Options trading can be complex and risky for investors. Read to be sure you understand how options work before trading.
Understanding options trading
An option is a contract that gives you the right to buy or sell an investment at a set price within a defined time period.
There are two main types of options: calls and puts.
Settlement typically occurs one business day after an option is exercised or closed.
Trading options involves higher risk than traditional stock trading.
Before you can begin trading options, you must submit an application for each account and have it approved.
What is options trading?
When you buy an option, you gain the right to either buy or sell a specific security (such as a stock) at a locked-in price sometime in the future. As the buyer, you can exercise or close the option before its expiration or allow it to expire.
There are two basic kinds of options: calls and puts. When you buy a call, you’ve locked in the right to purchase a security at a specific price. When you buy a put, you’ve locked in the right to sell a security at a specific price. In both cases, you decide whether to use that right—but the person who wrote (sold) you the option must fulfill their obligation if you do.
Get details on the types of options
Options have many different uses within a portfolio, but it’s important to understand the risks and considerations before applying any options strategy. Unlike owning stocks outright, options provide flexibility and leverage. With options, you can:
- Speculate on price movements.
- Generate income through selling to open contracts.
- Hedge existing positions to manage risk.
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How does options trading work?
Options trading involves several key components that determine an option’s value and behavior.
How contracts are created and traded
When someone writes (sells) an option, they create a contract that another individual or entity can buy. These contracts trade on regulated exchanges like the Chicago Board Options Exchange (CBOE), where buyers and sellers meet to make trades at current market prices.
Options contracts are listed by the options exchanges based on demand. Many contracts that are listed can go without any activity.
Key pricing factors
Here are 3 important terms to know when it comes to options and their pricing:
- Strike price is the price at which you can buy or sell the underlying stock if you exercise the option. Think of it as the price you’ve locked in.
- Premium is what you pay upfront to buy the option itself, and you’re paying this cost regardless of what happens next.
- Expiration date is your deadline. After this date passes, your option becomes worthless if you haven’t used it.
The price of an option is determined by two components:
- Intrinsic value is the real, immediate profit you’d make if you exercised the option right now. For example, if a stock is trading at $55 and you hold a call option with a $50 strike price, you have $5 of intrinsic value built in.
- Extrinsic factors include market volatility and time value—which is how long your option has before its expiration date. Options with a longer time until expiration cost more since there’s more opportunity for the market to move in your favor.
When you put all this together—strike price, time remaining, volatility, current stock price, plus factors like interest rates and dividends—mathematical models calculate what an option should be worth. As any of these inputs change, the option’s price adjusts in response.
Learn key differences between call and put options.
How to trade options
You have 4 ways to make options transactions:
1. Buy to open: An order to purchase an option and establish a new long position (you own the option). When you buy options, you’re paying a premium upfront for the right to buy or sell.
2. Sell to close: An order to sell an option you currently hold (purchased with “buy to open”).
3. Sell to open: An order to write (sell) an option and establish a new short position (you assume the obligation). When you sell options, you’re collecting premium income and assuming the new obligation to buy or sell. While selling options can generate income for your portfolio, it requires careful risk management.
4. Buy to close: An order to buy back an option you previously wrote (sold with “sell to open”).
Understanding when to buy versus when to sell—and which strategy aligns with your market outlook and risk tolerance—is key to effective options trading and long-term portfolio management.
How options settle
Settlement is what happens when an option is exercised—the underlying shares (or cash for certain index options) are transferred between buyer and seller.
Exercise vs. assignment
When you exercise an option, settlement is the process where shares (or cash for certain index options) actually change hands between buyer and seller. For stock options, this means 100 shares per contract are transferred electronically into or out of your brokerage account at the strike price.
It’s important to understand the two sides of this transaction:
- Exercise is when you (the option holder) decide to use your right to buy or sell the shares.
- Assignment is when you (the option seller) are required to fulfill your obligation because someone on the other side exercised their option.
In other words, exercise is your choice; assignment happens to you.
Important note: If your option is “in the money” at expiration—meaning the stock price moves above the strike price (for a call) or below the strike price (for a put) by at least $0.01—most brokerages automatically exercise it unless you say otherwise. The holder of the contract has the right to exercise or not.
Options typically follow a T+1 settlement cycle, which means trade date plus one business day. If you exercise a call option on Monday, you receive the shares and owe payment by Tuesday.
Here are some considerations for buying, selling, and exercising options:
Buying an option
You must have enough money in your settlement fund to cover your purchase when you place an order. You can’t place an order and fund it later.
Selling an option
The trade will settle on the following business day.
Exercising an option
You must place your request through an investment professional by calling 800-992-8327.
Keep in mind that, in most cases, options that are in the money by $0.01 or more are automatically exercised at expiration.
Risks of options trading to consider
Options trading carries significant risks, so it’s important to understand them before participating.
4 key risks to consider:
- Leverage and loss potential. As a buyer, you can lose 100% of the premium you paid if your options expire worthless. As a seller, certain strategies like naked calls expose you to potentially unlimited losses if the underlying stock moves dramatically against your position. Naked puts carry substantial but not unlimited risk—your maximum loss occurs if the stock falls to zero, requiring you to buy worthless shares at the strike price.
- Time decay. Options lose value every day as expiration approaches, a concept known as time decay. Even if you’re correct about price direction, you can still lose money if the move doesn’t happen quickly enough. Time can work against you with every passing day if you own an options contract but can work in your favor if you’re a writer of contracts.
- Illiquidity. Options with low trading volume have wide bid-ask spreads, making it difficult and expensive to enter or exit positions. Illiquid options can put you in unfavorable situations where you can’t close your position at a fair price—or sometimes at all.
- Volatility. Changes in anticipated volatility significantly affect option prices independent of how the stock market actually moves. Your position can lose value even when the stock moves in your favor if market volatility decreases unexpectedly.
Is options trading right for you?
Options require active monitoring, sophisticated market knowledge, and tolerance for potentially losing your entire investment. They’re generally not suitable for:
- Investors with low risk tolerance.
- Those seeking passive, long-term wealth building.
- Beginners without solid stock market fundamentals.
Before you start: Consider whether your investment goals, timeline, and risk appetite truly align with options trading. Many investors achieve better outcomes through traditional buy-and-hold strategies or diversified index funds that don’t require constant attention or expose you to total capital loss.
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