Welcome to our “Options Basics” FAQ section! Whether you’re new to options trading or looking to brush up on key concepts, this guide is here to help.
We’ve compiled answers to the most common questions about options, from understanding the fundamentals to more advanced strategies.
Our goal is to simplify the complex world of options trading, so you can make informed decisions and enhance your trading knowledge.
Explore the questions below to get started!
What are options?
Options are financial contracts that give you the right to buy or sell something (like stocks) at a specific price, by a certain date.
There are two main types:
- Call Option: Gives you the right to buy something at a set price.
- Put Option: Gives you the right to sell something at a set price.
You don’t have to buy or sell—you can choose not to. But you pay a fee (called a “premium”) for having the option to do so.
Think of it like reserving the right to buy a concert ticket at today’s price, even if the ticket price goes up in the future. If the price doesn’t go up, you don’t have to buy it, but you lose the reservation fee.
What’s the difference between a call and a put option?
A call option gives you the right to buy something (like a stock) at a specific price, by a certain date. You use a call option if you think the price of the stock will go up, so you can buy it at the lower, agreed-upon price.
A put option gives you the right to sell something at a specific price, by a certain date. You use a put option if you think the price of the stock will go down, so you can sell it at the higher, agreed-upon price.
In short:
- Call = Right to buy
- Put = Right to sell
You pay a fee to have these rights, but you’re not obligated to use them if it doesn’t benefit you.
How does options trading work?
Options trading lets you buy or sell the right to trade a stock at a specific price, by a certain date, without having to actually own the stock.
Here’s how it works:
- Buying an option: You can buy a call option (if you think the stock price will go up) or a put option (if you think the stock price will go down).
- If you’re right, you can make a profit by either buying or selling the stock at a better price than it’s trading for on the market.
- If you’re wrong, you lose the money you paid for the option (called the “premium”).
- Selling an option: You can also sell options to others. When you sell an option, you collect the premium, but you also take on the risk that the buyer may choose to use their option (meaning you’ll have to buy or sell the stock at the agreed price).
- Expiration date: Options have a set time limit, after which they expire. If you don’t use the option before it expires, it’s worthless, and you lose the premium.
In simple terms, options trading is like making a bet on where a stock’s price will go, but with a time limit. You can make money if you’re right about the stock’s movement, but you only risk losing the money you spent on the option if you’re wrong.
What is an option premium?
An option premium is the price you pay to buy an option. It’s like a fee that gives you the right to buy or sell a stock at a certain price within a set time.
This premium is influenced by a few things:
- Stock price: The higher the stock price moves in the direction you’re betting on (up for calls, down for puts), the more valuable the option becomes.
- Time left: The more time left before the option expires, the higher the premium, because there’s more chance for the stock price to move in your favor.
- Volatility: If the stock is more likely to move a lot, the premium will be higher, since there’s a better chance of a profitable trade.
Think of the option premium as the cost of reserving the right to buy or sell the stock at a specific price. Whether you use that right or not, the premium is non-refundable.
What does it mean to buy an option?
Buying an option means you’re paying for the right, but not the obligation, to buy or sell a stock at a specific price, by a certain date.
There are two types of options you can buy:
- Call Option: You buy the right to buy a stock at a set price. You would do this if you think the stock price is going to rise. If the price goes up, you can buy at the lower price and make a profit.
- Put Option: You buy the right to sell a stock at a set price. You would do this if you think the stock price is going to fall. If the price drops, you can sell at the higher price and make a profit.
When you buy an option, you pay a fee (called the “premium”) for this right. However, you’re not required to use it. If the option doesn’t help you make money (like if the stock price doesn’t move the way you hoped), you can choose to let the option expire, losing only the premium you paid.
In short, buying an option is like paying for a chance to make a profit based on where you think the stock price will go, without actually owning the stock.
What does it mean to sell an option?
Selling an option means you are giving someone else the right to buy or sell a stock at a specific price, by a certain date, in exchange for receiving a payment (called the premium).
There are two types of options you can sell:
- Sell a Call Option: You give someone the right to buy a stock from you at a set price. You receive the premium upfront, but if the stock price rises above the agreed price, the buyer may choose to buy it from you at that lower price. This means you could be forced to sell the stock at a loss, but you keep the premium as compensation.
- Sell a Put Option: You give someone the right to sell a stock to you at a set price. If the stock price falls below that agreed price, the buyer may choose to sell it to you at the higher price. Again, you keep the premium, but if the stock price drops a lot, you may have to buy the stock at a higher price than it’s worth.
When you sell an option, you take on more risk because the buyer can choose to exercise the option (forcing you to act). However, you collect the premium as your profit for taking on that risk.
In short, selling an option means you’re betting that the price of the stock won’t move as much as the buyer expects. If you’re right, you keep the premium; if you’re wrong, you might have to fulfill the buyer’s request, possibly at a loss.
What are strike prices in options trading?
The strike price (also called the exercise price) is the price at which you can buy or sell the stock if you decide to use your option.
- For a call option, the strike price is the price at which you can buy the stock.
- For a put option, the strike price is the price at which you can sell the stock.
When you buy an option, you choose a strike price, and this price is important because it helps determine if your option will be profitable or not.
- If the stock price goes above the strike price (for a call) or below the strike price (for a put), your option may become valuable.
- If the stock price doesn’t move in the direction you want (for example, if a call option’s stock price stays below the strike price), the option could expire worthless.
In simple terms, the strike price is the “target” price that your option is betting on. Whether your option becomes profitable depends on whether the stock price moves past that strike price by the time the option expires.
