A Newbie's Guide to Reading an Options Chain

Options have a language all of their own, and when you begin to trade options, the information may
seem overwhelming. When looking at an options chart, it first seems like rows of random numbers,
but options chain charts provide valuable information about the security today and where it might
be going in the future.

Not all public stocks have options, but for those that do, the information is presented in real-time
and in a consistent order. Learning the language of an option chain can help investors become more
informed, which can make all the difference between making or losing money in the options
markets.

Key Takeaways

An option chain has two sections: calls and puts. A call option gives the right to buy a stock while a
put gives the right to sell a stock.

The price of an options contract is called the premium, which is the upfront fee that an
investor pays for purchasing the option.
• An option's strike price is also listed, which is the stock price at which the investor buys the
stock if the option is exercised.
• Options list various expiry dates, which impact an option's premium.
• Finding Options Information
• Real-time option chains can be found on most of the financial websites online with stock
prices. These include Yahoo Finance, The Wall Street Journal Online, and online trading
sites, such as Charles Schwab and TD Ameritrade.1234
• In most sites, if you find the chart of the underlying stock, there will be a link to the related
options chains.

What an Options Chain Tells You

Options contracts allow investors to buy or sell a security at a preset price. Options derive their
value from the underlying security or stock, which is why they're considered derivatives.

Calls and Puts

Options chains are listed in two sections: calls and puts. A call option gives you the right (but not
the obligation) to purchase 100 shares of the stock at a certain price up to a certain date. A put
option also gives you the right (and again, not the obligation) to sell 100 shares at a certain price up
to a certain date. Call options are always listed first.
Expiration Date
Options have various expiry dates. For example, you could buy a call option on a stock expiring in
April, or another expiring in July. Options with less than 30 days to their expiry date will start
losing value quickly, as there is less time to execute them. The order of columns in an option chain
is as follows: strike, symbol, last, change, bid, ask, volume, and open interest.
Each option contract has its own symbol, just like the underlying stock does. Options contracts on
the same stock with different expiry dates have different options symbols.

Strike Price
The strike price is the price at which you can buy (with a call) or sell (with a put). Call options with
higher strike prices are almost always less expensive than lower striked calls. The reverse is true for
put options—lower strike prices also translate into lower option prices. With options, the market
price must cross over the strike price to be executable. For example, if a stock is currently trading at
$30.00 per share and you buy a call option for $45, the option is not worth anything until the market
price crosses above $45.

Premium
The last price is the most recent posted trade, and the change column shows how much the last trade
varied from the previous day's closing price. Bid and ask show the prices that buyers and sellers,
respectively, are willing to trade at right now.
Think of options (just like stocks) as big online auctions. Buyers are only willing to pay so much,
and the seller is only willing to accept so much. Negotiating happens at both ends until the bid and
ask prices start coming closer together.
Finally, either the buyer will take the offered price or the seller will accept the buyer's bid and a
transaction will occur. With some options that do not trade very often, you may find the bid and ask
prices very far apart. Buying an option like this can be a big risk, especially if you are a new options
trader.
The price of an options contract is called the premium, which is the upfront fee that a buyer pays to
the seller through their broker for purchasing the option. Option premiums are quoted on a per-share
basis, meaning that an options contract represents 100 shares of the stock. For example, a $5
premium for a call option would mean that that investor would need to pay $500 ($5 * 100 shares)
for the call option to buy that stock.

Fluctuation
The option's premium fluctuates constantly as the price of the underlying stock changes. These
fluctuations are called volatility and impact the likelihood of an option being profitable. If a stock
has little volatility, and the strike price is far from the stock's current price in the market, the option
has a low probability of being profitable at expiry. If there's little chance the option will be
profitable, the premium or cost of the option is low.
Conversely, the higher the probability a contract could be profitable, the higher the premium.
Other factors impact the price of an option, including the time remaining on an options contract as
well as how far into the future the expiration date is for the contract. For example, the premium will
decrease as the options contract draws closer to its expiration since there's less time for an investor
to make a profit.
Conversely, options with more time remaining until expiry have more opportunities for the stock
price to move beyond the strike and be profitable. As a result, options with more time remaining
typically have higher premiums.
Open Interest and Volume
While the volume column shows how many options traded in a particular day, the open interest
column shows how many options are outstanding. Open interest is the number of options that exist
for a stock and include options that were opened in days prior. A high number of open interest
means that investors are interested in that stock for that particular strike price and expiration date.
Open interest is important because investors want to see liquidity, meaning there's enough demand
for that option so that they can easily enter and exit a position. However, high open interest doesn't
necessarily provide an indication that the stock will rise or fall, since for every buyer of an option,
there's a seller. In other words, just because there's a high demand for an option, it doesn't mean
those investors are correct in their directional views of the stock.

In- or Out-of-the-Money Options

Both call and put options can be either in or out of the money, and this information can be critical
in making your decision about which option to invest in. In-the-money options have strike prices
that have already crossed over the current market price and have underlying value.
For example, if you buy a call option with a current strike price of $35 and the market price is
$37.50, the option already has an intrinsic value of $2.50. Intrinsic value is merely the difference
between the strike price of an option and the current stock price. You could buy it and immediately
sell it for a profit. That guaranteed profit is already built into the price of the option, and in-the-
money options are always far more expensive than out of the money ones.
In other words, the premium for the option also comes into play in determining profitability. If the
$35 strike option had a $5 premium, the option wouldn't be profitable enough to exercise (or cash
out) even though there's $2.50 in intrinsic value. It's important that investors factor in the cost of the
premium when calculating the potential profitability of a trade.
If an option is out of the money, it means the strike price hasn't yet crossed the market price. You
are wagering the stock will go up in price (for a call) or down in price (for a put) before the option
expires. If the market price doesn't move in the direction you wanted, the option expires worthless.
Below is a table that shows the relationship between an option's strike price and the stock's price for
call and put options. Please note that the term underlying represents the price of the stock that's
being traded through the options contract.

The Bottom Line

Knowing how to read options chains is an integral skill to master because it can help you make bet-
ter investing decisions and come out on the winning side more often.
What Is an Option?
The term option refers to a financial instrument that is based on the value of underlying securities
such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on
the type of contract they hold—the underlying asset. Unlike futures, the holder is not required to
buy or sell the asset if they decide against it.
Each options contract will have a specific expiration date by which the holder must exercise their
option. The stated price on an option is known as the strike price. Options are typically bought and
sold through online or retail brokers.

Key Takeaways
 Options are financial derivatives that give buyers the right, but not the obligation, to buy or
sell an underlying asset at an agreed-upon price and date.
 Call options and put options form the basis for a wide range of option strategies designed for
hedging, income, or speculation.
 Options trading can be used for both hedging and speculation, with strategies ranging from
simple to complex.
 Although there are many opportunities to profit with options, investors should carefully
weigh the risks.

Understanding Options
Options are versatile financial products. These contracts involve a buyer and seller, where the buyer
pays a premium for the rights granted by the contract. Call options allow the holder to buy the asset
at a stated price within a specific timeframe. Put options, on the other hand, allow the holder to sell
the asset at a stated price within a specific timeframe. Each call option has a bullish buyer and a
bearish seller while put options have a bearish buyer and a bullish seller.1
Traders and investors buy and sell options for several reasons. Options speculation allows a trader
to hold a leveraged position in an asset at a lower cost than buying shares of the asset. Investors use
options to hedge or reduce the risk exposure of their portfolios.
In some cases, the option holder can generate income when they buy call options or become an op-
tions writer. Options are also one of the most direct ways to invest in oil. For options traders, an op-
tion's daily trading volume and open interest are the two key numbers to watch in order to make the
most well-informed investment decisions.
American options can be exercised any time before the expiration date of the option, while Euro-
pean options can only be exercised on the expiration date or the exercise date. Exercising means uti-
lizing the right to buy or sell the underlying security.
Types of Options
Calls
A call option gives the holder the right, but not the obligation, to buy the underlying security at the
strike price on or before expiration. A call option will therefore become more valuable as the under-
lying security rises in price (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising, since it has unlimited up-
side potential but the maximum loss is the premium (price) paid for the option.

Puts
Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the
underlying stock at the strike price on or before expiration. A long put, therefore, is a short position
in the underlying security, since the put gains value as the underlying's price falls (they have a nega-
tive delta). Protective puts can be purchased as a sort of insurance, providing a price floor for in-
vestors to hedge their positions.

American vs. European Options

American options can be exercised at any time between the date of purchase and the expiration
date. European options are different from American options in that they can only be exercised at
the end of their lives on their expiration date.
The distinction between American and European options has nothing to do with geography, only
with early exercise. Many options on stock indexes are of the European type. Because the right to
exercise early has some value, an American option typically carries a higher premium than an other-
wise identical European option. This is because the early exercise feature is desirable and com-
mands a premium.
In the U.S., most single stock options are American while index options are European.

Special Considerations
Options contracts usually represent 100 shares of the underlying security. The buyer pays a pre-
mium fee for each contract.1 For example, if an option has a premium of 35 cents per contract, buy-
ing one option costs $35 ($0.35 x 100 = $35). The premium is partially based on the strike price or
the price for buying or selling the security until the expiration date.
Another factor in the premium price is the expiration date. Just like with that carton of milk in the
refrigerator, the expiration date indicates the day the option contract must be used. The underlying
asset will determine the use-by date. For stocks, it is usually the third Friday of the contract's
month.

Options Spreads
Options spreads are strategies that use various combinations of buying and selling different options
for the desired risk-return profile. Spreads are constructed using vanilla options, and can take ad-
vantage of various scenarios such as high- or low-volatility environments, up- or down-moves, or
anything in-between.
Spread strategies can be characterized by their payoff or visualizations of their profit-loss profile,
such as bull call spreads or iron condors.

