Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying stock at a specific price before a certain date. While options can seem complex or risky at first, understanding their basics can add valuable flexibility to your stock trading. This guide breaks down core concepts, practical examples, and key risk controls any stock trader should know before exploring options.
1. What Are Stock Options?
Options are financial derivatives based on an underlying stock. Each options contract typically controls 100 shares of that stock. There are two main types of options:
- Call options: Give the holder the right to buy the stock at the strike price before expiration.
- Put options: Give the holder the right to sell the stock at the strike price before expiration.
The strike price is the agreed price for buying or selling the stock if the option is exercised. The expiration date is the last date the option can be exercised.
2. Key Terms Explained
- Premium: The price you pay to buy an option contract.
- In the money (ITM): A call option where stock price > strike price; a put option where stock price < strike price.
- Out of the money (OTM): Call option when stock price < strike price; put option when stock price > strike price.
- At the money (ATM): Stock price roughly equals strike price.
- Intrinsic value: How much an option is ITM.
- Time value: Premium minus intrinsic value; represents value of time left until expiration.
3. Why Stock Traders Use Options
Options can be used for several purposes in conjunction with stock trading:
- Hedging: Protect gains or limit downside risk on stock holdings using puts.
- Generating income: Selling covered calls on owned stocks to collect premiums.
- Speculation with defined risk: Buying calls or puts to profit from anticipated moves at limited cost.
- Improving entry or exit: Using options to enter or exit a position at a predetermined price.
4. Basic Options Strategies for Stock Traders
Here are some practical, beginner-friendly strategies integrating options with stock trading:
Covered Call
What it is: Owning stock and selling call options against it.
Purpose: Generate income on stock holdings while willing to sell stock if it rises above strike price.
Example: You own 100 shares of XYZ at $50. You sell 1 call option with $55 strike expiring in 30 days for a $1.00 premium. If stock stays below $55, you keep premium and stock. If stock goes above $55, shares may be called away, but you locked in $5 gain plus $1 premium.
Protective Put
What it is: Owning stock and buying put options as insurance.
Purpose: Hedge against losses below a certain price while continuing to hold stock for upside.
Example: You own 100 shares of ABC at $40 and buy a $38 strike put option for $0.75 premium expiring in 60 days. If ABC falls below $38, you can sell shares at $38, limiting losses (-$2.75/share considering premium), protecting your downside.
Long Call
What it is: Buying a call option to control stock exposure with limited capital.
Purpose: Speculate on upside movement with limited risk.
Example: You expect DEF at $30 to rally but want to risk only $150 (premium). Buying one $32 strike call option for $1.50 costs $150. If DEF rises above $33.50 (strike + premium), you start making a profit. Loss limited to the premium if stock falls.
5. How to Evaluate an Options Trade: A Step-by-Step Checklist
- Define your objective: income, protection, or speculation?
- Understand the underlying stock’s current price and trend.
- Select appropriate strike price based on risk tolerance and outlook.
- Check time until expiration balancing cost and time risk.
- Calculate maximum risk and potential reward.
- Confirm you have sufficient capital and margin requirements.
- Plan your exit: profit target, stop loss, or time exit.
- Consider commissions and fees impacting net return.
6. Worked Example: Hedging a Stock with Protective Puts
You own 500 shares of LMN priced at $20, concerned about short-term volatility but don’t want to sell. You want to limit your maximum possible loss to about $1 per share over next 2 months.
- Find a suitable put option: $19 strike expiring in 60 days costs $0.85 premium.
- Buying 5 contracts (each controlling 100 shares) costs 5 × 100 × $0.85 = $425 premium.
- If stock price falls below $19, your shares can be sold at $19 limiting loss to approximately $1 plus premium, total $1.85 per share.
- If stock rises or stays above $19, your loss is only the premium ($425) but stock upside remains intact.
7. Common Mistakes When Starting With Options
- Ignoring time decay: Options lose value as expiration approaches; buying options and holding too long can erode your premium.
- Trading without clear plan: Entering options trades without defined objectives or exit rules leads to costly mistakes.
- Overleveraging: Risking too much capital on long options without realizing how quickly losses can occur.
- Not understanding margin requirements: Margin rules for selling options can lead to unexpected margin calls if not monitored.
- Overcomplicating strategies too early: Stick to simple, well-understood strategies before exploring complex spreads.
- Neglecting to monitor positions: Options prices change fast; not managing ongoing risk can lead to outsized losses.
8. Risk Management Tips for Options Trading
- Limit risk to a small percentage of your total trading capital on any single option trade.
- Prefer buying options (limited risk) over naked selling strategies as a beginner.
- Use stop-loss or mental cutoffs for exiting losing option positions.
- Regularly review your portfolio to understand exposure to underlying stocks and options combined.
- Be cautious with using leverage embedded in options—it can amplify both gains and losses.
9. Practice Plan: Learn Options in 7 Days
- Day 1: Review core definitions: calls, puts, strike, expiration, premium.
- Day 2: Study option chains of several familiar stocks; identify strike prices and premiums.
- Day 3: Practice calculating maximum loss and profit for simple call and put buys.
- Day 4: Simulate a covered call trade using a stock you hypothetically own.
- Day 5: Analyze protective put scenarios for risk-limiting hedges.
- Day 6: Use an options pricing calculator to see impact of time decay and volatility.
- Day 7: Set up a paper trading account or notebook journal to track hypothetical options trades and outcomes.
10. Final Thoughts
Options can be powerful tools for stock traders when approached carefully and with education. This guide has introduced foundational concepts, practical strategies, risk controls, and a learning plan to build your confidence. Always remember to start small, stay disciplined, and continue learning as you explore how options may fit your trading style.