increments between strike prices are standardized across the industry — for example, $1, $2.50, $5, $10 — and are based on the stock price.

The price you pay for an option, called the premium, has two components: intrinsic value and time value. Intrinsic value is the difference between the strike price and the share price, if the stock price is above the strike. Time value is whatever is left, and factors in how volatile the stock is, the time to expiration and interest rates, among other elements. For example, suppose you have a $100 call option while the stock costs $110. Let’s assume the option’s premium is $15. The intrinsic value is $10 ($110 minus $100), while time value is $5.

This leads us to the final choice you need to make before buying an options contract.

4. Determine the option time frame

Every options contract has an expiration period that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.

There are two styles of options, American and European, which differ depending on when the options contract can be exercised. Holders of an American option can exercise at any point up to the expiry date whereas holders of European options can only exercise on the day of expiry. Since American options offer more flexibility for the option buyer (and more risk for the option seller), they usually cost more than their European counterparts.

Expiration dates can range from days to months to years. Daily and weekly options tend to be the riskiest and are reserved for seasoned option traders. For long-term investors, monthly and yearly expiration dates are preferable. Longer expirations give the stock more time to move and time for your investment thesis to play out. As such, the longer the expiration period, the more expensive the option.

A longer expiration is also useful because the option can retain time value, even if the stock trades below the strike price. An option’s time value decays as expiration approaches, and options buyers don’t want to watch their purchased options decline in value, potentially expiring worthless if the stock finishes below the strike price. If a trade has gone against them, they can usually still sell any time value remaining on the option — and this is more likely if the option contract is longer.

Options trading examples

Even simple options trades, like buying puts or buying calls, can be difficult to explain without an example. Below we're walking through a hypothetical call option and put option purchase.

An example of buying a call

Imagine a company called XYZ Corp. with a share price of $100. If you think the price is going to rise to $120 by some future date, you could buy a call option with a strike price less than $120 (ideally a strike price no higher than $120 minus the cost of the option, so that the option remains profitable at $120).

If the stock does indeed rise above the strike price, your option is in the money. That means you can exercise it for a profit, or sell it to another options trader for a profit. If it doesn't, then your option is out-of-the-money, and you can walk away having only lost the premium you paid for the option.

An example of buying a put

Similarly, if you think XYZ's share price is going to dip to $80, you could buy a put option (giving you the right to sell shares) with a strike price above $80 (ideally a strike price no lower than $80 plus the cost of the option, so that the option remains profitable at $80).

If the stock drops below the strike price, your option is in the money and you can profit from it. Otherwise, you'd forfeit the premium and walk away.

Why trade options?

"The pros are you could make a little bit extra money on investing in the short term," Moyers says. "The con is you could lose everything, depending on how you structure your options trading."

Once you have learned the strategies and you're willing to put the time in, there are several upsides to options trading, Frederick says. For instance, you can use a covered call to help you generate income in a sideways market.

Frederick says most covered calls are sold out of the money, which generates income immediately. If the stock falls slightly, goes sideways, or rises slightly, the options will expire worthless with no further obligation, he says. If the stock rises and is above the strike price when the options expire, the stock will be called away at a profit in addition to the income gained when the options were sold.