Options Trading: A beginner’s guide
Discover the fundamentals of options trading, beginner-friendly strategies, and tips to manage risks while boosting your investment portfolio.
Updated 
9 min. read
Options trading is a versatile financial strategy that can enhance your investment portfolio. Whether you’re looking to hedge against risks, speculate on market trends, or generate income, options trading offers diverse opportunities. In this guide, we’ll cover the fundamentals of options trading, key terms, beginner-friendly strategies, and address common questions to help you get started confidently.
What is options trading?
Options are financial instruments that allow investors to buy and sell contracts that grant the holder the right — but not the obligation — to buy or sell an underlying asset at a specified price (the “strike price”) within a set timeframe. These underlying assets can include stocks, commodities, or other financial instruments. At its core, options trading offers flexibility and allows investors to capitalize on various market conditions, whether the market is trending upward, downward, or moving sideways. Here's a high-level overview of its key components:
- Underlying Asset: The asset, such as a stock, on which the options contract is based.
- Strike Price: The price at which the holder can buy or sell the underlying asset.
- Expiration Date: The last date by which the holder can exercise their option.
- Premium: The cost of purchasing the options contract, paid by the buyer to the seller.
Benefits of options trading
Options trading comes with unique advantages that can appeal to both novice and seasoned investors:
- Leverage: With a smaller upfront investment (the premium), you can control a larger position in the underlying asset.
- Risk Management: Use options as a hedge to protect your portfolio against potential losses.
- Profit in Any Market Condition: Options allow for strategies that can profit from bullish, bearish, neutral, or volatile markets.
- Income Generation: Selling options can provide a steady income stream through the collection of premiums.
Risks of options trading
While options trading offers significant opportunities, it also involves inherent risks:
- Complexity: Understanding the nuances of options can be challenging for beginners.
- Potential for Total Loss: If an option expires worthless, the buyer loses the entire premium paid.
- Time Decay: Options lose value as they approach their expiration date, which can erode profitability.
- High Volatility: Market fluctuations can lead to rapid changes in an option’s value.
By understanding these benefits and risks, investors can make informed decisions about incorporating options into their investment strategies.
How do options work? Key terms to understand
Option contracts are agreements between buyers and sellers, each with unique terms. Here’s a quick breakdown of essential terms:
| Term | Definition |
|---|---|
| Call Option | Right, but not obligation, to buy an asset at a predetermined price (strike price). |
| Put Option | Right, but not obligation, to sell an asset at a predetermined price (strike price). |
| Strike Price | The agreed-upon price to buy or sell the underlying asset. |
| Premium | The cost paid by the buyer to the seller for the options contract. |
| Expiration Date | The date the option contract expires. |
| Contract Size | One option contract normally represents 100 shares of an underlying security. |
Call options vs. put options: A detailed comparison
Understanding the differences between call and put options is essential for any options trader. Here’s an in-depth comparison:
| Aspect | Call Option Holder | Put Option Holder |
|---|---|---|
| Right | The right, but not obligation, to buy the underlying asset at the strike price. | The right, but not obligation, to sell the underlying asset at the strike price. |
| Market Outlook | Bullish (expecting the price of the asset to rise). | Bearish (expecting the price of the asset to fall). |
| Profit Potential | Unlimited (as the asset price can rise indefinitely). | Limited (the asset price can only fall to $0). |
| Risk | Limited to the premium paid for the option. | Limited to the premium paid for the option. |
| In the Money (ITM) | The stock price is above the strike price. | The stock price is below the strike price. |
| Out of the Money (OTM) | The stock price is below the strike price. | The stock price is above the strike price. |
| Example Use Case | Speculating on a stock price to increase or locking in a purchase price. | Hedging against a decline in stock price or speculating on a stock price to drop. |
A call holder typically uses this contract in a bullish scenario, expecting the asset’s price to rise and potentially realizing substantial gains if that occurs. Meanwhile, a put holder anticipates a price drop and aims to benefit when the asset’s value falls, although gains are inherently limited by the asset’s price floor of zero. For both call and put holders, risk is confined to the premium paid for the option, providing a defined maximum loss. A call is considered “in the money” if the asset’s price exceeds its strike, whereas a put is “in the money” when the asset’s price trades below its strike. Overall, both calls and puts offer distinct ways to speculate on—or hedge against—price movements while capping potential losses at the initial premium.
Options vs. Stocks: What’s the difference?
| Aspect | Options | Stocks |
|---|---|---|
| Ownership | Derivatives; no ownership of the company | Represent Ownership |
| Cost | Lower upfront cost | Higher upfront cost |
| Risk/Reward | Higher potential return and risk than stocks | Lower risk than options |
| Expiration | Fixed expiration date | No expiration date |
| Complexity | Requires intermediate / advanced knowledge | Suitable for beginners |
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Options Trading example
Let’s dive into a detailed example to understand the potential of options trading:
Imagine stock XYZ is currently trading at $50 per share. You believe the price will increase, so you purchase a call option with the following terms:
- Strike Price: $55
- Premium: $2 (total cost: $200, as one contract represents 100 shares)
- Expiration Date: 30 days till expiry
Scenario 1: Stock price rises
If stock XYZ’s price rises to $65 before the option’s expiration then this call option contract would be ‘In The Money’, or ITM, because the underlying price ($65 per share) is greater than the contract’s strike price ($55 per share). There are two scenarios to consider.
