Options Trading

Updated on January 4, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Options Trading?

Options trading refers to a contract between the buyer and the seller, where the option holder bets on the future price of an underlying security or index. On the expiration date, the holder has the right to purchase or sell at the strike price but isn’t obligated to do so.

Traders maximize their returns while taking a limited risk by holding a short or long position. To predict future trends, traders apply different technical indicators and determine the direction of stock movement, its range, and the time frame.

Key Takeaways

  • Options trading is a process of speculating the strike price of an underlying security or index on the expiration date. To finalize the options contract, a trader pays a small percentage as premium.
  • Beginners prefer trading strategies like long call, long put, short put, covered call, and protective put options.
  • The advanced options trading strategies include short call, short straddle, short strangle, short combination, long straddle, long strangle, and long combination trading.

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Basics of Options Trading Explained

Options Trading Strategies

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Source: Options Trading (wallstreetmojo.com)

An optionOptionOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more is nothing but a bet. Now, let us understand related terminologies:

Options are financial contracts that allow the buyer a right, but not an obligation. Futures or stocks can be bought or sold on a specific date at a particular price (strike price) on a predetermined date (expiration date).

Primarily, there are two forms of options—call and put. The call option holder gets into the contract with the writer to purchase or sell a security if the price goes up to the strike price—on the expiration date. Thus, a call buyer has a bullish view of the underlying stock or index, while a call seller thinks the prices will either stay the same or drop.

In a put option, the buyer bets on a lower future price on the expiration date. Here, the put buyer is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more and feels that the underlying stock or index price will fall on the expiration date. In contrast, the put seller assumes that the price will remain unchanged or rise in the future.

Options Trading Strategies for Beginners

#1 – Short Put

In a short put, the options trader expects the underlying stock’s price to go below the strike price on the expiration date. And if it does, the option holder purchases that stock. It is a strategy that facilitates the trader to get a stock at a lower price.

#2 – Long Call

The long call options trading is adopted by bullish investors who assume that a stock or index price will rise in the future—usually within nine months. Buying calls can be an excellent way to capture the upside potential with limited downside riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more, i.e., to the extent of the option holder’s premium. But if there is a rise in Nasdaq, then the potential return is unlimited. 

#3 – Long Put

Here, the option holder expects the stock price or index to go down in the coming nine months (expiration date). Thus, the bet is on the bearish movement of the security or index.

#4 – Covered Call

In the covered call, the seller already owns the underlying security, writes the call option to the bullish investor, and assumes a slight rise in the stock price. If the buyer exercises the contract when the stock touches or exceeds the strike price, the seller can hand over the stock to the former. Here, the seller makes a profit from the premium paid by the buyer.

#5 – Protective Put

As the name suggests, the protective put is an option that is purchased for mitigating the risk on the stock that the buyer already owns. Here, the trader is optimistic about the stock but, to avoid any loss, prefers to hedgeHedgeHedge refers to an investment strategy that protects traders against potential losses due to unforeseen price fluctuations in an assetread more their stock holding with a put option—very similar to having an insurance policy. If the price falls beyond the strike price, the option holder can sell off the stock at the predetermined price at the expiration date.

Advanced Options Trading Strategies

#1 – Short Call

Here, the call seller expects the price of a particular underlying stock to fall. Thus, if the prices go down, the writer can sell the stock to the buyer, making a profit (the buyer is the second party in this options contract). But if the prices go up, the loss is unlimited.

#2 – Short Straddle

Such an option is a combination of call and put strategies. Here the trader writes a call and put options with the same strike price and one expiration date. If the trader bets on the stock price to fall under the put option but the price goes up, they need not exercise the put option but have to buy the stock at a higher price under the call option. However, the trader can benefit from the put option trade if the price falls.

#3 – Short Strangle

It is a mix of a short call and a short put, both with different strike prices. Here the trader expects the stock price to remain between the range of short call’s strike price and the short put’s strike price. This is because it aims at gaining from the expected decrease in the implied volatilityImplied VolatilityImplied Volatility refers to the metric that is used in order to know the likelihood of the changes in the prices of the given security as per the point of view of the market. It is calculated by putting the market price of the option in the Black-Scholes model.read more between the two.

#4 – Short Combination

It is a two-way strategy, where a call and a put option are sold together for a single underlying security. But the strike prices and the expiration periods vary for both. It aims at attaining a stable position where both the options neutralize each other.

#5 – Long Straddle

In this strategy, the buyer takes up a long call with a long putLong PutLong put is a strategy used in options trading by the investors while purchasing a put option with a common belief that particular security's price shall go lower than its striking price before or at the arrival of the date of expiry.read more for a common underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates.read more. Also, the expiration date and the strike price are the same for both. Moreover, it is traded when news about an asset flares speculating potential volatility. 

#6 – Long Strangle

The buyer, on the one hand, takes a long call with a strike price more than the asset’s market value and then buys a long put with the strike price below the market value.

#7 – Long Combination

Here, the trader sells an in-the-money put and buys an in-the-money call simultaneously. It is done with a bullish perspective and doesn’t need much capital since the premium acquired on the OTM put is paid for the OTM call.

Weekly Options Trading Strategies

Traders make profits every week from weekly options. They are listed on Thursdays and expire on Fridays. Usually, weekly traders opt for the following strategies:

#1 – Credit Spread

A credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ).read more refers to the yield difference, identified as basic points of the US treasury bond—1% difference means 100 basic points. In such a strategy, the trader writes an option for a high premium and buys another option with a lesser premium for the same underlying stock. The trader ends up deriving a credit margin from both options.

#2 – Iron Condors

Here, the trader adopts the delta-neutral strategy, where they go for a long put, short put, long call, and short call altogether. All four options have varying strike prices but one expiration date. The trader gains when the underlying security or asset shows less movement.

Frequently Asked Questions (FAQs)

How do options trading work?

The option buyer speculates a certain future price for the underlying stock or index and enters into a contract with the writer to acquire the right to purchase or sell the same if the strike price is attained. 
The option holder has to pay a premium amount for entering into this contract. The premium is lost if the buyer doesn’t execute the contract on the expiration date. Also, the profit for the option holder is unlimited, but the risk is limited to the premium paid.

Which indicator is best for options trading?

The Relative Index Strength (RSI) is considered the best metric for options traders.

How to trade options successfully?

To become a successful options trader, one must keep the following points in mind:
• Select the right strategy for options trading;
• It is better to short sell options;
•Once the strike price of the stock or index is attained, sell immediately;
• Traders holding an unprofitable option should leave it;

This has been a guide to what is Options Trading & its meaning. Here we explain the basics of options trading strategies for beginners and advanced traders. You can learn more about derivatives and trading from the following articles –

Reader Interactions

Comments

  1. Diyan says

    Hi Dheeraj ,

    Thank you for detail information. As a student of finance I find it very helpful.

    in explanation of PUT’s strategies(#3 and #4) it is written that:
    Breakeven: (Stock Price – Premium)

    I think it should have been Strike price instead of Stock price.
    Am I wrong or this is just a technical mistake?

    • Dheeraj Vaidya says

      Many thanks Diyan for pointing out this mistake :-)
      I corrected the same in the post.
      Best,
      Dheeraj

  2. james afful says

    Very useful. Please can you share information on futures?

    • Dheeraj Vaidya says

      Hi James,

      thanks :-) will come with the same on Futures shortly.

      Best,
      Dheeraj

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