What is options trading? Basics for beginners
Editorial staff, J.P. Morgan Wealth Management
- Options are contracts that give the owner the right – but not the obligation – to buy or sell an underlying security at a set price by a fixed date.
- The four types of options trading are buying calls, selling calls, buying puts and selling puts.
- Three popular reasons to trade options are the cost efficiency they may provide, risk management (if used properly) and potential consistent income generation (in certain situations).
When you think of options, you may think of the choices you have to make when deciding what to eat for breakfast or what to wear to work.
In the investing world, options are financial contracts that give investors the right, but not the obligation, to buy or sell an underlying asset like a stock at an agreed-upon price and date.
What is options trading?
Options trading is a way to buy and sell contracts. These contracts (options) give the owner the right to buy or sell the underlying security, like stocks, at a set price by a set date.
To trade options, there are three components you need to understand:
- Strike price: The price that’s assigned to the buyer if they exercise their right to buy or sell the underlying asset (i.e., the investor has the right to buy a stock for $15 per share).
- Expiration date: The date when the option contract becomes invalid or expires.
- Premium: The cost for buying the option, which is paid to the seller.
If you buy an option, you want its value to go up so you can sell it for more than your purchase price, allowing you to profit from the difference. If you sell an option, you want its value to go down or expire worthless so you can keep the premium you collected upfront without having to buy back the option or fulfill the obligation.
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How does options trading work?
Options trading usually happens through a brokerage platform, which serves as the middleman between the two parties: buyer and seller. If the value of the contract goes up, the buyer can sell it for profit. If it stays the same or decreases, the seller keeps the premium the buyer paid. It is crucial to understand the risks involved, as options trading can lead to significant losses.
There are two main types of contracts in options trading: calls and puts.
Calls
The buyer of a call pays a premium for the right, but not the obligation, to buy an asset – such as a stock – at the strike price on or before the option’s expiration date. If the buyer exercises the option on or before the expiration date, the seller has the obligation to sell that asset to the buyer at the strike price. The seller receives the premium regardless of whether the contract is exercised or not. Here are some examples:
Buying a call: Chad thinks a stock is going to increase above a certain price within the next three months. Instead of buying the stock outright and tying up the full cost of the share, he decides to buy an option on the stock with an expiration of three months out.
He pays a premium for the ability to buy the stock at a set price. If on the expiration date, the stock is below the strike price, the option expires worthless, and Chad has lost the premium he paid. If the option is above the strike price, Chad gets to participate in the stock’s appreciation by buying the stock below the current market value. In all cases, Chad pays the premium for this option.
Selling a call: Mayra owns shares of ABC and does not expect that it will increase very much over the next three months. Mayra doesn’t want to sell her shares yet because she thinks the stock will appreciate in the long term. She wants to find a way to earn a bit of extra income from this stock. She sells a call option with a strike price that is above the current market price and collects a premium.
If in three months’ time, the stock remains below the strike price, Mayra has benefitted from receiving the premium but also doesn’t need to sell her stock. If the stock does increase above the strike price, Mayra must sell her shares at the strike price and will miss out on any potential gains above the strike price. This is known as a covered call. If Mayra were to sell a naked call, she would not own the stock at the outset and would have to buy the shares if the buyer exercised the option, which exposes her to an unlimited loss; this strategy has significantly more risk than a covered call and is used by more experienced investors.
These examples are for educational purposes only and do not constitute investment advice. Options trading involves significant risks, and investors should consult with a financial advisor before engaging in such strategies.
Puts
Let’s say that you sell an asset – such as a stock – at the strike price on or before the expiration date. If the buyer exercises the option on or before the expiration date, the seller has the obligation to buy that asset from the option buyer at the strike price. The seller receives the premium regardless of whether the contract is exercised or not. Here are some examples:
Buying a put: Tom owns shares in ABC that he wants to keep, but he would like to protect part of his gains in case the stock price goes down. He may consider buying a put option that gives him the right to sell ABC at a predetermined price.
If ABC declines considerably in value, he can exercise this option and sell the shares at the strike price, which would be higher than the market price. This locks in a minimum sale price for the shares until the contract expires. If ABC’s shares go up in value, the put will expire worthless and Tom will lose his investment in the option (the premium he paid).