Options Risk Metrics: The Greeks

The options market uses the term the "Greeks" to describe the different dimensions of risk involved
in taking an options position, either in a particular option or a portfolio. These variables are called
Greeks because they are typically associated with Greek symbols.
Each risk variable is a result of an imperfect assumption or relationship of the option with another
underlying variable. Traders use different Greek values to assess options risk and manage op-
tion portfolios.3

Delta
Delta (Δ) represents the rate of change between the option's price and a $1 change in the underlying
asset's price. In other words, the price sensitivity of the option relative to the underlying. Delta of
a call option has a range between zero and one, while the delta of a put option has a range between
zero and negative one.4 For example, assume an investor is long a call option with a delta of 0.50.
Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by
50 cents.
Delta also represents the hedge ratio for creating a delta-neutral position for options traders.4 So if
you purchase a standard American call option with a 0.40 delta, you need to sell 40 shares of stock
to be fully hedged. Net delta for a portfolio of options can also be used to obtain the portfolio's
hedge ratio.
A less common usage of an option's delta is the current probability that it will expire in-the-money.
For instance, a 0.40 delta call option today has an implied 40% probability of finishing in-the-
money.

Theta
Theta (Θ) represents the rate of change between the option price and time, or time sensitivity -
sometimes known as an option's time decay. Theta indicates the amount an option's price would de-
crease as the time to expiration decreases, all else equal.5 For example, assume an investor is long
an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes,
all else being equal. If three trading days pass, the option's value would theoretically decrease by
$1.50.
Theta increases when options are at-the-money, and decreases when options are in- and out-of-the
money. Options closer to expiration also have accelerating time decay. Long calls and long puts
usually have negative Theta. Short calls and short puts, on the other hand, have positive Theta. By
comparison, an instrument whose value is not eroded by time, such as a stock, has zero Theta.

Gamma
Gamma (Γ) represents the rate of change between an option's delta and the underlying asset's price.
This is called second-order (second-derivative) price sensitivity. Gamma indicates the amount the
delta would change given a $1 move in the underlying security.6 Let's assume an investor is long
one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10.
Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or de-
crease by 0.10.
Gamma is used to determine the stability of an option's delta. Higher gamma values indicate that
delta could change dramatically in response to even small movements in the underlying's price.
Gamma is higher for options that are at-the-money and lower for options that are in- and out-of-the-
money, and accelerates in magnitude as expiration approaches.
Gamma values are generally smaller the further away from the date of expiration. This means that
options with longer expirations are less sensitive to delta changes. As expiration approaches,
gamma values are typically larger, as price changes have more impact on gamma.
Options traders may opt to not only hedge delta but also gamma in order to be delta-gamma neutral,
meaning that as the underlying price moves, the delta will remain close to zero.

Vega
Vega (V) represents the rate of change between an option's value and the underlying asset's implied
volatility. This is the option's sensitivity to volatility. Vega indicates the amount an option's price
changes given a 1% change in implied volatility.7 For example, an option with a Vega of 0.10 indi-
cates the option's value is expected to change by 10 cents if the implied volatility changes by 1%.
Because increased volatility implies that the underlying instrument is more likely to experience ex-
treme values, a rise in volatility correspondingly increases the value of an option. Conversely, a de-
crease in volatility negatively affects the value of the option. Vega is at its maximum for at-the-
money options that have longer times until expiration.
Those familiar with the Greek language will point out that there is no actual Greek letter named
vega. There are various theories about how this symbol, which resembles the Greek letter nu, found
its way into stock-trading lingo.

Rho
Rho (p) represents the rate of change between an option's value and a 1% change in the interest rate.
This measures sensitivity to the interest rate. For example, assume a call option has a rho of 0.05
and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to
$1.30, all else being equal. The opposite is true for put options. Rho is greatest for at-the-money op-
tions with long times until expiration.

Minor Greeks
Some other Greeks, which aren't discussed as often, are lambda, epsilon, vomma, vera,
speed, zomma, color, ultima.
These Greeks are second- or third-derivatives of the pricing model and affect things like the change
in delta with a change in volatility. They are increasingly used in options trading strategies as com-
puter software can quickly compute and account for these complex and sometimes esoteric risk fac-
tors.
Advantages and Disadvantages of Options
Buying Call Options
As mentioned earlier, call options allow the holder to buy an underlying security at the stated strike
price by the expiration date called the expiry. The holder has no obligation to buy the asset if they
do not want to purchase the asset. The risk to the buyer is limited to the premium paid. Fluctuations
of the underlying stock have no impact.
Buyers are bullish on a stock and believe the share price will rise above the strike price before the
option expires. If the investor's bullish outlook is realized and the price increases above the strike
price, the investor can exercise the option, buy the stock at the strike price, and immediately sell the
stock at the current market price for a profit.
Their profit on this trade is the market share price less the strike share price plus the expense of the
option—the premium and any brokerage commission to place the orders. The result is multiplied by
the number of option contracts purchased, then multiplied by 100—assuming each contract repre-
sents 100 shares.
If the underlying stock price does not move above the strike price by the expiration date, the option
expires worthlessly. The holder is not required to buy the shares but will lose the premium paid for
the call.

Selling Call Options

Selling call options is known as writing a contract. The writer receives the premium fee. In other
words, a buyer pays the premium to the writer (or seller) of an option. The maximum profit is the
premium received when selling the option. An investor who sells a call option is bearish and be-
lieves the underlying stock's price will fall or remain relatively close to the option's strike price dur-
ing the life of the option.
If the prevailing market share price is at or below the strike price by expiry, the option expires
worthlessly for the call buyer. The option seller pockets the premium as their profit. The option is
not exercised because the buyer would not buy the stock at the strike price higher than or equal to
the prevailing market price.
However, if the market share price is more than the strike price at expiry, the seller of the option
must sell the shares to an option buyer at that lower strike price. In other words, the seller must ei-
ther sell shares from their portfolio holdings or buy the stock at the prevailing market price to sell to
the call option buyer. The contract writer incurs a loss. How large of a loss depends on the cost ba-
sis of the shares they must use to cover the option order, plus any brokerage order expenses, but less
any premium they received.
As you can see, the risk to the call writers is far greater than the risk exposure of call buyers. The
call buyer only loses the premium. The writer faces infinite risk because the stock price could con-
tinue to rise increasing losses significantly.

Buying Put Options

Put options are investments where the buyer believes the underlying stock's market price will fall
below the strike price on or before the expiration date of the option. Once again, the holder can sell
shares without the obligation to sell at the stated strike per share price by the stated date.
Since buyers of put options want the stock price to decrease, the put option is profitable when the
underlying stock's price is below the strike price. If the prevailing market price is less than the strike
price at expiry, the investor can exercise the put. They will sell shares at the option's higher strike
price. Should they wish to replace their holding of these shares they may buy them on the open mar-
ket.
Their profit on this trade is the strike price less the current market price, plus expenses—the pre-
mium and any brokerage commission to place the orders. The result would be multiplied by the
number of option contracts purchased, then multiplied by 100—assuming each contract represents
100 shares.
The value of holding a put option will increase as the underlying stock price decreases. Conversely,
the value of the put option declines as the stock price increases. The risk of buying put options is
limited to the loss of the premium if the option expires worthlessly.

Selling Put Options

Selling put options is also known as writing a contract. A put option writer believes the underlying
stock's price will stay the same or increase over the life of the option, making them bullish on the
shares. Here, the option buyer has the right to make the seller, buy shares of the underlying asset at
the strike price on expiry.
If the underlying stock's price closes above the strike price by the expiration date, the put option ex-
pires worthlessly. The writer's maximum profit is the premium. The option isn't exercised because
the option buyer would not sell the stock at the lower strike share price when the market price is
more.
If the stock's market value falls below the option strike price, the writer is obligated to buy shares of
the underlying stock at the strike price. In other words, the put option will be exercised by the op-
tion buyer who sells their shares at the strike price as it is higher than the stock's market value.
The risk for the put option writer happens when the market's price falls below the strike price. The
seller is forced to purchase shares at the strike price at expiration. The writer's loss can be signifi-
cant depending on how much the shares depreciate.
The writer (or seller) can either hold on to the shares and hope the stock price rises back above the
purchase price or sell the shares and take the loss. Any loss is offset by the premium received.
An investor may write put options at a strike price where they see the shares being a good value and
would be willing to buy at that price. When the price falls and the buyer exercises their option, they
get the stock at the price they want with the added benefit of receiving the option premium.
Pros
 A call option buyer has the right to buy assets at a lower price than the market when the
stock's price rises
 The put option buyer profits by selling stock at the strike price when the market price is be-
low the strike price
 Option sellers receive a premium fee from the buyer for writing an option
Cons
 The put option seller may have to buy the asset at the higher strike price than they would
normally pay if the market falls
  The call option writer faces infinite risk if the stock's price rises and are forced to buy shares
at a high price
 Option buyers must pay an upfront premium to the writers of the option

Example of an Option
Suppose that Microsoft (MFST) shares trade at $108 per share and you believe they will increase in
value. You decide to buy a call option to benefit from an increase in the stock's price. You purchase
one call option with a strike price of $115 for one month in the future for 37 cents per contact. Your
total cash outlay is $37 for the position plus fees and commissions (0.37 x 100 = $37).
If the stock rises to $116, your option will be worth $1, since you could exercise the option to ac-
quire the stock for $115 per share and immediately resell it for $116 per share. The profit on the op-
tion position would be 170.3% since you paid 37 cents and earned $1—that's much higher than the
7.4% increase in the underlying stock price from $108 to $116 at the time of expiry.
In other words, the profit in dollar terms would be a net of 63 cents or $63 since one option contract
represents 100 shares [($1 - 0.37) x 100 = $63].
If the stock fell to $100, your option would expire worthlessly, and you would be out $37 premium.
The upside is that you didn't buy 100 shares at $108, which would have resulted in an $8 per share,
or $800, total loss. As you can see, options can help limit your downside risk.

