How Do Options Work? Here's What Beginners Need to Know

As different investing apps make it easier to learn about options and trade them, more people are becoming interested in trying to make money from them. However, as with any investment, it’s a good idea to understand the basics before jumping in.

So, how do options work? Let’s take a look at the ins and outs of options, the pros and cons of trading them, and what you need to know to decide if this investment strategy is a smart fit for you.

What are options?

An option is a contract that allows you the ability to purchase or sell an asset at a set price, as long as you complete the transaction by a certain date. When you trade options, you’re buying or selling a contract, not the underlying asset. When you’re learning how to invest money, this is one of the important distinctions to be aware of.

It’s important to understand that options are derivatives. So rather than buying or selling an asset, including a stock or commodity, you’re buying or selling a contract based on that asset. Potential underlying assets for options usually include individual stocks, stock indexes, ETFs, bonds, commodities, and foreign currencies.

An options contract offers terms for how you can access the underlying asset at a specific price — as long as you do so before the option’s expiration. For example, you might be able to buy an options contract that allows you to purchase shares of a stock at $50 apiece if you do so before the contract’s expiration date. In most cases, an options contract expires on the Saturday following the third Friday of the month, although some contracts might have a specific date.

Additionally, you have to pay attention to the option’s premium, which is listed in the options contract. Many options contracts automatically assume 100 shares of stock, so if there’s a $1.50 premium, you’ll pay $150 upfront just for the privilege to buy the options contract.

Finally, there are two main types of options:

• Call option: This is the right to buy shares at a specified price. As the option holder, if you exercise your right to buy, the seller must provide the shares to you at the price in the contract.
• Put option: On the other hand, a put option gives the contract buyer the right to sell the underlying asset at a specified price. It’s a little confusing, but you are basically purchasing the right to sell.

No matter which type of option you purchase, it’s important to remember that when you buy an option, you’re buying a contract to execute a trade with certain terms before the expiration date. You can sell that contract to someone else (hopefully for more than you bought it for), you can execute the contract and move forward according to the terms, or you can let the option expire and do nothing.

How do options work?

To understand how options work, you first need to understand how options are presented. A good example is a basic stock option. When looking at the option, you might see:

XYZ May 50 Call $1.50

What does this mean? Let’s break it down:

• XYZ indicates the stock ticker symbol. This is the underlying stock involved in the options contract.
• May is the month the option expires.
• 50 provides the amount you can buy or sell the underlying stock for. This is called the strike price and in this case, it is $50.
• Call indicates that this is a call option. So in this case purchasing the option means you’ll gain the ability to purchase the stock in question. If the option were a put option, you’d have the right to sell the underlying stock at $50 per share.
• $1.50 is the premium you’ll pay per share involved. So, if the options contract is a standard 100 shares, you’ll pay $150 as an upfront and non-refundable premium for the contract.

When buying and selling options, you have four options strategies you can take — you can buy calls, sell calls, buy puts, sell puts. As you trade options, you’re buying and selling contracts. So you can buy or sell call contracts, or you can buy or sell put contracts.

Either way, the hope is that if you buy options, you can sell them for more than you originally paid. Or, at the very least, that you can execute the options contract and complete the transaction to get a good deal compared to the current price of the underlying asset.

In-the-money vs out-of-the-money

When understanding how options work, it’s important to know whether you’re in-the-money or out-of-the-money (or, sometimes, at-the-money). This depends on the strike price — the price listed in the options contract as the predetermined price at which you can buy or sell the underlying asset.

If you’re getting a call option, you’re considered in-the-money if the strike price is below the stock price. For example, if you bought an XYZ option and the strike price is $50, you’re in-the-money if the current price of XYZ on the stock market is above $50. Say XYZ goes to $75 a share. You’re entitled to buy 100 shares of the stock at $50. You’re in-the-money because you’re getting a better deal on the stock than what you’d pay on the open market.

On the other hand, you’re out-of-the-money if the underlying asset drops below the strike price. In our example, if XYZ falls to a share price of $40, and you exercise the contract at $50, you end up paying more than market price for your shares because that’s what’s in the contract.

However, with a put option, which is the right to sell the underlying asset, in-the-money versus out-of-the-money works in the opposite way. Because you could potentially sell the underlying asset, you’re in-the-money if the market price falls below the strike price and out-of-the-money if you could sell shares for more on the open market than what’s demanded in the options contract.

When any options contract — whether it’s a call or put option — is at-the-money, that means that the strike price is the same as the market price of the underlying asset.

