Options Trading: How Contracts Work and Why Traders Use Them

Key Takeaways

• Options trading involves contracts that grant rights rather than ownership of shares.
• Options trading includes buying and selling call and put contracts with defined expiration dates.
• Risk, timing, and volatility play central roles in options trading outcomes.

What Is Options Trading?

Options trading is the act of buying or selling option contracts on an exchange. An option contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, before the contract expires.
Unlike stock trading, where ownership changes hands immediately, options trading centers on the potential for future transactions. The value of an option depends on how the underlying asset’s price behaves relative to the strike price and how much time remains before expiration.

The Two Types of Options Traded

There are two fundamental types of options used in options trading: call options and put options.
A call option gives the holder the right to buy the underlying asset at the strike price before expiration. Call options are typically traded when the trader expects the price of the underlying stock to rise.
A put option gives the holder the right to sell the underlying asset at the strike price before expiration. Put options are commonly traded when the trader expects the stock price to fall.
In both cases, the buyer pays a premium for the contract, while the seller receives the premium and takes on the obligation associated with the option.

How Options Trading Works Step by Step

Options trading begins with selecting a contract defined by three main elements: the underlying asset, the strike price, and the expiration date. Each contract represents a standardized number of shares, typically 100.
The trader pays a premium to enter the position. From that point, the option’s value fluctuates based on movements in the underlying stock, changes in volatility, and the passage of time. Traders can exit the position by selling the option before expiration or, in some cases, by exercising it.
Most options trades are closed before expiration rather than exercised. This allows traders to realize gains or limit losses without entering a stock position.

Why People Trade Options

Options trading is used for several distinct purposes.
Some traders use options for speculation, aiming to profit from expected price movements with less upfront capital than buying shares directly. Because options can amplify price movements, small changes in the underlying stock can lead to larger percentage changes in option value.
Others use options for hedging, protecting existing stock positions against unfavorable price movements. For example, buying a put option can limit downside risk for someone who already owns shares.
Options are also used for income strategies, where traders sell options to collect premiums. These strategies typically involve accepting limited upside or downside in exchange for immediate income.

Pricing and Value in Options Trading

The price of an option, known as the premium, reflects several components. One component is intrinsic value, which exists when the option is already profitable based on the current stock price. Another component is time value, which reflects the remaining opportunity for the option to become profitable before expiration.
Volatility plays a critical role in options trading. Higher expected volatility generally increases option premiums because larger price swings raise the probability that the option will move into a profitable range.
Time also affects value. As expiration approaches, time value decreases, a process known as time decay. This makes timing a central consideration in options trading.

Risks Involved in Options Trading

Options trading involves risks that differ from those of stock trading. Option buyers can lose the entire premium if the option expires worthless. Option sellers may face significant losses if the underlying asset moves sharply against their position.
Because options are affected by multiple variables at once, including price direction, volatility, and time, outcomes can be less intuitive than stock trades. This complexity requires careful consideration of risk and position sizing.

Requirements for Options Trading

Most brokers require approval before allowing clients to trade options. This approval process typically considers factors such as trading experience, financial resources, and risk tolerance.
Different levels of approval may be required depending on whether a trader plans to buy options only or engage in more complex strategies that involve selling options.

Frequently Asked Questions

Is Options Trading the same as investing in stocks?

No. Options trading involves contracts that reference stocks rather than ownership of shares. Options have expiration dates and pricing dynamics that do not apply to stocks.

Can beginners trade options?

Beginners can trade options, but understanding basic mechanics and risks is essential before attempting more advanced strategies.

Do all options get exercised?

No. Many options are traded and closed before expiration. Only a portion of options contracts are exercised.

The Bottom Line

Options trading involves buying and selling contracts that grant the right to buy or sell an underlying asset at a predetermined price within a set time frame. By understanding how options contracts work, why traders use them, and how risk and timing influence outcomes, market participants can better evaluate whether options trading fits their financial goals and experience level.