Options Terminology to Know

Options trading involves a lot of lingo, here are just some of the key terminology to know the mean-
ings of:
 At-the-money (ATM) - an option whose strike price is exactly that of where the underlying
is trading. ATM options have a delta of 0.50.
 In-the-money (ITM) - an option with intrinsic value, and a delta greater than 0.50. For a call,
the strike price of an ITM option will be below the current price of the underlying; for a put,
above the current price.
 Out-of-the-money (OTM) - an option with only extrinsic (time) value and a delta a less than
0.50. For a call, the strike price of an OTM option will be above the current price of the un-
derlying; for a put, below the current price.
 Premium - the price paid for an option in the market
 Strike price - the price at which you can buy or sell the underlying, also known as the exer-
cise price.
 Underlying - the security upon which the option is based
 Implied volatility (IV) - the volatility of the underlying (how quickly and severely it moves),
as revealed by market prices
 Exercise - when an options contract owner exercises the right to buy or sell at the strike
price. The seller is then said to be assigned.
 Expiration - the date at which the options contract expires, or ceases to exist. OTM options
will expire worthless.
The Basics of Option Prices
Options are contracts that give option buyers the right to buy or sell a security at a predetermined
price on or before a specified day. The price of an option, called the premium, is composed of a
number of variables. Options traders need to be aware of these variables so they can make an in-
formed decision about when to trade an option.
When investors buy options, the biggest driver of outcomes is the price movement of the underlying
security or stock. Call option buyers of stock options need the underlying stock price to rise,
whereas put option buyers need the stock's price to fall.
However, there are many other factors that impact the profitability of an options contract. Some of
those factors include the stock option price or premium, how much time is remaining until the con-
tract expires, and how much the underlying security or stock fluctuates in value.

Key Takeaways
 Options prices, known as premiums, are composed of the sum of its intrinsic and time value.
 Intrinsic value is the price difference between the current stock price and the strike price.
 An option's time value or extrinsic value of an option is the amount of premium above its in-
trinsic value.
 Time value is high when more time is remaining until expiry since investors have a higher
probability that the contract will be profitable.

Understanding the Basics of Option Prices

Options contracts provide the buyer or investor with the right, but not the obligation, to buy and sell
an underlying security at a preset price, called the strike price. Options contracts have an expiration
date called an expiry and trade on options exchanges. Options contracts are derivatives because they
derive their value from the price of the underlying security or stock.1
A buyer of an equity call option would want the underlying stock price to be higher than the strike
price of the option by expiry. On the other hand, a buyer of a put option would want the underlying
stock price to be below the put option strike price by the contract's expiry.
There are many factors that can impact the value of an option's premium and ultimately, the prof-
itability of an options contract. Below are two of the key components that comprise of an option's
premium and ultimately whether it's profitable, called in the money (ITM), or unprofitable, called
out of the money (OTM).

Intrinsic Value
One of the key drivers for an option's premium is the intrinsic value. Intrinsic value is how much of
the premium is made up of the price difference between the current stock price and the strike price.
For example, let's say an investor owns a call option on a stock that is currently trading at $49 per
share. The strike price of the option is $45, and the option premium is $5. Because the stock price is
currently $4 more than the option's strike price, then $4 of the $5 premium is comprised of intrinsic
value.
In the example, the investor pays the $5 premium upfront and owns a call option, with which it can
be exercised to buy the stock at the $45 strike price. The option isn't going to be exercised until it's
profitable or in-the-money. We can figure out how much we need the stock to move in order
to profit by adding the price of the premium to the strike price: $5 + $45 = $50. The break-even
point is $50, which means the stock must move above $50 before the investor can profit (excluding
broker commissions).
In other words, to calculate how much of an option's premium is due to intrinsic value, an investor
would subtract the strike price from the current stock price. Intrinsic value is important because if
the option premium is primarily made up intrinsic value, the option's value and profitability are
more dependent on movements in the underlying stock price. The rate at which a stock price fluctu-
ates is called volatility.

Measuring Intrinsic Value

An option's sensitivity to the underlying stock's movement is called delta. A delta of 1.0 tells in-
vestors that the option will likely move dollar for dollar with the stock, whereas a delta of 0.6 means
the option will move approximately 60 cents for every dollar the stock moves.
The delta for puts is represented as a negative number, which demonstrates the inverse relationship
of the put compared to the stock movement. A put with a delta of -0.4 should increase by 40 cents
in value if the stock drops $1 per share.

Time Value
The time remaining until an option's expiration has a monetary value associated with it, which is
known as time value. The more time that remains before the option's expiry, the more time value is
embedded in the option's premium.
In other words, time value is the portion of the premium above the intrinsic value that an option
buyer pays for the privilege of owning the contract for a certain period. As a result, time value is of-
ten referred to as extrinsic value.
Investors are willing to pay a premium for an option if it has time remaining until expiration be-
cause there's more time to earn a profit. The longer the time remaining, the higher the premium
since investors are willing to pay for that extra time for the contract to become profitable or have in-
trinsic value.
Remember, the underlying stock price needs to move beyond the option's strike price in order to
have intrinsic value. The more time that remains on the contract, the higher the probability the
stock's price could move beyond the strike price and into profitability. As a result, time value plays
a significant role, in not only determining an option's premium but also the likelihood of the con-
tract expiring in-the-money.

Time Decay
Over time, the time value decreases as the option expiration date approaches. The less time that re-
mains on an option, the less incentive an investor has to pay the premium since there's less time to
earn a profit. As the option's expiration date draws near, the probability of earning a profit becomes
less likely, resulting in an increasing decline in time value. This process of declining time value is
called time decay.
Typically, an options contract loses approximately one-third of its time value during the first half of
its life. Time value decreases at an accelerating pace and eventually reaches zero as the option's ex-
piration date draws near.
Time value and time decay both play important roles for investors in determining the likelihood of
profitability on an option. If the strike price is far away from the current stock price, there needs to
be enough time remaining on the option to earn a profit. Understanding time decay and the pace at
which time value erodes is key in determining whether an option has any chance of having intrinsic
value.
Options with more extrinsic value are less sensitive to the stock's price movement while options
with a lot of intrinsic value are more in sync with the stock price.

Measuring Time Value

Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient
market timing because theta eats away at the premium. A common mistake option investors make is
allowing a profitable trade to sit long enough that theta reduces the profits substantially.
For example, a trader may buy an option for $1, and see it increase to $5. Of the $5 premium, only
$4 is intrinsic value. If the stock price doesn't move any further, the premium of the option will
slowly degrade to $4 at expiry. A clear exit strategy should be set before buying an option.

Time Value and Volatility

The rate at which a stock's price fluctuates, called volatility, also plays a role in the probability of an
option expiring in the money. Implied volatility, also known as vega, can inflate the option pre-
mium if traders expect volatility.
Implied volatility is a measure of the market's view of the probability of stock's price changing in
value. High volatility increases the chance of a stock moving past the strike price, so options traders
will demand a higher price for the options they are selling.
This is why well-known events like earnings are often less profitable for option buyers than origi-
nally anticipated. While a big move in the stock may occur, option prices are usually quite high be-
fore such events, which offsets the potential gains.
Conversely, when a stock price is very calm, option prices tend to fall, making them relatively
cheap to buy. However, unless volatility expands again, the option will stay cheap, leaving little
room for profit.

The Bottom Line

An option's value or premium is determined by intrinsic and extrinsic value. Intrinsic value is the
moneyness of the option, while extrinsic value has more components. Before booking an options
trade, consider the variables in play and have an entry and exit strategy.
How Do Options Work?
Options are a type of derivative product that allow investors to speculate on or hedge against the
volatility of an underlying stock. Options are divided into call options, which allow buyers to profit
if the price of the stock increases, and put options, in which the buyer profits if the price of the stock
declines. Investors can also go short an option by selling them to other investors. Shorting (or sell-
ing) a call option would therefore mean profiting if the underlying stock declines while selling a put
option would mean profiting if the stock increases in value.

What Are the Main Advantages of Options?

Options can be very useful as a source of leverage and risk hedging. For example, a bullish investor
who wishes to invest $1,000 in a company could potentially earn a far greater return by purchasing
$1,000 worth of call options on that firm, as compared to buying $1,000 of that company’s shares.
In this sense, the call options provide the investor with a way to leverage their position by increas-
ing their buying power.
On the other hand, if that same investor already has exposure to that same company and wants to re-
duce that exposure, they could hedge their risk by selling put options against that company.

What Are the Main Disadvantages of Options?

The main disadvantage of options contracts is that they are complex and difficult to price. This is
why options are considered to be a security most suitable for experienced professional investors. In
recent years, they have become increasingly popular among retail investors. Because of their capac-
ity for outsized returns or losses, investors should make sure they fully understand the potential im-
plications before entering into any options positions. Failing to do so can lead to devastating losses.

How Do Options Differ From Futures?

Both options and futures are types of derivatives contracts that are based off of some underlying as-
set or security. The main difference is that options contracts grant the right but not the obligation to
buy or sell the underlying in the future. Futures contracts have this obligation.

Is an Options Contract an Asset?

Yes, an options contract is a derivatives security, which is a type of asset.

The Bottom Line

Options are a type of derivative product that allow investors to speculate on or hedge against the
volatility of an underlying stock. Options are divided into call options, which allow buyers to profit
if the price of the stock increases, and put options, in which the buyer profits if the price of the stock
declines. Investors can also go short an option by selling them to other investors. Shorting (or sell-
ing) a call option would therefore mean profiting if the underlying stock declines while selling a put
option would mean profiting if the stock increases in value.
Getting Acquainted With Options Trading
What Is Stock Options Trading?
Trading options is very different from trading stocks because options have distinct characteristics
from stocks. Investors need to take the time to understand the terminology and concepts involved
with options before trading them.
Options are financial derivatives, meaning that they derive their value from the underlying security
or stock. Options give the buyer the right, but not the obligation, to buy or sell the underlying stock
at a pre-determined price.1

Key Takeaways
 Options give a buyer the right, but not the obligation, to buy (call) or sell (put) the underly-
ing stock at a pre-set price called the strike price.
 Options have a cost associated with them, called a premium, and expiration date.
 A call option is profitable when the strike price is below the stock's market price since the
trader can buy the stock at a lower price.
 A put option is profitable when the strike is higher than the stock's market price since the
trader can sell the stock at a higher price

Understanding Stock Options Trading

Trading options is more like betting on horses at the racetrack: Each person bets against all the
other people there. The track simply takes a small cut for providing the facilities. So trading op-
tions, like betting at the horse track, is a zero-sum game. The option buyer's gain is the option
seller's loss and vice versa.
One important difference between stocks and options is that stocks give you a small piece of owner-
ship in a company, while options are just contracts that give you the right to buy or sell the stock at
a specific price by a specific date.
It's important to remember that there are always two sides to every option transaction: a buyer and a
seller. In other words, for every option purchased, there's always someone else selling it.