Selling a put: Kelly thinks the price of a stock will go up in the long term. She sells a put and collects the premium. If the buyer exercises the put, Kelly has the obligation to buy ABC shares from the buyer at the agreed-upon strike price. If the price of the stock goes down below the strike price, Kelly has to buy the stock at the strike price and therefore will have to pay the difference between the strike price and the market price.
In any event, the only profit Kelly is guaranteed is the premium she received for selling the put. If Kelly is selling a cash-secured put, she has to set aside in her brokerage account the amount of money she would need to buy the shares at the strike price.
What types of investment accounts allow options trading?
While most people tend to trade options in a regular, taxable brokerage account, certain options strategies are permitted in eligible IRA accounts as well. These include covered calls, cash-secured puts, long calls and long puts. Because IRAs are designed for retirement savings, regulations prohibit riskier strategies like uncovered options or trading on margin. Consulting with a professional is essential to determine if options trading aligns with your long-term strategy. You can apply with your broker to trade options in your IRA cash account if you meet certain eligibility requirements.
There are certain risks and benefits to trading options in an IRA, so it is important to consult with a professional if you are unsure whether it meets your long-term strategy. In general, options trading is a strategy better utilized by experienced investors because there is the potential for significant losses if a trade does not go as expected. Meanwhile, some benefits include the potential for earnings to grow tax-deferred or tax-free. This means you can reinvest your gains without immediate tax consequences, potentially leading to greater compounding over time.
How can I trade options in my IRA?
Trading options in an IRA works similarly to a regular brokerage account, but with a few important differences. You must have enough cash or stock in the account to support the trade. That means:
- A covered call must be backed by shares you already own.
- A cash-secured put must be backed by enough cash to buy the stock if assigned.
- Long calls and puts must be fully paid for at the time of purchase.
- Because IRAs can't use margin, trades must be fully funded – adding a layer of discipline and risk control.
Pros and cons of options trading
There are upsides and risks to any form of investing. That said, options trading may be a particularly high-risk, high-reward strategy.
Potential benefits
There are many reasons someone may want to trade options, but three common ones include:
- Cost efficiency: Options allow investors to control a larger position with a small amount of capital. Additionally, they may offer a less expensive way for investors to express which direction they expect the underlying asset’s price will move. For example, an investor who expects a stock to increase in value could buy the right to buy more stock if it goes above their strike price by buying options. The cost (premium) to buy this right will be less than actually buying the stock at a future higher price. The downside is that if the stock’s price never gets above the strike price, the investor loses the premium they paid.
- Manage risk: Investors may use options to mitigate the risks to their portfolio. For example, a traditional buy-and-hold investor who is aware of the ups and downs of the stock market may want to use put options to protect the unrealized gains in their portfolio. In doing so, they may be guarding against unexpected market declines that could wipe out more of their gains than they had anticipated. The cost for this “insurance” is the premium they pay.
- Generate income: Finally, investors may use options as an income generator. Basically, this involves selling options to collect premiums. This strategy may be risky because it requires a thorough understanding of options and is usually practiced by more experienced investors.
- Compounding potential: By generating income or limiting losses, options strategies may help you stay invested through market ups and downs. Over time, that stability can support compounding – where gains build on gains.
- Strategic entry and exit points: Cash-secured puts may allow you to buy stock at a lower effective price, while long puts can serve as a form of downside protection – especially in uncertain markets.
Potential risks
As with any type of speculative activity, trading options involves risks. For options buyers, the risk is the loss of their premiums if the options expire worthless.
For option sellers, the risk is potentially higher – especially for sellers of call options. For the put seller, the underlying asset could go to zero, and they would be liable for the difference between where the put buyer exercised and zero. For the call option seller, the risk can be much more, as the price of the underlying asset could, in theory, be unlimited. If the call buyer exercises the option, then the call seller is obligated to sell the underlying asset to them and is exposed to infinite risk.
With both puts and calls, if the option you sell expires worthless on the expiration date, the seller of the option earns the premium.