Option 1: Sell the option contract
The value of the option contract itself will have increased since the right to purchase shares of Stock XYZ for $55 per share when Stock XYZ is trading for $65 per share is valuable. You could simply sell the option contract. For example, let’s say the option contract is now priced at $10 on the market. Your overall profit would be $800 (less trading commissions). Here’s how that would be calculated:
- Initial Cost of Option Contract: -$200 ($2 contract price x 100)
- Total Sale Value of Option Contract: $1,000 ($10 contract price x 100)
- Net Profit: $800 ($1,000 - $200) less commissions
Option 2: Exercise the option contract
If you exercise the option contract then you would be obligated to buy 100 shares of Stock XYZ for $55 per share. You could then continue to hold the 100 shares of Stock XYZ, or you could sell them at the current market price of $65 per share to lock in your profit. If you did so, your total profit would be $800 (less trading commissions). Here’s how that would be calculated:
- Initial Cost of Option Contract: -$200 ($2 contract price x 100)
- Exercise Option to Buy Stock XYZ at $55 per share: -$5,500 ($55 x 100 shares)
- Sell Stock XYZ at $65 per share: +$6,500 ($65 x 100 shares)
- Net Profit: $800 ($6,500 - $5,500 - $200)
Here’s the corresponding break-even graph for this call option scenario:
Scenario 2: Stock price stagnates
If stock XYZ remains at $50 by the expiration date, the option is considered out of the money (OTM). You could let the option expire, and your total loss would be limited to the premium paid ($200). Alternatively, you can sell the option contract before expiry to reduce your loss.
Scenario 3: Stock price falls
If stock XYZ’s price drops to $45, the option remains out of the money. Again, your total loss is limited to the premium of $200, avoiding further losses that direct stock ownership might incur. You still have the ability to sell the option contract before expiry to reduce your loss.
By limiting your potential loss to the premium paid, options trading provides a cost-effective way to speculate on price movements while managing risk.
Options trading strategies for beginners
Long Calls
A “long call” strategy involves buying a call option in anticipation that the underlying security’s price will rise. If the price does move higher, the investor has two ways to potentially profit before the option expires: they can choose to exercise the call and buy the stock at the (lower) strike price, or they can sell the option contract itself—at a higher price—to capture the increase in its market value. This approach allows confident investors to benefit from upward price movements while limiting their downside risk to the premium paid.
Covered Calls
A covered call strategy involves an investor who already owns a stock selling a call option on that same stock to collect a premium. The goal is typically for the stock price to remain below the call option’s strike price, allowing the option to expire worthless. In that scenario, the investor keeps both their shares and the premium received. This approach can help generate extra income from stock ownership, although it also limits potential gains if the stock price climbs above the strike price.
Long Put
The “long put” strategy is when an investor buys a put option with the hopes that the underlying security decreases before the contract expires. Investors like to use this method because they can take advantage of stock decreasing without having to face major risks.
Married Put
Sometimes called the “synthetic call option,” the married put strategy is when an investor buys a put option that is at-the-money (ATM), while also owning underlying securities in that contract. This method is also known as hedging a security or portfolio. For example, if you owned stock XYZ and additionally bought a put option, this would be a hedge because while XYZ may go down in value, in this case the put option may increase in value offsetting the loss.
It is important to note that options trading can be risky. These particular strategies are commonly used by beginners to gain experience with options, but it’s essential to understand the risks involved and consider your own financial goals and risk tolerance before implementing any strategy. If you want to explore more about options trading, there are several videos covering the basics of call options, put options, and a few option trading strategies, such as writing covered calls, in the learning centre. There is also an in-depth course on options for beginners you can take for free.
Frequently Asked Questions (FAQs) on Options Trading
Options trading typically requires less capital than stock investing. For example, you might pay a $200 premium for an options contract, allowing you to control 100 shares of an asset without needing the full amount to purchase those shares outright. However, selling options may require higher account balances to cover potential obligations.
The potential earnings depend on the strategy and market conditions. For instance, buying call options offers unlimited upside if the stock price rises significantly. Conversely, selling options can generate steady income through premiums, though the risks must be managed carefully.
Learning the basics of options trading, such as call and put options, can take a few weeks. However, mastering advanced strategies like spreads or straddles requires ongoing study and practical experience. Many investors start with small trades while they continue to learn.
Options trading is more complex than stocks because of the added variables, such as expiration dates, strike prices, and premiums. While stock trading is straightforward (buy low, sell high), options require a deeper understanding of market conditions and risk management to execute effectively.
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