Types of Options
The two types of options are calls and puts. When you buy a call option, you have the right, but not
the obligation, to purchase a stock at a set price, called the strike price, any time before the option
expires. When you buy a put option, you have the right, but not the obligation, to sell a stock at the
strike price any time before the expiration date.1
When individuals sell options, they effectively create a security that didn't exist before. This is
known as writing an option, and it explains one of the main sources of options since neither the as-
sociated company nor the options exchange issues the options.1
When you write a call, you may be obligated to sell shares at the strike price any time before the ex-
piration date. When you write a put, you may be obligated to buy shares at the strike price any time
before expiration.1
There are also two basic styles of options: American and European. An American-style option can
be exercised at any time between the date of purchase and the expiration date. A European-style op-
tion can only be exercised on the expiration date. Most exchange-traded options are American style,
and all stock options are American style. Many index options are European style.2

Option Pricing
The price of an option is called the premium. The buyer of an option can't lose more than the initial
premium paid for the contract, no matter what happens to the underlying security. So the risk to the
buyer is never more than the amount paid for the option. The profit potential, on the other hand, is
theoretically unlimited.
In return for the premium received from the buyer, the seller of an option assumes the risk of having
to deliver (if a call option) or taking delivery (if a put option) of the shares of the stock. Unless that
option is covered by another option or a position in the underlying stock, the seller's loss can be
open-ended, meaning the seller can lose much more than the original premium received.
Please note that options are not available at just any price. Stock options are generally traded with
strike prices in intervals of $0.50 or $1, but can also be in intervals of $2.50 and $5 for higher-
priced stocks. Also, only strike prices within a reasonable range around the current stock price are
generally traded. Far in- or out-of-the-money options might not be available.

Option Profitability
When the strike price of a call option is above the current price of the stock, the call is not profitable
or out-of-the-money. In other words, an investor is not going to buy a stock at a higher price (the
strike) than the current market price of the stock. When the call option strike price is below the
stock's price, it's considered in-the-money since the investor can buy the stock for a lower price than
in the current market.
Put options are the exact opposite. They're considered out-of-the-money when the strike price is be-
low the stock price since an investor wouldn't sell the stock at a lower price (the strike) than in the
market. Put options are in the money when the strike price is above the stock price since investors
can sell the stock at a higher (strike) price than the market price of the stock.

Expiration Dates
All stock options expire on a certain date, called the expiration date. For normal listed options, this
can be up to nine months from the date the options are first listed for trading. Longer-term option
contracts, called long-term equity anticipation securities (LEAPS), are also available on many
stocks. These can have expiration dates up to three years from the listing date.3
Options expire at market close on Friday, unless it falls on a market holiday, in which case expira-
tion is moved back one business day. Monthly options expire on the third Friday of the expiration
month, while weekly options expire on each of the other Fridays in a month.4
Unlike shares of stock, which have a two-day settlement period, options settle the next day.5 To set-
tle on the expiration date, you have to exercise or trade the option by the end of the day on Friday.
Stock Option Trading FAQs
What Is a Stock Options Contract?
A stock option contract entitles the owner of the contract to 100 shares of the underlying stock upon
expiration. So, if you purchase seven call option contracts, you are acquiring the right to purchase
700 shares. And, if the owner of a call option decides to exercise their right to buy the stock at a
particular price, the option writer must deliver the stock at that price.

What Do Stock Options Cost?

Options contracts usually represent 100 shares of the underlying security, and the buyer will pay a
premium fee for each contract. For example, if an option has a premium of $0.55 per contract, buy-
ing one option would cost $55 ($0.55 x 100 = $55).

How Do You Make Money Trading Options?

You can make money by being an option buyer or an option writer. If you are a call option buyer,
you can make a profit if the underlying stock rises above the strike price before the expiration date.
If you are a put option buyer, you can make a profit if the price falls below the strike price before
the expiration date.

Is Options Trading Better Than Stocks?

Options trading can be riskier than trading stocks. However, when it is done properly, it can be
more profitable for the investor than traditional stock market investing.

4 Ways to Trade Options

Long/short calls and long/short puts
While there are many exotic-sounding variations, there are ultimately only four basic positions to
trade in the options market: You can either buy or sell call options, or buy or sell put options. In es-
tablishing a new position, options traders can either buy or sell to open. Existing positions are can-
celed by either selling or buying to close.
Regardless of which side of the trade you take, you're making a bet on the price direction of the un-
derlying asset. But the buyer and seller of options stand to profit in very different ways.

Key Takeaways
 There are four basic options positions: buying a call option, selling a call option, buying a
put option, and selling a put option.
 With call options, the buyer is betting that the market price of an underlying asset will ex-
ceed a predetermined price, called the strike price, while the seller is betting it won't.
 With put options, the option buyer is betting the market price of an underlying asset will fall
below the strike price, while the seller is betting it won't.
  Buyers of call or put options are limited in their losses to the cost of the option (it's pre-
mium). Unhedged sellers of options face theoretically unlimited losses.
 Spreads with options involve simultaneously buying and selling different options contracts
on the same underlying

Trading Call Options

A call option gives the buyer, or holder, the right to buy the underlying asset—such as a stock, cur-
rency, or commodity futures contract—at a predetermined price before the option expires. As the
name "option" implies, the holder has the right to buy the asset at the agreed price—called the strike
price—but not the obligation.
Every option is essentially a contract, or bet, between two parties. In the case of call options, the
buyer is betting that the price of the underlying asset will be higher on the open market than the
strike price—and that it will exceed the strike price before the option expires. If so, the option buyer
can buy that asset from the option seller at the strike price and then resell it for a profit.
The buyer of a call option must pay an upfront fee for the right to make that deal. The fee, called a
premium, is paid at the outset to the seller, who is betting the asset's market price won't be higher
than the price specified in the option. In most basic options, that premium is the profit the seller
seeks. It is also the risk exposure, or maximum loss, of the option buyer. The premium is based on a
percentage of the size of the possible trade.

Trading Put Options

A put option, on the other hand, gives the buyer the right to sell an underlying asset at a specified
price on or before a certain date. In this case, the buyer of the put option is essentially shorting the
underlying asset, betting that its market price will fall below the strike price in the option. If so, they
can buy the asset at the lower market price and then sell it to the option seller, who is obligated to
buy it at the higher, agreed strike price.
Again, the put seller, or writer, is taking the other side of the trade, betting the market price won't
fall below the price specified in the option. For making this bet, the put seller receives a premium
from the option buyer.
Call and put options have a risk metric known as the delta. The delta tells you how much the op-
tion's price will tend to change given a $1 move in the underlying security.

To Open vs. to Close

There are additional terms to know when executing these four basic trades. The phrase "buy to
open" refers to a trader buying either a put or call option that establishes a new position. Buying to
open increases the open interest in a particular option, and increasing open interest can signal
greater liquidity and point to market expectations. "Sell to close" is when the holder of the options
(i.e., the original buyer of the option) closes out their call or put position by selling it for either a net
profit or loss. Note that options positions will always expire on the expiration date for a particular
contract. At that point, in-the-money options will be exercised and out-of-the-money options will
expire worthless. There is no need to sell to close if an options position is held to expiration.
A trader may also "sell to open," establishing a new position that is short either a call or a put. A
short put is actually taking a long position in the underlying market because put options rise in
value as the underlying price declines. When you sell an option "naked" (i.e., unhedged), the option
seller (known sometimes as the writer) is exposed, in theory, to unlimited risk. This is because the
seller of an option receives the premium at the time of the trade, but if a short call position sees a
rapidly rising underlying market, they can quickly see losses mount. "Buy to close" means the op-
tion writer is closing out the put or call option they sold.

Other Options Terminology

In addition to these four basic options positions, traders can also use options to build spreads or
combinations. A spread involves buying and selling options together on the same underlying, while
a combination is buying (selling) two or more options. Here are a few basics:
 Vertical call/put spread: Buy (sell) one call (put) and sell (buy) and more out-of-the-money
call (put). Vertical spreads that profit in up markets are bull spreads; in down markets bear
spreads.
 Calendar Spread: Buy (sell) an option with one maturity to sell (buy) an option with a differ-
ent maturity.
 Straddle: buying both a call and a put of the same strike and expiration
 Strangle: buying both a call and a put at the same expiration but different (out-of-the-
money) strikes.
 Butterfly: a market-neutral strategy involving buying (selling) a straddle and selling (buy-
ing) a strangle
 Covered Call: sell shares against an existing stock position.
 Protective Put: buy shares against an existing stock position.

Is Trading Options Good for Beginners?

Options are more complex than basic stocks trading and require margin accounts. Therefore, basic
options strategies may be appropriate for certain beginners but only after all risks are understood as
well as how options work. In general, options used to hedge existing positions or for taking long po-
sitions in puts or calls are the most appropriate for less-experienced traders.

What Is the Difference Between a Call Option and a Put

Option?
A call option gives the holder the right (but not the obligation) to buy the underlying asset at a spec-
ified price at or before its expiration. A put contract instead grants the right to sell it.

Can I Lose Money Buying a Call?

If you buy a call, the breakeven price will be the strike price of the call plus the premium (i.e., the
price) paid for it. So, if a $25-strike call is trading at $2.00 when the share price is at $20, the stock
would have to rise above $27.00 before it expires to break even. If not, the trader will lose up to a
maximum of the $2.00 paid for the contract.
Essential Options Trading Guide
Options trading isn't for novices. Find out what you need to
get started.
Options trading may seem overwhelming at first, but it's easy to understand if you know a few key
points. Investor portfolios are usually constructed with several asset classes. These may be stocks,
bonds, ETFs, and even mutual funds.
Options are another asset class, and when used correctly, they offer many advantages that trading
stocks and ETFs alone cannot.

Key Takeaways
 An option is a contract giving the buyer the right—but not the obligation—to buy (in the
case of a call) or sell (in the case of a put) the underlying asset at a specific price on or be-
fore a certain date.
 People use options for income, to speculate, and to hedge risk.
 Options are known as derivatives because they derive their value from an underlying asset.
 A stock option contract typically represents 100 shares of the underlying stock, but options
may be written on any sort of underlying asset from bonds to currencies to commodities.

