Options trading is both similar to stock trading – and very different. If you’ve been asking, “how do options work?” you’ve come to the right place.
What are options?
First, let’s talk about what options are. Options are financial derivative instruments that are contracts between a seller and a buyer. The contract offers the buyer the right, but not the obligation, to purchase the underlying instrument (stock, commodity, index, or bond) at a specific price (called the strike price) by a certain time.
Once the contract deadline passes, the instrument expires. If the option is in the money, the contract is settled in cash or exchanged for shares. If it is out of the money, the option expires worthless.
Before we move on, let’s define in the money and out of the money.
If an option is in the money, it means the stock price has moved higher than the strike price.
If an option is out of the money, it means the stock price has not yet moved higher than the strike price.
How do options work? They give you leverage.
In the stock market, an option gives the buyer or seller the right to control 100 shares of the underlying asset without actually purchasing the shares. Hence, an option trader can control a significant amount of stock for a fraction of the price.
The leverage that options provide is the reason we trade options. You, the trader, need only risk a relatively small amount of capital to achieve extraordinary gains. Sometimes, you can enjoy 10 to 20 times the rate of return of the underlying asset.
How do options work: example trade
Now that you’re excited about the tremendous leverage in options trading, let’s talk about the mechanics.
How do options work: Calls & Puts
Options traders buy and sell call options and put options via the Chicago Board of Options Exchange (CBOE). A call option rises when the price of the underlying asset rises, while a put option rises when the underlying instrument falls. (You can read more about calls v puts here.)
Options expire daily, weekly and monthly. Weekly options expire at the close of trading on a Friday. Monthly options generally expire at the close of trading on the third Friday of the month. In addition, some exchange traded funds (ETF’s) expire each quarter (which may not be on a Friday).
You can find a deeper dive in how to trade options here.