Puts, calls, strike prices, premiums, derivatives, bear put spreads and bull call spreads — the jargon is just one of the complex aspects of options trading. But don’t let any of it scare you away.
Options can provide flexibility for investors at every level and help them manage risk. To see if options trading has a place in your portfolio, here are the basics of what options are, why investors use them and how to get started.
What are options?
An option is a contract to buy or sell a stock, usually 100 shares of the stock per contract, at a pre-negotiated price and by a certain date.
Just as you can buy a stock because you think the price will go up or short a stock when you think its price is going to drop, an option allows you to bet on which direction you think the price of a stock will go. But instead of buying or shorting the asset outright, when you buy an option you’re buying a contract that allows — but doesn’t obligate — you to do a number of things, including:
- Buy or sell shares of a stock at an agreed-upon price (the “strike price”) for a limited period of time.
- Sell the contract to another investor.
- Let the option contract expire and walk away without further financial obligation.
Options trading may sound like it’s only for commitment-phobes, and it can be if you’re simply looking to capitalize on short-term price movements and trade in and out of contracts — which we don’t recommend. But options are useful for long-term buy-and-hold investors, too.
Why use options?
Investors use options for different reasons, but the main advantages are:
- Buying an option requires a smaller initial outlay than buying the stock.
- An option buys an investor time to see how things play out.
- An option protects investors from downside risk by locking in the price without the obligation to buy.
If there’s a company you’ve had your eye on and you believe the stock price is going to rise, a “call” option gives you the right to purchase shares at a specified price at a later date. If your prediction pans out you get to buy the stock for less than it’s selling for on the open market. If it doesn’t, your financial losses are limited to the price of the contract.
You also can limit your exposure to risk on stock positions you already have. Let’s say you own stock in a company but are worried about short-term volatility wiping out your investment gains. To hedge against losses, you can buy a “put” option that gives you the right to sell a particular number of shares at a predetermined price. If the share price does indeed tank, the option limits your losses, and the gains from selling help offset some of the financial hurt.
How to start trading options
In order to trade options, you’ll need a broker. Check out our detailed roundup of the best brokers for options traders, so you can compare commission costs, minimums, and more, as well as our explainer on how to open a brokerage account. Or stay here and answer a few questions to get a personalized recommendation on the best broker for your needs.
More about options and trading
Here are some more of our articles on the ins and outs of trading options:
This post has been updated.