How Do Options Work? Learn the Lingo, Pros, and Cons

How do options work: woman using her mobile phone

Options trading gets a bad rap for being complicated and risky. But investors don’t seem to care, as options are becoming quite popular. When done right, becoming an options trader can actually ease the risk of owning stocks and generate extra cash for retirement. If your interest is piqued, you might be wondering, “How do options work?”

Keep reading to get a refresher on what options are, learn how stock options work, and weigh the pros and cons of options trading.

What Are Options?

Stock options are contracts. They can be bought or sold.

These contracts are binding agreements that give the buyer, also called the option holder, the right to buy or sell shares of a specified company at a specified price within a specified time period. 

Pay attention to one very important phrase in that definition: the right. The option holder gains the right to buy or sell an underlying stock. There is no obligation.

Breaking Down the Basics 

When it comes to options, there is some basic terminology to understand. In the definition, you may have noticed the word “specified” in there a few times. 

Let’s break down each of those variables. 

The specific price at which the option buyer has the right to buy or sell the stock is called the strike price

The specified period of time for the option buyer to buy or sell the stock at the set price ends or “expires” on the expiration date.

One more piece of the equation is what the option seller gets in return. That amount is called the option premium.

For example, on January 1, imagine you buy an options contract that gives you the right to purchase 100 shares of XYZ stock at a predetermined price of $50 per share, but only if you do so before the 25th of the month. You paid $45 for the options contract for this particular stock.

In this example, $50 is the strike price, the expiration date is January 25, and $45 is the premium.

How Do Options Work?

How do options work: TRADE spelled using wooden blocks

So you know what options are, and you know some basic terminology. Let’s dig a little deeper to further understand how they work.

Options Are Derivatives

Before we go any further, it’s important to understand that, in the above example, the $45 premium only gets you the right to purchase XYZ stock. 

You see, options are derivatives. This means that when you trade options, you’re not buying the stock. Instead, you’re buying a contract that derives intrinsic value from shares of the underlying stock, or any type of underlying asset. Other underlying assets for options contracts can include stock index funds, ETFs, bonds, commodities, and foreign currencies.

So based on the current price and your predictions about future movement of the stock price, options can prove to be either very valuable, totally worthless, or somewhere in between.

Two Main Types of Options

There are many types of stock options trading strategies investors can use. For investors who are new to options trading, it’s best to focus on the two most common types: call options and put options.

Call Options

If you buy a call option, you are buying the right to buy a specific number of shares at the strike price at any time before the expiration date. 

  • If you choose to use, or exercise, your call option, the seller of the call option must sell the stock to you. 
  • If you don’t exercise the option, you lose the premium you paid, and the option expires.

You would buy a call option if you expect the share price of the underlying security to rise. 

Let’s say the strike price on the underlying asset is $50. If the stock market value rises above $50 per share before the expiration date, you’d exercise your option and buy XYZ stock at a discount. 

Bottom line: The call option enables you to buy the stock for less than its market price.

If you sell a call option, you are expecting the stock price to decrease. If you sold an option for someone to buy your XYZ stock at $50 per share and the price falls or never rises above $50 per share, the buyer is likely to let the option expire. You pocket the premium and keep your XYZ shares.

Put Options

If you buy a put option, you are buying the right to sell a specific number of shares of an underlying asset at the strike price any time before the expiration date. In other words, you’re locking in a sell price for your shares. You would buy a put option if you expect the price of your shares to drop.

Imagine you buy a put option to sell 100 shares of XYZ stock at $50 per share. The price drops to $42 per share. The put option seller must buy the stock from you if you exercise your option at a price that’s better than the market price.

Bottom line: That put option is protecting you from losses and acting like a hedge to let you profit if the market price of your stock dips.

If you sell a put option, you are expecting the price of the stock to increase. Again, if you sold an option to someone giving them the right to sell the XYZ stock to you and the price never dips below the strike price, the buyer is likely to let the option expire. You don’t have to buy their shares, and you keep the option’s premium.

Pros and Cons of Trading Options

Just like with any investment, there are upsides, and there are downsides. 

The upsides include:

  • Income generation: If you sell options strategically, rather than buy them, you’ll collect the premium. If the option is never exercised, it’s like free money. Of course, this is unlikely to happen 100% of the time.
  • Risk management: If you’ve ever heard of hedging your risk, this is what options trading can do for you. In other words, you can mitigate the risk in your portfolio because you’re essentially merging an options trading strategy with your original investment in the underlying shares. You’re protecting your portfolio from a certain degree of loss should the stock market tank.

The downsides include:

  • Time decay: Hopefully, you’re getting the picture that options are time-sensitive. The tick tock of the clock gets louder as the expiration date approaches and the stock isn’t doing what you had hoped it would. Your risk increases with every day that passes.
  • Forgoing dividends: Dividend investing is an important building block for any portfolio. But when you trade options and obtain stock, the right to collect dividends is not included.

As long as you plan accordingly for the risks, you can figure out a way to take advantage of the benefits.

How to Get Started with Options

There are a few basic steps to go through before you begin trading with options. 

The first is educating yourself. You’re on the right track just by reading this article. Next, it’s time to look at some stocks that you might use as your underlying asset.  

From there, you should perform your due diligence by thoroughly researching the stock and the company to determine what you think will happen to the stock price. Will it rise? Will it fall?

The next step is to begin understanding option quotes. Take a look at the various combinations of strike prices, expiration dates, and premiums. 

Take the Next Step, and Give Options Trading a Try

Man seriously reading the paper while having breakfast

You were wondering about options trading, and you came to the right place. Now you’ve got a basic foundation. You’ve learned the lingo, what options are, the two main types, the pros and cons of this trading strategy, and a little about basic due diligence. 

With all of this under your belt, you might be feeling ready to get started using options trading in your investment strategy. You can try options trading on your own. Or you can choose to get some additional support from the experts. To find the right options trades for your portfolio, subscribe to Investors Alley’s “Options Floor Trader PRO” newsletter, and we’ll walk you through finding and making the right trades.