Pros of options trading

• Can play a role in hedging against the downside risk of other assets that you own.
• You usually have a smaller upfront cost than actually buying the underlying asset.
• You gain the potential to use leverage and magnify gains.
• Gives you the ability to set up complicated trading choices that go beyond simply buying or selling the underlying asset.

Cons of options trading

• You essentially have to be able to predict short-term fluctuations in the prices of the underlying asset.
• Leverage can work against you as well as on your behalf. Borrowing to access more options can mean bigger losses.
• Many options contracts expire worthless with the option holder already having paid the premium.
• In many cases, you’re likely to end up paying short-term capital gains taxes on your profits, which are taxed at a higher rate than long-term gains.

Why do people invest in options?

As with most types of investing and trading, people choose options because they hope it has the potential to help them make money.

One reason some investors like options is due to the way options can help them manage downside risk. Put options can act as a hedge against losses on an underlying asset. For example, let’s say you buy shares of a stock at $15 apiece. You’d like to have the option to sell them, just in case the price drops. So you buy a put option on that stock for $12, allowing you to sell at that strike price within a time period of six months.

If the price of the stock rises above $15 a share by the time the option expires, you do nothing and you’ve lost your premium. However, what if the price of the stock drops to $9 per share in that time frame? Now you can exercise the put option and sell your shares for $12 apiece. Now, instead of losing $6 per share on the stock, you’ve lost $3 per share. You’ve limited your losses.

However, many people are more interested in options for the speculation aspect. The idea is that you can buy a stock call option and sell it later for more than you paid for it if it’s in-the-money. You potentially control access to a greater number of shares through the options contract, and you can use that leverage to increase your profits by selling your options to someone else for more than you paid. For some traders, this is a way to make money quickly, using relatively small amounts of money.

This strategy could also work in the opposite way for put options traders. If you think an asset’s price will fall, buying put options can provide you with a way to make money if you’re right. The asset price drops substantially and you sell the put option to someone who wants to exercise it and sell the underlying asset for more than its market value. Basically, you can sell the contract at a price that allows you to reap the benefit of the difference between the strike price and the market price.

It’s important to note, however, that if you fail to find a buyer, or if you’re wrong about the direction of the price of an underlying asset, you could end up losing much more than expected. Because options trading relies on the ability to correctly assess short-term pricing movements and market events that could impact those prices, you could easily be wrong.

Additionally, during times of high volatility, when exactly you enter or exit an options trade could make a big difference in your profit or loss because price swings over a short period of time can determine whether you’re in-the-money or out-of-the-money.

Is options trading right for you?

Options trading is usually best for those with a relatively high risk tolerance and who have some “fun” money available to play with. When trading options, it’s important to recognize that you could potentially lose more money than you invest if you’re using leverage to buy options on margin. That level of risk isn't right for everyone. If you do decide to move forward with options trading, take the time to understand how the investments work and where they fit into your portfolio. 

Getting started with options trading

It’s possible to buy options with many traditional brokerage accounts. There are also online trading platforms and apps that make it easier to buy and sell options. 

Here are a few apps that can help you get started with options trading: 

• Gatsby is a commission-free options trading app with a minimum investment of $10. Learn more in our Gatsby review. 
• Robinhood is a popular commission-free trading app that offers options trading, crypto trading, and more traditional stocks and bonds. Check out our Robinhood review for more information. 
• Webull also offers commission-free trading in stocks, options, ETFs, and cryptocurrency. It has a higher minimum at $2,000 for margin accounts. Learn about what it has to offer in our Webull review. 

However, it’s important to understand that even though these apps can make it easy to trade options, you should still take the time to understand how they work. In some cases, these apps can make it so easy to trade options that beginners end up losing more than they expected because they don’t fully understand what they’re doing.

FAQs

Bottom line

While some investors like buying and selling options, it’s important to understand that this type of trading comes with its own risks, as well as potential rewards. Before you get started, it’s vital to realize that options are contracts on underlying assets not ownership of assets. They are derivatives as in they derive their value from the underlying assets. Be sure to carefully consider whether options trading is right for you, know how it works, and be prepared for the potential losses before you get started.

If you’re interested in long-term investing as a way to build wealth, you might also want to look through our list of the best investment apps. Some of these can help you purchase fractional shares and get started with very little money, while others will even handle most of the heavy lifting automatically on your behalf. For those hoping to build long-term wealth, especially those who have a low risk tolerance, options trading might not be the best choice.