Like all investment decisions, buying and selling options comes with risks that you should consider carefully first. It’s important to ensure any options trades you engage in line up with your risk tolerance and long-term investment goals.
Options trading example
Say an investor is bullish on ABC stock over the long term (meaning they believe the stock price will rise) but isn’t sure about its short-term prospects. The investor doesn’t want to buy the stock at its current market price of $50 per share and wait for the stock’s price to rise. In this scenario, buying a call option may be a strategy to consider.
After research, the investor decides to buy one ABC 55 call option that expires in six months for $1. This means that, if the call is exercised, then the investor will have bought 100 shares at $55 per share. (Stock options are standardized at 100 shares per one option contract). This option is “out of the money (OTM),” meaning its strike price is above ABC’s current market price of $50 per share.
Here are some more details about the situation:
- The cost, or premium, for buying this call is $100, or $1 x 100 shares.
- The break-even point would be the cost of the option plus the option’s strike price ($1 + $55). So, it would not make sense for the investor to exercise this call option unless the market price of ABC stock is at least $56. Otherwise, they would lose money.
- If the market price doesn’t reach $56 before the option expires – in this case, six months – then the investor doesn’t exercise the option and loses $100. If, however, the market price exceeds $56, then the investor would exercise it and could potentially sell back the stock right away for a profit.
- The profit would be the difference between the current market price of ABC stock and the investor’s break-even price, or $56 per share. So, if the market price of ABC is at $60 prior to this option’s expiration, then the investor would exercise this option and have a profit of $4 per share ($60 – $56). This would translate to a profit of $400 for all 100 shares.
Measuring risk in options trading
An option’s price can be influenced by several factors. The “Greeks” are a way to measure the risk that these factors can pose. The two most common Greeks are Delta and Gamma.
Delta
This measures the change in an option’s price relative to the change in the underlying asset’s price. A call will have a positive Delta ranging from 0 to 1, while a put will have a negative delta ranging from 0 to -1.
If a call has a Delta of 0.25, then for every $1 up or down in the price of the underlying asset (all else being constant), the price of the call will go up or down by $0.25. Conversely, if a put has a Delta of -0.25, then for every $1 up or down in the price of the underlying asset, the price of the put will go up or down by $0.25.
Gamma
This measures the change in the option’s Delta relative to the change in the underlying asset’s price. For example, a call option with a Delta of 0.25 will see its price rise by $0.25 if the underlying asset’s price rises by $1. However, its Delta will also change.
Say the “new” Delta is 0.30. This relative change of 0.05 [(0.30 − 0.25) / $1] can be thought of as the option’s Gamma. Generally, Gamma is at its highest when the option is “at the money (ATM).” In other words, the option’s Delta will change the most when the option’s strike price is at or near the underlying asset’s market price.
The bottom line
Options trading may provide an opportunity for certain kinds of investors, but it comes with a lot of risk. Buyers can lose all the money they spent on an option, and sellers can be on the hook for big losses if prices rise. It’s important to ensure any options trades you engage in line up with your risk tolerance and long-term investment goals. Consider connecting with a J.P. Morgan advisor to see if options may be a good fit for your investment strategy or if you have any questions.
Frequently asked questions about options trading
There are several ways someone may use options to hedge against risk. Let’s dive into two examples. First, imagine you own a stock that you believe will go up in value, but you want some protection in case of an unexpected downturn. You could buy a put option on that stock, locking in a specific selling price for the duration of the contract. If the stock falls below the strike price, you can minimize your losses by selling your shares at above-market prices, minus the option premium you paid.
In another example, a business that depends on a commodity, like natural gas, might buy a call option to hedge against a price increase, locking in a price ceiling until the expiration date.
The Commodity Futures Trading Commission (CFTC) is an independent federal agency with regulatory responsibilities over U.S. derivatives markets, including options on commodities, futures and swaps. The Securities and Exchange Commission (SEC) regulates options on stocks and other securities.
No form of investing is “better” than another universally. You always have to take into account things like risk tolerance, your portfolio, available funds and long-term goals.
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Editorial staff, J.P. Morgan Wealth Management