What Are Options?

Options are contracts that give the bearer the right—but not the obligation—to either buy or sell an
amount of some underlying asset at a predetermined price at or before the contract expires. Like
most other asset classes, options can be purchased with brokerage investment accounts.
Options are powerful because they can enhance an individual’s portfolio. They do this through
added income, protection, and even leverage. Depending on the situation, there is usually an option
scenario appropriate for an investor’s goal. A popular example would be using options as an effec-
tive hedge against a declining stock market to limit downside losses. In fact, options were really in-
vented for hedging purposes. Hedging with options is meant to reduce risk at a reasonable cost.
Here, we can think of using options like an insurance policy. Just as you insure your house or car,
options can be used to insure your investments against a downturn.
Imagine that you want to buy technology stocks, but you also want to limit losses. By using put op-
tions, you could limit your downside risk and enjoy all the upside in a cost-effective way. For short
sellers, call options can be used to limit losses if the underlying price moves against their trade—es-
pecially during a short squeeze.
Options can also be used for speculation. Speculation is a wager on future price direction. A specu-
lator might think the price of a stock will go up, perhaps based on fundamental analysis or technical
analysis. A speculator might buy the stock or buy a call option on the stock. Speculating with a call
option—instead of buying the stock outright—is attractive to some traders because options pro-
vide leverage. An out-of-the-money call option may only cost a few dollars or even cents compared
to the full price of a $100 stock.

Options Are Derivatives

Options belong to the larger group of securities known as derivatives. A derivative's price is depen-
dent on or derived from the price of something else. Options are derivatives of financial securities—
their value depends on the price of some other asset. Examples of derivatives include calls, puts, fu-
tures, forwards, swaps, and mortgage-backed securities, among others.

How Options Work

In terms of valuing option contracts, it is essentially all about determining the probabilities of future
price events. The more likely something is to occur, the more expensive an option that profits from
that event would be. For instance, a call value goes up as the stock (underlying) goes up. This is the
key to understanding the relative value of options.
The less time there is until expiry, the less value an option will have. This is because the chances
of a price move in the underlying stock diminish as we draw closer to expiry. This is why an option
is a wasting asset. If you buy a one-month option that is out of the money, and the stock doesn’t
move, the option becomes less valuable with each passing day. Because time is a component of the
price of an option, a one-month option is going to be less valuable than a three-month option. This
is because with more time available, the probability of a price move in your favor increases, and
vice versa.
Accordingly, the same option strike that expires in a year will cost more than the same strike for
one month. This wasting feature of options is a result of time decay. The same option will be worth
less tomorrow than it is today if the price of the stock doesn’t move.
Volatility also increases the price of an option. This is because uncertainty pushes the odds of an
outcome higher. If the volatility of the underlying asset increases, larger price swings increase the
possibilities of substantial moves both up and down. Greater price swings will increase the chances
of an event occurring. Therefore, the greater the volatility, the greater the price of the option. Op-
tions trading and volatility are intrinsically linked to each other in this way.
On most U.S. exchanges, a stock option contract is the option to buy or sell 100 shares; that's why
you must multiply the contract premium by 100 to get the total amount you’ll have to spend to buy
the call.
What happened to our option investment
May 1 May 21 Expiry Date
Stock Price $67 $78 $62
Option Price $3.15 $8.25 worthless
Contract Value $315 $825 $0
Paper Gain/Loss $0 $510 -$315
The majority of the time, holders choose to take their profits by trading out (closing out) their posi-
tion. This means that option holders sell their options in the market, and writers buy their positions
back to close. Only about 10% of options are exercised, 60% are traded (closed) out, and 30% ex-
pire worthlessly.
Fluctuations in option prices can be explained by intrinsic value and extrinsic value, which is also
known as time value. An option's premium is the combination of its intrinsic value and time value.
Intrinsic value is the in-the-money amount of an options contract, which, for a call option, is the
amount above the strike price that the stock is trading. Time value represents the added value an in-
vestor has to pay for an option above the intrinsic value. This is the extrinsic value or time value. So
the price of the option in our example can be thought of as the following:
Premium = Intrinsic Value + Time Value
$8.25 $8.00 $0.25
In real life, options almost always trade at some level above their intrinsic value, because the proba-
bility of an event occurring is never absolutely zero, even if it is highly unlikely.

Types of Options: Calls and Puts

Options are a type of derivative security. An option is a derivative because its price is intrinsically
linked to the price of something else. If you buy an options contract, it grants you the right but not
the obligation to buy or sell an underlying asset at a set price on or before a certain date.
A call option gives the holder the right to buy a stock and a put option gives the holder the right to
sell a stock. Think of a call option as a down payment on a future purchase.
Options involve risks and are not suitable for everyone. Options trading can be speculative in nature
and carry a substantial risk of loss.

Call Options
A call option gives the holder the right, but not the obligation, to buy the underlying security at the
strike price on or before expiration. A call option will therefore become more valuable as the under-
lying security rises in price (calls have a positive delta).
A long call can be used to speculate on the price of the underlying rising, since it has unlimited up-
side potential but the maximum loss is the premium (price) paid for the option.

Call Option Example

A potential homeowner sees a new development going up. That person may want the right to pur-
chase a home in the future but will only want to exercise that right after certain developments
around the area are built.
The potential homebuyer would benefit from the option of buying or not. Imagine they can buy a
call option from the developer to buy the home at say $400,000 at any point in the next three years.
Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant
such an option for free. The potential homebuyer needs to contribute a down payment to lock in that
right.
With respect to an option, this cost is known as the premium. It is the price of the option contract. In
our home example, the deposit might be $20,000 that the buyer pays the developer. Let’s say two
years have passed, and now the developments are built and zoning has been approved. The home-
buyer exercises the option and buys the home for $400,000 because that is the contract purchased.
The market value of that home may have doubled to $800,000. But because the down payment
locked in a predetermined price, the buyer pays $400,000. Now, in an alternate scenario, say the
zoning approval doesn’t come through until year four. This is one year past the expiration of this
option. Now the homebuyer must pay the market price because the contract has expired. In either
case, the developer keeps the original $20,000 collected.

Put Options
Opposite to call options, a put gives the holder the right, but not the obligation, to instead sell the
underlying stock at the strike price on or before expiration. A long put, therefore, is a short position
in the underlying security, since the put gains value as the underlying's price falls (they have a nega-
tive delta). Protective puts can be purchased as a sort of insurance, providing a price floor for in-
vestors to hedge their positions.

Put Option Example

Now, think of a put option as an insurance policy. If you own your home, you are likely familiar
with the process of purchasing homeowner’s insurance. A homeowner buys a homeowner’s policy
to protect their home from damage. They pay an amount called a premium for a certain amount of
time, let’s say a year. The policy has a face value and gives the insurance holder protection in the
event the home is damaged.
What if, instead of a home, your asset was a stock or index investment? Similarly, if an investor
wants insurance on their S&P 500 index portfolio, they can purchase put options. An investor may
fear that a bear market is near and may be unwilling to lose more than 10% of their long position in
the S&P 500 index. If the S&P 500 is currently trading at $2,500, they can purchase a put option
giving them the right to sell the index at $2,250, for example, at any point in the next two years.
If in six months the market crashes by 20% (500 points on the index), they have made 250 points by
being able to sell the index at $2,250 when it is trading at $2,000—a combined loss of just 10%. In
fact, even if the market drops to zero, the loss would only be 10% if this put option is held. Again,
purchasing the option will carry a cost (the premium), and if the market doesn’t drop during that pe-
riod, the maximum loss on the option is just the premium spent.

Uses of Call and Puts Options

Call options and put options are used in a variety of situations. The table below outlines some use
cases for call and put options.
Call Options Put Options
Buyers of call options use them to hedge against Buyers of put options use them to hedge
their position of a declining price for the security or against their position of a rising price for the
commodity. security or commodity.
American importers can use call options on the American exporters can use put options on the
U.S. dollar to hedge against a decline in their U.S. dollar to hedge against a rise in their
purchasing power. selling costs.
Holders of American depository receipts (ADRs) in
Manufacturers in foreign countries can use put
foreign companies can use call options on the U.S.
options on the U.S. dollar to hedge against a
dollar to hedge against a decline in dividend
decline in their native currency for payment.
payments.
Short sellers have limited gains from put
Short sellers use call options to hedge against their
options because a stock’s price can never fall
positions.
below zero.
How to Trade Options
Many brokers today allow access to options trading for qualified customers. If you want access to
options trading you will have to be approved for both margin and options with your broker. Once
approved, there are four basic things you can do with options:
1. Buy (long) calls
2. Sell (short) calls
3. Buy (long) puts
4. Sell (short) puts
Buying stock gives you a long position. Buying a call option gives you a potential long position in
the underlying stock. Short-selling a stock gives you a short position. Selling a naked or uncovered
call gives you a potential short position in the underlying stock.
Buying a put option gives you a potential short position in the underlying stock. Selling a naked or
unmarried put gives you a potential long position in the underlying stock. Keeping these four sce-
narios straight is crucial.
People who buy options are called holders and those who sell options are called writers of options.
Here is the important distinction between holders and writers:
1. Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice
to exercise their rights. This limits the risk of buyers of options to only the premium spent.
2. Call writers and put writers (sellers), however, are obligated to buy or sell if the option ex-
pires in the money (more on that below). This means that a seller may be required to make
good on a promise to buy or sell. It also implies that option sellers have exposure to more—
and in some cases, unlimited—risks. This means writers can lose much more than the price
of the options premium.
Options can also generate recurring income. Additionally, they are often used for speculative pur-
poses, such as wagering on the direction of a stock.
Note that options trading usually comes with trading commissions: often a flat per-trade fee plus a
smaller amount per contract. For instance, $4.95 + $0.50 per contract.

