What is Trade Options? A Complete Beginner’s Guide to Definitions, Mechanics, and Strategies
If you have ever dipped your toes into the stock market, you probably know the basic "buy low, sell high" strategy. You buy a share of a company, wait for its price to go up, and sell it for a profit. But what if there was a way to profit from a stock's movement without actually owning the stock itself? Or a way to protect your portfolio from a market crash?
This is where options come in. To a beginner, the question "what is trade options" might seem like a gateway into a world of complex math and jargon. However, at its heart, options trading is simply about trading rights and contracts. In this guide, we will break down everything from the basic definitions to the practical steps of your first trade.
Key Takeaways
- Definition: Options are contracts giving you the right (but not the requirement) to buy or sell an asset at a fixed price.
- Two Types: Call options (betting on a price increase) and Put options (betting on a price decrease).
- The Cost: You pay a fee called a "Premium" to own an option.
- Risk vs. Reward: Options offer leverage (greater control with less money) but come with the risk of losing the entire premium if the stock doesn't move as expected.
Understanding the Core: What Are Options?
Imagine you are looking to buy a house that costs $500,000. You’re worried the price might go up next month, but you aren't ready to buy it today. You pay the owner $5,000 for the right to buy that house at $500,000 anytime in the next 30 days.
If the neighborhood suddenly becomes popular and the house value jumps to $600,000, you still have the right to buy it for $500,000. You just made a $100,000 gain (minus your $5,000 fee). If the value drops, you simply don't buy the house, and your only loss is the $5,000 fee.
In the financial world, this "reservation" is called an option. Specifically, in the stock market, a stock option is a contract between two parties based on an underlying stock. For a deeper dive into how these differ from standard shares, you can check out our guide on what is a stock option.
The Two Pillars: Call Options vs. Put Options
Now that we understand the concept of a "right," we need to look at the two directions you can trade. Every option is either a "Call" or a "Put."
Call Options
A Call Option gives you the right to buy a stock at a specific price. You buy a Call if you think the stock price is going up.
- Example: Imagine Apple (AAPL) is trading at $150. You buy a Call option with a "Strike Price" of $150. If Apple's price climbs to $170, your option allows you to buy it at the "discounted" price of $150. You can see a detailed walkthrough of this in our buy call option example beginner guide.
Put Options
A Put Option gives you the right to sell a stock at a specific price. You buy a Put if you think the stock price is going down.
- Example: If you own a stock at $100 and you’re worried it might crash, you buy a Put option at $100. Even if the stock drops to $60, your Put option forces someone to buy it from you at $100. It acts like an insurance policy.
Speaking the Language: Essential Terms You Must Know
To navigate the market, you need to understand the four components of every options contract. Think of these as the "fine print" of your agreement:
- Underlying Asset: The specific stock (like Tesla or Nvidia) the option is based on.
- Strike Price: The pre-agreed price at which you can buy or sell the stock.
- Expiration Date: Options don't last forever. They have a "best before" date. After this date, the contract becomes worthless.
- Premium: This is the price you pay to buy the option. It is non-refundable, regardless of whether you use the option or not.
The Mechanic of Choice: What Does It Mean to Exercise?
Once you own an option and the stock price moves in your favor, you have a choice to make. You can either sell the option itself to another trader for a profit, or you can "Exercise" it.
Exercising an option means you are actually using your right to buy or sell the underlying stock at the strike price. For example, if you exercise a Call option, you are telling the market, "I am now using my right to buy these 100 shares at the agreed price." Most retail traders prefer to sell the option contract rather than exercise it, but knowing what does it mean to exercise stock options is crucial for understanding how the contract ends its life cycle.
Why Traders Choose Options: Leverage and Hedging
You might be wondering: "Why not just buy the stock?" Options offer two unique superpowers: Leverage and Hedging.
Leverage allows you to control a large amount of stock with a relatively small amount of money. One options contract usually represents 100 shares of the underlying stock. Instead of spending $15,000 to buy 100 shares of a $150 stock, you might only spend $500 on a premium to control those same 100 shares.
Hedging is the "safety" side of options. Just as you pay a premium for car insurance to protect yourself from a potential accident, investors use Put options to protect their portfolios from market downturns.
The Practical Side: How to Start Trading Options
Unlike buying stocks, you can’t just open any brokerage account and start trading options immediately. Because options involve more risk, regulators like the Financial Industry Regulatory Authority (FINRA) require brokers to "approve" you for specific levels of trading.
Brokerages typically use a tiered system:
- Level 1: Covered calls and protective puts (the lowest risk).
- Level 2: Buying basic calls and puts.
- Level 3: Complex "spreads" (buying and selling multiple options at once).
- Level 4: Selling "uncovered" options (the highest risk).
When you apply, the broker will ask about your financial goals and experience to ensure you aren't taking on more risk than you can handle.
Navigating the Risks: The Greeks and Time Decay
While the rewards can be high, options have a unique risk called Time Decay. Since every option has an expiration date, the contract loses a little bit of value every single day it sits in your account—even if the stock price doesn't move.
In the industry, we use "The Greeks" to measure these risks. The two most important for beginners are:
- Delta: This tells you how much the price of your option will change for every $1 move in the stock.
- Theta: This is the "silent killer." It tells you how much value the option loses every day as it gets closer to expiration.
Conclusion
Understanding what is trade options is the first step toward a more flexible investment strategy. Whether you are looking to amplify your gains through leverage or protect your hard-earned savings through hedging, options provide tools that standard stock trading simply cannot match. However, remember that with great power comes the need for education. Start small, understand your "Greeks," and always keep an eye on that expiration date.
Sources
- U.S. Securities and Exchange Commission (SEC) - Investor.gov: Options
- FINRA - Rule 2360 (Options)
- The Options Industry Council (OIC) - Options Disclosure Document (ODD)
- Investopedia - Options Basics Tutorial
- Charles Schwab - What is Trading Options?