Options Trading 101

Options Trading 101

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Introduction to Options Trading

Nov. 2, 2016
Investing, Investing Strategy
At NerdWallet, we strive to help you make financial decisions with confidence. To do this, many or all of the products featured here are from our partners. However, this doesn’t influence our evaluations. Our opinions are our own.
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Introduction to Options Trading

Nov. 2, 2016
Investing, Investing Strategy

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 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.

Here’s a comparison of three top brokers:

Merrill




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Open Account


TD Ameritrade' width=


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Open Account


E-Trade


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Open Account


Trade commission

$0




Options contract fee

$0.65 per contract






Promotion

Up to $600



cash credit with qualifying deposit





Trade commission

$0




Options contract fee

$0.65 per contract






Promotion

Up to $600



cash credit with qualifying deposit





Trade commission

$0




Options contract fee

$0.65 per contract



Volume discount available


Promotion

$100 to $2,500



cash credit with qualifying deposit




More about options and trading

Here are some more of our articles on the ins and outs of trading options:

Dayana Yochim is a staff writer at NerdWallet, a personal finance website: Email: [email protected]. Twitter: @DayanaYochim.

This post has been updated.

Options Trading 101

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5 Tips for Choosing an Options Broker

Dec. 9, 2019
Brokers, Investing, Investments
At NerdWallet, we strive to help you make financial decisions with confidence. To do this, many or all of the products featured here are from our partners. However, this doesn’t influence our evaluations. Our opinions are our own.
Advertiser Disclosure

5 Tips for Choosing an Options Broker

Dec. 9, 2019
Brokers, Investing, Investments

Options trading can be complicated. But if you choose your options broker with care, you’ll quickly master how to conduct research, place trades and track positions.

Here’s our advice on finding a broker that offers the service and the account features that best serve your options trading needs.

1. Look for a free education

If you’re new to options trading or want to expand your trading strategies, finding a broker that has resources for educating customers is a must. That education can come in many forms, including:

  • Online options trading courses.
  • Live or recorded webinars.
  • One-on-one guidance online or by phone
  • Face-to-face meetings with a larger broker that has branches across the country.

It’s a good idea to spend a while in student-driver mode and soak up as much education and advice as you can. Even better, if a broker offers a simulated version of its options trading platform, test-drive the process with a paper trading account before putting any real money on the line.

» Learn more: How to open a brokerage account

2. Put your broker’s customer service to the test

Reliable customer service should be a high priority, particularly for newer options traders. It’s also important for those who are switching brokers or conducting complex trades they may need help with.

Consider what kind of contact you prefer. Live online chat? Email? Phone support? Does the broker have a dedicated trading desk on call? What hours is it staffed? Is technical support available 24/7 or only weekdays? What about representatives who can answer questions about your account?

Even before you apply for an account, reach out and ask some questions to see if the answers and response time are satisfactory.

3. Make sure the trading platform is easy to use

Options trading platforms come in all shapes and sizes. They can be web- or software-based, desktop or online only, have separate platforms for basic and advanced trading, offer full or partial mobile functionality, or some combination of the above.

Visit a broker’s website and look for a guided tour of its platform and tools. Screenshots and video tutorials are nice, but trying out a broker’s simulated trading platform, if it has one, will give you the best sense of whether the broker is a good fit.

Some things to consider:

  • Is the platform design user-friendly or do you have to hunt and peck to find what you need?
  • How easy is it to place a trade?
  • Can the platform do the things you need, like creating alerts based on specific criteria or letting you fill out a trade ticket in advance to submit later?
  • Will you need mobile access to the full suite of services when you’re on the go, or will a pared-down version of the platform suffice?
  • How reliable is the website, and how speedily are orders executed? This is a high priority if your strategy involves quickly entering and exiting positions.
  • Does the broker charge a monthly or annual platform fee? If so, are there ways to get the fee waived, such as keeping a minimum account balance or conducting a certain number of trades during a specific period?

4. Assess the breadth, depth and cost of data and tools

Data and research are an options trader’s lifeblood. Some of the basics to look for:

  • A frequently updated quotes feed.
  • Basic charting to help pick your entry and exit points.
  • The ability to analyze a trade’s potential risks and rewards (maximum upside and maximum downside).
  • Screening tools.

Those venturing into more advanced trading strategies may need deeper analytical and trade modeling tools, such as customizable screeners; the ability to build, test, track and back-test trading strategies; and real-time market data from multiple providers.

Check to see if the fancy stuff costs extra. For example, most brokers provide free delayed quotes, lagging 20 minutes behind market data, but charge a fee for a real-time feed. Similarly, some pro-level tools may be available only to customers who meet monthly or quarterly trading activity or account balance minimums.

5. Don’t weigh the price of commissions too heavily

There’s a reason commission costs are lower on our list. Price isn’t everything, and it’s certainly not as important as the other items we’ve covered. But because commissions provide a convenient side-by-side comparison, they often are the first things people look at when picking an options broker.

A few things to know about how much brokers charge to trade options:

  • The two components of an options trading commission are the base rate — essentially the same as thing as the trading commission that investors pay when they buy a stock — and the per-contract fee. Commissions have come way down recently; many brokers now offer free commissions. Contract fees run from 15 cents to $1.25 or more.
  • Some brokers bundle the trading commission and the per-contract fee into a single flat fee.
  • Some brokers also offer discounted commissions based on trading frequency, volume or average account balance. The definition of “high volume” or “active trader” varies by brokerage.

If you’re new to options trading or use the strategy only sparingly you’ll be well-served by choosing either a broker that offers a single flat rate to trade or one that charges no commission (you likely won’t be able to avoid the per-contract fee). If you’re a more active trader, you should review your trading cadence to see if a tiered pricing plan would save you money.

» MORE: NerdWallet’s top brokers for options trading