Examples of Trading Options

Call options and put options can only function as effective hedges when they limit losses and maxi-
mize gains. Suppose you’ve purchased 100 shares of Company XYZ’s stock, betting that its price
will increase to $20. Therefore, your total investment is $1,000. To hedge against the risk that the
price might decline, you purchase one put option (each options contract represents 100 shares of un-
derlying stock) with a strike price of 10, each worth $2 (for a total of $200).
Consider the situation when the stock’s price goes your way (i.e., it increases to $20). In such a sce-
nario, your put options expire worthless. But your losses are limited to the premium paid (in this
case, $200). If the price declines (as you bet it would in your put options), then your maximum
gains are also capped. This is because the stock price cannot fall below zero, and therefore, you can-
not make more money than the amount you make after the stock’s price falls to zero.
Now, consider a situation in which you’ve bet that XYZ’s stock price will decline to $5. To hedge
against this position, you’ve purchased call stock options, betting that the stock’s price will increase
to $20. What happens if the stock’s price goes your way (i.e., it declines to $5)? Your call options
will expire worthless and you will have losses worth $200. There are no upper limits on XYZ’s
price after it takes off. Theoretically, XYZ can go all the way to $100,000 or higher. Therefore,
your gains are not capped and are unlimited.
The table below summarizes gains and losses for options buyers.
Maximum Gain Maximum Loss
Call Buyer Unlimited Premium
Put Buyer Limited Premium

Using Long Calls

As the name indicates, going long on a call involves buying call options, betting that the price of the
underlying asset will increase with time. For example, suppose a trader purchases a contract with
100 call options for a stock that's currently trading at $10. Each option is priced at $2. Therefore,
the total investment in the contract is $200. The trader will recoup her costs when the stock’s price
reaches $12.
Thereafter, the stock’s gains are profits for her. There are no upper bounds on the stock’s price, and
it can go all the way up to $100,000 or even further. A $1 increase in the stock’s price doubles the
trader’s profits because each option is worth $2. Therefore, a long call promises unlimited gains. If
the stock goes in the opposite price direction (i.e., its price goes down instead of up), then the op-
tions expire worthless and the trader loses only $200. Long calls are useful strategies for investors
when they are reasonably certain a given stock’s price will increase.

Writing Covered Calls

In a short call, the trader is on the opposite side of the trade (i.e., they sell a call option as opposed
to buying one), betting that the price of a stock will decrease in a certain time frame. Because it is a
naked call, a short call can have unlimited gains because if the price goes the trader’s way, then they
could rake in money from call buyers.
But writing a call without owning actual stock can also mean significant losses for the trader be-
cause, if the price doesn’t go in the planned direction, then they would have to spend a considerable
sum to purchase and deliver the stock at inflated prices.
A covered call limits their losses. In a covered call, the trader already owns the underlying asset.
Therefore, they don’t need to purchase the asset if its price goes in the opposite direction. Thus, a
covered call limits losses and gains because the maximum profit is limited to the amount of premi-
ums collected. Covered calls writers can buy back the options when they are close to in the money.
Experienced traders use covered calls to generate income from their stock holdings and balance out
tax gains made from other trades.

Long Puts
A long put is similar to a long call except that the trader will buy puts, betting that the underlying
stock’s price will decrease. Suppose a trader purchases a one 10-strike put option (representing the
right to sell 100 shares at $10) for a stock trading at $20. Each option is priced at a premium of $2.
Therefore, the total investment in the contract is $200. The trader will recoup those costs when the
stock’s price falls to $8 ($10 strike - $2 premium).
Thereafter, the stock’s losses mean profits for the trader. But these profits are capped because the
stock’s price cannot fall below zero. The losses are also capped because the trader can let the op-
tions expire worthless if prices move in the opposite direction. Therefore, the maximum losses that
the trader will experience are limited to the premium amounts paid. Long puts are useful for in-
vestors when they are reasonably certain that a stock’s price will move in their desired direction.

Short Puts
In a short put, the trader will write an option betting on a price increase and sell it to buyers. In this
case, the maximum gains for a trader are limited to the premium amount collected. However, the
maximum losses can be unlimited because she will have to buy the underlying asset to fulfill her
obligations if buyers decide to exercise their option.
Despite the prospect of unlimited losses, a short put can be a useful strategy if the trader is reason-
ably certain that the price will increase. The trader can buy back the option when its price is close to
being in the money and generates income through the premium collected.

Combinations
The simplest options position is a long call (or put) by itself. This position profits if the price of the
underlying rises (falls), and your downside is limited to the loss of the option premium spent.
If you simultaneously buy a call and put option with the same strike and expiration, you’ve created
a straddle. This position pays off if the underlying price rises or falls dramatically; however, if the
price remains relatively stable, you lose premium on both the call and the put. You would enter this
strategy if you expect a large move in the stock but are not sure in which direction.
Basically, you need the stock to have a move outside of a range. A similar strategy betting on an
outsized move in the securities when you expect high volatility (uncertainty) is to buy a call and
buy a put with different strikes and the same expiration—known as a strangle. A strangle requires
larger price moves in either direction to profit but is also less expensive than a straddle.
On the other hand, being short a straddle or a strangle (selling both options) would profit from a
market that doesn’t move much.

Spreads
Spreads use two or more options positions of the same class. They combine having a market opin-
ion (speculation) with limiting losses (hedging). Spreads often limit potential upside as well. Yet
these strategies can still be desirable since they usually cost less when compared to a single options
leg. There are many types of spreads and variations on each. Here, we just discuss some of the ba-
sics.
Vertical spreads involve selling one option to buy another. Generally, the second option is the same
type and same expiration but a different strike. A bull call spread, or bull call vertical spread, is cre-
ated by buying a call and simultaneously selling another call with a higher strike price and the same
expiration. The spread is profitable if the underlying asset increases in price, but the upside is lim-
ited due to the short call strike. The benefit, however, is that selling the higher strike call reduces
the cost of buying the lower one. Similarly, a bear put spread, or bear put vertical spread, involves
buying a put and selling a second put with a lower strike and the same expiration. If you buy and
sell options with different expirations, it is known as a calendar spread or time spread.
A butterfly spread consists of options at three strikes, equally spaced apart, wherein all options are
of the same type (either all calls or all puts) and have the same expiration. In a long butterfly, the
middle strike option is sold and the outside strikes are bought in a ratio of 1:2:1 (buy one, sell two,
buy one). If this ratio does not hold, it is no longer a butterfly. The outside strikes are commonly re-
ferred to as the wings of the butterfly, and the inside strike as the body. The value of a butterfly can
never fall below zero. Closely related to the butterfly is the condor—the difference is that the mid-
dle options are not at the same strike price.

Synthetics
Combinations are trades constructed with both a call and a put. There is a special type of combina-
tion known as a “synthetic.” The point of a synthetic is to create an options position that behaves
like an underlying asset but without actually controlling the asset. Why not just buy the stock?
Maybe some legal or regulatory reason restricts you from owning it. But you may be allowed to cre-
ate a synthetic position using options. For instance, if you buy an equal amount of calls as you sell
puts at the same strike and expiration, you have created a synthetic long position in the underlying.
Boxes are another example of using options in this way to create a synthetic loan, an options spread
that effectively behave like a zero-coupon bond until it expires.

American vs. European Options

American options can be exercised at any time between the date of purchase and the expiration
date.1 European options are different from American options in that they can only be exercised at
the end of their lives on their expiration date.2
The distinction between American and European options has nothing to do with geography, only
with early exercise. Many options on stock indexes are of the European type. Because the right to
exercise early has some value, an American option typically carries a higher premium than an other-
wise identical European option. This is because the early exercise feature is desirable and com-
mands a premium.
There are also exotic options, which are exotic because there might be a variation on the payoff pro-
files from the plain vanilla options. Or they can become totally different products all together with
"optionality" embedded in them. For example, binary options have a simple payoff structure that is
determined if the payoff event happens regardless of the degree.
Other types of exotic options include knock-out, knock-in, barrier options, lookback options, Asian
options, and Bermuda options. Again, exotic options are typically for professional derivatives
traders.

Short-Term Options vs. Long-Term Options

Options can also be categorized by their duration. Short-term options are those that generally expire
within a year. Long-term options with expirations greater than a year are classified as long-term eq-
uity anticipation securities, or LEAPs. LEAPs are identical to regular options except that they have
longer durations.
Short-Term Options Long-Term Options LEAPs
Time value does not decay as Time value decay is minimal
Time value and extrinsic value of
rapidly for long-term options for a relatively long period
short-term options decay rapidly due
because they have a longer because the expiration date is
to their short durations.
duration. a long time away.
 Short-Term Options Long-Term Options LEAPs
The main component of
The main component of risk
The main risk component in holding holding long-term options is
in holding LEAPs is an
short-term options is the short the use of leverage, which can
inaccurate assessment of a
duration. magnify losses, to conduct the
stock’s future value.
trade.
They are generally
They are more expensive underpriced because it is
They are fairly cheap to purchase. compared to short-term difficult to estimate the
options. performance of a stock far out
in the future.
They are generally used during
They are generally used as a LEAPs expire in January and
catalyst events for the underlying
proxy for holding shares in a investors purchase them to
stock’s price, such as an earnings
company and with an eye hedge long-term positions in a
announcement or a major news
toward an expiration date. given security.
development.
They can be American- or European- They can be American- or They are American-style
style options. European-style options. options only.
They are taxed at a short-term capital They are taxed at a long-term They are taxed at a long-term
gains rate. capital gains rate. capital gains rate.
Options can also be distinguished by when their expiration date falls. Sets of options now expire
weekly on each Friday, at the end of the month, or even on a daily basis. Index and ETF options
also sometimes offer quarterly expiries.

Reading Options Tables

More and more traders are finding option data through online sources. Though each source has its
own format for presenting the data, the key components of an options table (or options chain) gen-
erally include the following variables:
 Volume (VLM) simply tells you how many contracts of a particular option were traded dur-
ing the latest session.
 The "bid" price is the latest price level at which a market participant wishes to buy a particu-
lar option.
 The "ask" price is the latest price offered by a market participant to sell a particular option.
 Implied Bid Volatility (IMPL BID VOL) can be thought of as the future uncertainty of price
direction and speed. This value is calculated by an option-pricing model such as the Black-
Scholes model and represents the level of expected future volatility based on the current
price of the option.
 An Open Interest (OPTN OP) number indicates the total number of contracts of a particular
option that have been opened. Open interest decreases as open trades are closed.
 Delta can be thought of as a probability. For instance, a 30-delta option has roughly a 30%
chance of expiring in the money. Delta also measures the option's sensitivity to immediate
price changes in the underlying. The price of a 30-delta option will change by 30 cents if the
underlying security changes its price by $1.
 Gamma is the speed the option for moving in or out of the money. Gamma can also be
thought of as the movement of the delta.
  Vega is a Greek value that indicates the amount by which the price of the option would be
expected to change based on a one-point change in implied volatility.
 Theta is the Greek value that indicates how much value an option will lose with the passage
of one day's time.
 The "strike price" is the price at which the buyer of the option can buy or sell the underlying
security if they choose to exercise the option.

