How to trade options
Editorial staff, J.P. Morgan Wealth Management
- A call option gives the buyer the right to purchase a set number of shares of the underlying asset at a defined price, while a put option gives the buyer the right to sell a set number of shares of the underlying asset at a defined price.
- Call options increase in value as the underlying asset’s price increases, while put options increase in value as the underlying asset’s price declines.
- Option buyers (holders) pay premiums, while option sellers (writers) receive premiums.
An options contract opens the door to another way of investing, giving you the ability to buy or sell assets at a set price within a specific time frame. Much like exploring new types of accounts or investment strategies, you might be curious about how options work and whether trading them is right for you.
Options can offer flexibility and a range of strategies for investors. Deciding if and how to trade options, however, depends on understanding their unique features and risks.
In this article, we’ll cover what options are and walk through the basics of how they can be traded.
What are options?
An option is a contract between a buyer and seller that gives the buyer the right, but not the obligation, to buy or sell the underlying security. This choice is the main characteristic that differentiates an options contract from other financial instruments like stocks and futures.
An underlying security is usually a financial instrument that is publicly traded, like a stock, exchange-traded fund (ETF), equity index (such as the S&P 500) or futures contract. An option is considered a derivative because its value is dependent on, or derived from, the value of this underlying security.
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Basic features of an options contract
Before we get into the nitty-gritty of options trading, let’s run through the basics:
An options contract is structured in a way so that both parties are aware of certain features before entering the contract. These features include the price at which the buyer may buy or sell the underlying asset, the date that the contract will expire and the cost of the contract.
- This pre-determined price at which the buyer may exercise their right is known as the strike price.
- The date upon which the option ceases to be valid is known as the expiration date.
- The cost to buy the option is called the premium. The buyer, who is also known as the holder, pays the premium to the seller, who is also known as the writer.
Typically, a single options contract is designed to purchase or sell a standard amount of 100 shares of the underlying security or investment. For example, an investor buying one call option of ABC stock is buying the right to buy 100 shares of ABC at the strike price from the seller if they exercise the options contract.
Understanding the difference between call vs. put options
An options contract can be either a call or a put. The buyer of a call option is actually purchasing the right to buy the underlying security at an agreed price or strike price. While the buyer can exercise this right at any time, they will likely do so only if they stand to gain from it. So, when an investor buys a call option on ABC stock, they are saying that if the price of ABC stock rises above the strike price, then they may exercise their right to buy that stock.
Similarly, the buyer of a put option is buying the right to sell the underlying security at the strike price. So, an investor buying a put option on ABC stock is saying that if the price of ABC stock falls below the strike price, then they may exercise their right to sell that stock.
The seller of the options contract takes the opposite side of this setup. So, the seller of a call option would be liable to sell the underlying security to the buyer should the buyer exercise the contract, and the seller of a put option would have to buy the underlying security from the buyer should the buyer exercise the contract.
However, the seller side of the transaction is typically riskier given the potential for significant loss. This can occur if market movement drastically affects the price of the underlying asset and the other party exercises their right, forcing the seller to buy/sell the option at a worse price than the current market value of the underlying asset. Therefore, only more experienced, sophisticated investors should consider selling options due to the possibility of significant loss.
What may be a bit harder to grasp is that one can buy the right to buy and/or buy the right to sell. On the flip side, one can sell the right to buy and/or sell the right to sell.
Like other financial instruments, options contracts can either be traded on an exchange (such as the New York Stock Exchange), in which case they are called exchange-traded options, or they can be traded privately over-the-counter (OTC). Exchange-traded options are defined contracts with terms that are standardized and set by the listing exchange. OTC options, conversely, are customized contracts negotiated between the buyer and seller, which allows greater flexibility. However, there is elevated risk with OTC options due to increased complexity, potential counterparty risk (risk the other party will not fulfill their part of the contract) and decreased liquidity (how quickly can you exit the option position), as well as the fact there is no centralized exchange overseeing the transaction.
Why people trade options
Generally, options are used for income or to hedge against risk. Experienced investors may use options for speculation purposes as well, although this is riskier since it involves predicting price movements within a specific time frame and relying on market volatility for a potential profit.
In a nutshell, the basic “rules” for buying or selling options can be summarized like this:
- If an investor thinks the price of the underlying asset will increase, then they will likely buy a call or sell a put. The put seller will receive the premium but will not have to buy the underlying asset unless the put buyer exercises the contract.
- If an investor thinks the price of the underlying asset will drop, then they will likely buy a put or sell a call. The call seller will receive the premium but will not have to sell the underlying asset unless the call buyer exercises the contract.
- If an investor thinks the price of the underlying asset will stagnate for a while, then they could sell a put or a call to collect the premiums.
The goal of selling options is to generate income. It is a risky strategy and is not recommended for investors new to the field of options trading because it can expose the seller to the risk of significant loss.
Placing an options trade
Options contracts are similar to other securities in that they can be traded on a listed or OTC exchange.
When placing an options trade – either buying or selling – the investor will first find a way to place the trade. Nowadays, most large online brokerages offer options trading. However, given that trading options is a bit more complex, brokerages may offer an options screener to gauge the knowledge and experience level of the investor, including whether they have sufficient total and liquid net worth for the strategies they want to engage in. Brokerages use this process to protect both themselves and the investor.
Once an account is approved and funded, then the investor is ready to place their trades. Prior to doing this, it is advisable that the investor go through a checklist that should include:
- Deciding on the goal they're trying to achieve (e.g., income, hedging or speculation)
- Deciding on their approach and/or attitude to the market (all options trades are classified as either bearish, bullish or neutral)
- Deciding on the type of option to trade, whether it’s a call or a put
- Deciding on whether to be the buyer or the seller of that option
- Selecting the strike price, the amount and the time until expiration
- Factoring in the premium costs that will be paid or collected
- Placing the trade
The bottom line
Trading options is not recommended for individuals who are new to the investing process. However, for those who have taken the time to learn about the intricacies of options trading, it can be an additional tool that could potentially enhance their portfolios. Consider speaking with a J.P. Morgan advisor to help you determine whether options are suitable for you.
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Editorial staff, J.P. Morgan Wealth Management
