Web Trader MT5 
To some, stock options are a quicker, more sophisticated way of profiting in the market. You may have heard it’s possible to make money in a market, whether it’s going up or down, or that options are less risky than buying a stock. This often results in the same question: how do they work, and how do you start?
If you want to learn how to trade stock options, the first thing to know is: options are not stocks; they are contracts based on stocks.
This makes all the difference. When you purchase a stock, you become a part-owner of a company. When you trade options, you are trading a contract that grants you certain rights associated with the price of a stock over a period.
This is what makes options versatile and complicated. It’s important to know what these contracts are, how they work, and what factors influence their price before you make any trades.
Quick Answer
- Stock options are contracts that allow you to buy (or sell) a stock at a certain price until a certain date.
- Options are contracts and are therefore a derivative
- You can only get started with a brokerage account that allows options trading
- When trading, you select a strike price, expiry date, and pay a premium
- There’s a risk that options could expire without value
- Beginners should initially use simpler strategies before moving to more complicated strategies
What Are Stock Options?
A stock option is a contract that allows you (not obligated) to buy or sell a stock at a fixed price before a specific date.
The underlying asset of each option is the stock to which the option relates. The strike price is the price at which you can buy or sell the stock, and the expiry date is when the contract expires. When you buy the option, you pay a premium, the price of the option.
There are two major types of options: call options and put options. A call option is the right to buy shares, and a put option is the right to sell shares. Both of these contracts can be used to take a particular view on the stock’s future price.
Derivatives are what make options different from stocks. They get their value from the underlying stock, but other components, such as time and market expectations, also influence them. So the price of the option can move even if the price of the underlying stock doesn’t move (or moves very little).
It’s important to understand these factors because each option trade is based on the interplay of these variables.
How Do Stock Options Work?
Stock options work by providing you with the right to take action on price changes within a set time, for a premium.
By purchasing an option, you are paying for the right (not the obligation) to do something. If the market moves in your favor, you can either exercise the option or sell the contract to make money. If not, you can walk away, at a loss of the premium paid.
Time is the key feature of this structure. With options, you don’t keep them forever; they expire. The closer you get to this date, the less the option is worth, even if the stock’s price hasn’t changed much. This is commonly known as time decay.
The other consideration is market expectations, which can be reflected in the option price. Assuming all other factors are equal (including the strike price), if the market is expected to move more before the option expires, the option will be worth more.
These three factors, movement, time, and expectations, affect whether an option is profitable or not.
Call Options
A call option allows you to purchase a stock at the strike price before the option expires.
Call options are generally used if you believe the stock’s price is going up. When the stock price rises above the strike price, the option gains value as it gives you the right to buy the stock at a price below the market price.
But how and when the stock moves is important. If the stock doesn’t move up sufficiently or quickly enough, the option may not be worth as much because of time decay. This is one reason why options are different from owning the underlying stock.
Put Options
A put option allows you to sell a stock at the strike price before the option expires.
Put options are typically used if you think the stock price will decrease. The value of the put option rises if the price of the stock falls below the strike price because you can sell the stock for more than it is worth.
Just like call options, time also plays an important role in put options. If the price doesn’t move in the expected direction within the time frame, the option expires worthless even though the expected movement might have eventually occurred.
How Do You Start Trading Stock Options?
To begin trading options, you must be approved for the type of account and understand how options work.
It begins with opening an account with a brokerage firm and applying for options trading approval. This is an additional step on top of the standard stock trade because of the extra risk. This may depend upon a range of criteria such as experience and financial expertise.
The next learning curve after approval is learning how to read the option chain. The option chain is a list of available options contracts for a stock. Here you will see several strike prices, expiration dates and pricing.
If you are new to options, it is important to focus on understanding how they work before considering any live trading, as losses can occur quickly due to time decay and leverage. For example, the relative price fluctuations of options to the stock may provide insight into the behavior of options.
So the way you really learn to trade options is by repetition. Watching how prices vary, considering how time influences value, and how expectations drive pricing. This stops costly mistakes down the road.
How Do You Place an Options Trade?
To make an options trade, an investor chooses a certain contract that’s based on strike price, expiration date, and other market criteria.
You need to read the option chain to understand how to buy stock options. The contracts also specify the bid and ask prices (the prices buyers are willing to pay and sellers are willing to accept).
The expiry date is the time you have to make the trade; the strike price is the price at which the option is useful. Other indicators, such as open interest, provide information on the volume of trading in the contract, and implied volatility indicates the expected movement in the market.
These factors work together. The longer the time or the greater the expected movement, the higher the cost of the contract because it will have a higher probability of becoming profitable.
When a contract is chosen, the option trade will require confirmation of the details and payment of the premium. Afterward, the value of the option will vary depending on the price movements of the stock and other factors.
What Are the Main Options Strategies for Beginners?
Simple options strategies emphasize learning how various positions react to price changes, rather than making a profit.
The purchase of a call option is a good starting option. This strategy involves anticipating an increase in a stock’s price and the value of the option rising if this occurs during the option period.
Purchasing a put option is the inverse, enabling investors to profit from a stock price drop.
Selling a covered call involves owning a stock and selling an option, which allows the trader to earn income from the premium, but also reduces their profit potential.
A protective put involves holding a stock while buying a put option to hedge against losses.
These are the first things people learn when they ask how to make money trading options, but it’s more important to understand how they work before using them.
How Do You Find Stocks to Trade Options On?
Generally, stocks that are good for trading options are liquid, have good participation and steady pricing.
Liquidity is significant in terms of the ease of execution of trades. Stocks that trade a lot tend to have tighter bid-ask spreads, which makes it easier to get in and out.
Another sign is open interest. Markets with higher open interest tend to be more liquid with better execution as they are generally higher volume.
If you are learning how to find stocks to trade options on, you can start with blue-chip stocks. They tend to be more active with options trading and can assist you in learning how options prices change.
What Are the Risks of Trading Stock Options?
Options trading is high risk and can result in the loss of the entire premium paid. Depending on the strategy used, losses may also be significantly higher in certain positions.
A particular risk is that options expire without value. If the expected price movement doesn’t happen within the time period of the contract, the entire investment could be lost.
Options are leveraged instruments, meaning small movements in the underlying asset can result in disproportionately large gains or losses. Since options enable an investor to control a larger position for less money, profits can be greater, but so will losses.
Then there’s the complexity factor. There are several factors that affect options, such as time and volatility. This can make them more difficult to manage.
It is important to understand these risks; it’s part of being a responsible options trader.
Frequently Asked Questions
A call option is the right to purchase a stock, and a put option is the right to sell a stock.
When buying options the maximum loss is limited to the premium paid. However certain strategies such as selling uncovered options can expose traders to losses exceeding their initial investment.
Yes, options trading requires a special account and additional approval.
This means the option was not profitable before expiration, and the premium is lost.
That’s an indication of how the market thinks the stock will do in the future.
This is an income technique involving owning a stock and selling a call.
Options are time-bound contracts, unlike shares, which involve ownership.
It’s a list of contracts with strike prices, expirations, and other pricing info.
Final Thoughts
Trading options provide a new way to engage with the market, rather than buying shares and waiting.
It involves the interaction of several variables, not just what direction prices will move in. Price, time, and expectations all come into play.
The more you know about these factors, the better your decision-making will be.
Compliance Note
This page is for educational purposes only and does not constitute investment advice. Options are complex, high-risk financial instruments and involve the risk of losing capital. They may not be suitable for all investors. Availability of options trading depends on jurisdiction and the specific products and services offered by your broker. You should ensure you fully understand the risks involved before making any trading decisions.
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