Options Risks: The "Greeks"

Because options prices can be modeled mathematically with a model such as the Black-Scholes
model, many of the risks associated with options can also be modeled and understood. This particu-
lar feature of options actually makes them arguably less risky than other asset classes, or at least al-
lows the risks associated with options to be understood and evaluated. Individual risks have been
assigned Greek letter names, and are sometimes referred to simply as "the Greeks."
The basic Greeks include:
 Delta: option's price sensitivity to price changes in the underlying
 Gamma: option's delta sensitivity to price changes in the underlying
 Theta: time decay, or option's price sensitivity to the passage of time
 Vega: option's price sensitivity to changes in volatility
 Rho: option's price sensitivity to interest rate changes

What Does Exercising an Option Mean?

Exercising an option means executing the contract and buying or selling the underlying asset at the
stated price.

Is Trading Options Better Than Stocks?

Options trading is often used to hedge stock positions, but traders can also use options to speculate
on price movements. For example, a trader might hedge an existing bet made on the price increase
of an underlying security by purchasing put options. However, options contracts, especially short
options positions, carry different risks than stocks and so are often intended for more experienced
traders.

What Is the Difference Between American Options and

European Options?
American options can be exercised anytime before expiration, but European options can be exer-
cised only at the stated expiry date.
How Is Risk Measured With Options?
The risk content of options is measured using four different dimensions known as "the Greeks."
These include the Delta, Theta, Gamma, and Vega.

What Are the 3 Important Characteristics of Options?

The three important characteristics of options are as follows:
 Strike price: This is the price at which an option can be exercised.
 Expiration date: This is the date at which an option expires and becomes worthless.
 Option premium: This is the price at which an option is purchased.

How Are Options Taxed?

Call and put options are generally taxed based on their holding duration. They incur capital gains
taxes. Beyond that, the specifics of taxed options depend on their holding period and whether they
are naked or covered.

The Bottom Line

Options do not have to be difficult to understand when you grasp their basic concepts. Options can
provide opportunities when used correctly and can be harmful when used incorrectly.

The Basics of Options Profitability

Options traders can profit by being an option buyer or an option writer. Options allow for potential
profit during both volatile times, regardless of which direction the market is moving. This is possi-
ble because options can be traded in anticipation of market appreciation or depreciation. As long as
the prices of assets like stocks, currencies, and commodities are moving, there is an options strategy
that can take advantage of it.

Key Takeaways
 Options contracts and strategies using them have defined profit and loss—P&L—profiles
for understanding how much money you stand to make or lose.
 When you sell an option, the most you can profit is the price of the premium collected, but
often there is unlimited downside potential.
 When you purchase an option, your upside can be unlimited and the most you can lose is the
cost of the options premium.
 Depending on the options strategy employed, an individual stands to profit from any number
of market conditions from bull and bear to sideways markets.
 Options spreads tend to cap both potential profits as well as losses.
Basics of Option Profitability
A call option buyer stands to make a profit if the underlying asset, let's say a stock, rises above the
strike price before expiry. A put option buyer makes a profit if the price falls below the strike
price before the expiration. The exact amount of profit depends on the difference between the stock
price and the option strike price at expiration or when the option position is closed.
A call option writer stands to make a profit if the underlying stock stays below the strike price. Af-
ter writing a put option, the trader profits if the price stays above the strike price. An option writer's
profitability is limited to the premium they receive for writing the option (which is the option
buyer's cost). Option writers are also called option sellers.

Option Buying vs. Writing

There are fundamental differences between buying and writing options. An option buyer has the
right to exercise the option, while the option writer must exercise the option. Time decay benefits
the option writer and works against an option buyer.
An option buyer can make a substantial return on investment if the option trade works out. This is
because a stock price can move significantly beyond the strike price. For this reason, option buyers
often have greater (even unlimited) profit potential. Alternatively, option writers have compara-
tively limited profit potential that is tied to the premiums received.
An option writer makes a comparatively smaller return if the option trade is profitable. This is be-
cause the writer's return is limited to the premium, no matter how much the stock moves. So why
write options? Option writers receive upfront premium earnings, may collect the full premium
amount regardless of whether the option expires out of the money, and can trade out of liquid op-
tions.

Evaluating Risk Tolerance

Here’s a simple test to evaluate your risk tolerance to determine whether you are better off being an
option buyer or an option writer. Let’s say you can buy or write 10 call option contracts, with the
price of each call at $0.50. Each contract typically has 100 shares as the underlying asset, so 10 con-
tracts would cost $500 ($0.50 x 100 x 10 contracts).
If you buy 10 call option contracts, you pay $500 and that is the maximum loss that you can incur.
However, your potential profit is theoretically limitless. So what’s the catch? The probability of the
trade being profitable is not very high. While this probability depends on the implied volatility of
the call option and the period of time remaining to expiration, let’s say it is 25%.
On the other hand, if you write 10 call option contracts, your maximum profit is the amount of the
premium income, or $500, while your loss is theoretically unlimited. However, the odds of the op-
tions trade being profitable are very much in your favor, at 75%.
So would you risk $500, knowing that you have a 75% chance of losing your investment and a 25%
chance of making a profit? Or would you prefer to make a maximum of $500, knowing that you
have a 75% chance of keeping the entire amount or part of it, but have a 25% chance of the trade
being a losing one?
The answer to those questions will give you an idea of your risk tolerance and whether you are bet-
ter off being an option buyer or option writer.
It is important to keep in mind that these are the general statistics that apply to all options, but at
certain times it may be more beneficial to be an option writer or a buyer of a specific asset. Apply-
ing the right strategy at the right time could alter these odds significantly.
The Securities and Exchange Commission recognizes risks involved in trading options and encour-
ages traders to educate themselves about the various types of options and how basic options strate-
gies work.1

Option Strategies Risk/Reward

While calls and puts can be combined in various permutations to form sophisticated options strate-
gies, let’s evaluate the risk/reward of the four most basic strategies.2

Buying a Call
This is the most basic option strategy. It is a relatively low-risk strategy since the maximum loss is
restricted to the premium paid to buy the call, while the maximum reward is potentially limitless.
Although, as stated earlier, the odds of the trade being very profitable are typically fairly low. "Low
risk" assumes that the total cost of the option represents a very small percentage of the trader's capi-
tal. Risking all capital on a single call option would make it a very risky trade because all the money
could be lost if the option expires worthless.

Buying a Put
This is another strategy with relatively low risk but the potentially high reward if the trade works
out. Buying puts is a viable alternative to the riskier strategy of short selling the underlying asset.
Puts can also be bought to hedge downside risk in a portfolio. But because equity indices typically
trend higher over time, which means that stocks on average tend to advance more often than they
decline, the risk/reward profile of the put buyer is slightly less favorable than that of a call buyer.

Writing a Put
Put writing is a favored strategy of advanced options traders since, in the worst-case scenario, the
stock is assigned to the put writer (they have to buy the stock), while the best-case scenario is that
the writer retains the full amount of the option premium. The biggest risk of put writing is that the
writer may end up paying too much for a stock if it subsequently tanks. The risk/reward profile of
put writing is more unfavorable than that of put or call buying since the maximum reward equals
the premium received, but the maximum loss is much higher. That said, as discussed before, the
probability of being able to make a profit is higher.

Writing a Call
Call writing comes in two forms, covered and naked. Covered call writing is another favorite strat-
egy of intermediate to advanced option traders, and is generally used to generate extra income from
a portfolio. It involves writing calls on stocks held within the portfolio. Uncovered or naked call
writing is the exclusive province of risk-tolerant, sophisticated options traders, as it has a risk pro-
file similar to that of a short sale in stock. The maximum reward in call writing is equal to the pre-
mium received. The biggest risk with a covered call strategy is that the underlying stock will be
“called away.” With naked call writing, the maximum loss is theoretically unlimited, just as it is
with a short sale.
Options Spreads
Often times, traders or investors will combine options using a spread strategy, buying one or more
options to sell one or more different options. Spreading will offset the premium paid because the
sold option premium will net against the options premium purchased. Moreover, the risk and return
profiles of a spread will cap out the potential profit or loss. Spreads can be created to take advantage
of nearly any anticipated price action, and can range from the simple to the complex. As with indi-
vidual options, any spread strategy can be either bought or sold.

Reasons to Trade Options

Investors and traders undertake option trading either to hedge open positions (for example, buying
puts to hedge a long position, or buying calls to hedge a short position) or to speculate on likely
price movements of an underlying asset.
The biggest benefit of using options is that of leverage. For example, say an investor has $900 to
use on a particular trade and desires the most bang-for-the-buck. The investor is bullish in the short
term on XYZ Inc. So, assume XYZ is trading at $90. Our investor can buy a maximum of 10 shares
of XYZ. However, XYZ also has three-month calls available with a strike price of $95 for a cost of
$3. Now, instead of buying the shares, the investor buys three call option contracts. Buying three
call options will cost $900 (3 contracts x 100 shares x $3).
Shortly before the call options expire, suppose XYZ is trading at $103 and the calls are trading at
$8, at which point the investor sells the calls. Here’s how the return on investment stacks up in each
case.
 Outright purchase of XYZ shares at $90: Profit = $13 per share x 10 shares = $130 = 14.4%
return ($130 / $900).
 Purchase of three $95 call option contracts: Profit = $8 x 100 x 3 contracts = $2,400 minus
premium paid of $900 = $1500 = 166.7% return ($1,500 / $900).
Of course, the risk with buying the calls rather than the shares is that if XYZ had not traded above
$95 by option expiration, the calls would have expired worthless and all $900 would be lost.
XYZ had to trade at $98 ($95 strike price + $3 premium paid), or about 9% higher from its price
when the calls were purchased, for the trade just to break even. When the broker's cost to place the
trade is also added to the equation, to be profitable, the stock would need to trade even higher.
These scenarios assume that the trader held till expiration. That is not required with American op-
tions. At any time before expiry, the trader could have sold the option to lock in a profit. Or, if it
looked like the stock was not going to move above the strike price, they could sell the option for its
remaining time value to reduce the loss. For example, the trader paid $3 for the options, but as time
passes, if the stock price remains below the strike price, those options may drop to $1. The trader
could sell the three contracts for $1, receiving $300 of the original $900 back and avoiding a total
loss.
The investor could also choose to exercise the call options rather than selling them to book profits/
losses, but exercising the calls would require the investor to come up with a substantial sum of
money to buy the number of shares their contracts represent. In the case above, that would require
buying 300 shares at $95.
Many private investment firms enter into options contracts. As of March 31, 2022, Berkshire Hath-
away held six open contracts with an aggregate fair value liability of $121 million and an aggregate
notional value of $2.6 billion.3
Selecting the Right Option
Here are some broad guidelines that should help you decide which types of options to trade.

Bullish or Bearish
Are you bullish or bearish on the stock, sector, or the broad market that you wish to trade? If so, are
you rampantly, moderately, or just a tad bullish/bearish? Making this determination will help you
decide which option strategy to use, what strike price to use and what expiration to go for. Let’s say
you are rampantly bullish on hypothetical stock ZYX, a technology stock that is trading at $46.

Volatility
Is the market calm or quite volatile? How about Stock ZYX? If the implied volatility for ZYX is not
very high (say 20%), then it may be a good idea to buy calls on the stock, since such calls could be
relatively cheap.

Strike Price and Expiration

As you are rampantly bullish on ZYX, you should be comfortable with buying out of the money
calls. Assume you do not want to spend more than $0.50 per call option, and have a choice of going
for two-month calls with a strike price of $49 available for $0.50, or three-month calls with a strike
price of $50 available for $0.47. You decide to go with the latter since you believe the slightly
higher strike price is more than offset by the extra month to expiration.
What if you were only slightly bullish on ZYX, and its implied volatility of 45% was three times
that of the overall market? In this case, you could consider writing near-term puts to capture pre-
mium income, rather than buying calls as in the earlier instance.

Option Trading Tips

As an option buyer, your objective should be to purchase options with the longest possible expira-
tion, to give your trade time to work out. Conversely, when you are writing options, go for the
shortest possible expiration to limit your liability.
Trying to balance the point above, when buying options, purchasing the cheapest possible ones may
improve your chances of a profitable trade. The implied volatility of such cheap options is likely to
be quite low, and while this suggests that the odds of a successful trade are minimal, the option may
be underpriced. So, if the trade does work out, the potential profit can be huge. Buying options with
a lower level of implied volatility may be preferable to buying those with a very high level of im-
plied volatility, because of the risk of a higher loss (higher premium paid) if the trade does not work
out.
There is a trade-off between strike prices and options expirations, as the earlier example demon-
strated. An analysis of support and resistance levels, as well as key upcoming events (such as an
earnings release), is useful in determining which strike price and expiration to use.
Understand the sector to which the stock belongs. For example, biotech stocks often trade with bi-
nary outcomes when clinical trial results of a major drug are announced. Deeply out-of-the-money
calls or puts can be purchased to trade on these outcomes, depending on whether one is bullish or
bearish on the stock. It would be extremely risky to write calls or puts on biotech stocks around
such events unless the level of implied volatility is so high that the premium income earned com-
pensates for this risk. By the same token, it makes little sense to buy deeply out of the money calls
or puts on low-volatility sectors like utilities and telecoms.
Use options to trade one-off events such as corporate restructurings and spin-offs, and recurring
events like earnings releases. Stocks can exhibit very volatile behavior around such events, allowing
the savvy options trader an opportunity to cash in. For instance, buying cheap out-of-the-money
calls before the earnings report on a stock that has been in a pronounced slump, can be a profitable
strategy if it manages to beat lowered expectations and subsequently surges.

How Do Options Work in Trading?

Options traders speculate on the future direction of the overall stock market or securities of individ-
ual companies. Instead of outright purchasing shares, options contracts can give you the right but
not obligation to execute a trade at a given price. In return for paying an upfront premium for the
contract, options trading is often used to scale returns at the risk of scaling losses.

What Are the 4 Types of Options?

The four basic types of option positions are buying a call, selling a call, buying a put, and selling a
put. A call is the right to buy a security at a given price. Therefore, a trader can buy a call if it
wishes to own the ability to buy at a certain price. A put is the right to sell a security at a given
price. Therefore, a trader can buy a put if it wishes to own the ability to sell at a certain price. On
the other side of the trade is the option writer who collects an upfront premium for entering into the
contract and selling the option.

When Should You Buy Options?

Options are most useful to capitalize on volatile markets. It doesn't matter which direction the mar-
ket is going; all option traders need is price movement in one direction or the other. In general, it's
usually best to enter into an option position when you expect market volatility to increase and best
to exist an option position when you expect market volatility to decrease. This is because low price
movement is not beneficial for an options contract (especially if the option is current out of the
money).

How Do Call Options Make Money?

A call option writer makes money from the premium they received for writing the contract and en-
tering into the position. This premium is the price the buyer paid to enter into the agreement.
A call option buyer makes money if the price of the security remains above the strike price of the
option. This gives the call option buyer the right to buy shares at a price lower than the market
price.

Can I Sell Options Immediately?

Options contracts can often be bought and sold during normal market hours through a broker on
many regulated exchanges. As long as the market is open, you can usually buy an option and sell it
the next day (assuming the market is also open the following day).
The Bottom Line
Investors with a lower risk appetite should stick to basic strategies like call or put buying, while
more advanced strategies like put writing and call writing should only be used by sophisticated in-
vestors with adequate risk tolerance. As option strategies can be tailored to match one’s unique risk
tolerance and return requirement, they provide many paths to profitability.

ETF Options vs. Index Options: What's the

Difference?
ETF Options vs. Index Options: An Overview
In 1982, stock index futures trading began.1 This marked the first time traders could actually trade a
specific market index itself, rather than the shares of the companies that comprised the index. First
came options on stock index futures, then options on indexes, which could be traded in stock ac-
counts.
Next came index funds, which allowed investors to buy and hold a specific stock index. The latest
burst of growth began with the advent of the exchange-traded fund (ETF) and has been followed by
the listing of options for trading against a wide swath of these new ETFs.

Key Takeaways
 An exchange-traded fund (ETF) is essentially a mutual fund that trades like a stock.
 ETF options are traded the same as stock options, which are "American style" and settle for
shares of the underlying ETF.
 Index options are settled “European style,” which means they are settled in cash.
 Index options cannot be exercised early while ETF options can.

ETFs and ETF Options

An ETF is essentially a mutual fund that trades like an individual stock. As a result, anytime during
the trading day, an investor can buy or sell an ETF that represents or tracks a given segment of the
markets.2 The vast proliferation of ETFs has been another breakthrough that has greatly expanded
the ability of investors to take advantage of many unique opportunities. Investors can now take long
or short positions—as well as in many cases, leveraged long or short positions the following types
of securities:
 Foreign and Domestic Stock Indexes (large-cap, small-cap, growth, value, sector, etc.)
 Currencies (yen, euro, pound, etc.)
 Commodities (physical commodities, financial assets, commodity indexes, etc.)
 Bonds (treasury, corporate, munis international)
As with index options, some ETFs have attracted a great deal of options trading volume while the
majority have attracted very little. Figure 2 displays some of the ETFs that enjoy the most attractive
options trading volume on the Cboe.
ETF Ticker
SPDR S&P 500 ETF Trust SPY
iShares Russell 2000 ETF IWM
Invesco QQQ ETF QQQQ
iShares MSCI Emerging Markets ETF EEM
SPDR Gold Shares GLD
The Financial Select Sector SPDR Fund XLF
The Energy Select Sector SPDR Fund XLE
SPDR Dow Jones Industrial Average ETF Trust DIA
VanEck Semiconductor ETF SMH
VanEck Oil Services ETF OIH
Figure 2: ETFs with Active Option Trading Volume
A reason to consider volume is that many ETFs track the same indexes that straight index options
track, or something very similar. Therefore, you should consider which vehicle offers the best op-
portunity in terms of option liquidity and bid-ask spreads.

Index Options
The listing of options on various market indexes allowed many traders for the first time to trade a
broad segment of the financial market with one transaction. The Cboe Exchange (Cboe) offers
listed options on over 450 domestic, foreign, sector, and volatility-based indexes.3
The first thing to note about index options is that there is no trading going on in the underlying in-
dex itself. It is a calculated value and exists only on paper. The options only allow one to speculate
on the price direction of the underlying index, or to hedge all or some part of a portfolio that might
correlate closely to that particular index.

Key Differences
There are several important differences between index options and options on ETFs. The most sig-
nificant of these revolves around the fact that trading options on ETFs can result in the need to as-
sume or deliver shares of the underlying ETF (this may or may not be viewed as a benefit by some).
This is not the case with index options.
The reason for this difference is that index options are "European" style options and settle in cash,
while options on ETFs are "American" style options and are settled in shares of the underlying se-
curity.45
American options are also subject to "early exercise," meaning that they can be exercised at any
time prior to expiration, thus triggering a trade in the underlying security.4 This potential for early
exercise or having to deal with a position in the underlying ETF can have major ramifications for a
trader.
Index options can be bought and sold prior to expiration; however, they cannot be exercised since
there is no trading in the actual underlying index. As a result, there are no concerns regarding early
exercise when trading an index option.
Special Considerations
The amount of options trading volume is a key consideration when deciding which avenue to go
down in executing a trade. This is particularly true when considering indexes and ETFs that track
the same, or similar, security.
For example, if a trader wanted to speculate on the direction of the S&P 500 Index using options,
they have several choices available. SPDR S&P 500 ETF Trust (SPY) and iShares Core S&P 500
ETF (IVV) each track the S&P 500 Index. Both SPY and IVV trade in great volume and in turn en-
joy very tight bid-ask spreads.67 This combination of high volume and tight spreads indicate that
investors can trade these two securities freely and actively.