Options trading can be exciting and rewarding. It is riskier than stock trading but requires less money upfront. You don’t have to own a stock to purchase a stock option. However, you need to own the stock to exercise certain options that you've purchased.
A call option gives the buyer the right to purchase 100 shares of an underlying stock for a set price -- the strike price -- on or before an expiration date. Options usually expire in one to three months, but some don’t expire for up to three years. You pay the call seller, or writer, a premium to buy the option. A put option is similar, except it gives you the right to sell 100 shares of the underlying stock. You trade options through a brokerage account.
You can open a brokerage account to trade options. But before your first trade, you’ll need to apply to your broker for an options trading level based on your knowledge and experience. Simple option trades, like buying puts and calls, require a Level 1 or Level 2 trading account. More complex and riskier option trading requires a higher level. When you buy an option, you cannot lose more than the original premium. Option sellers can lose a lot more and therefore require a higher trading level. Once you have option trading permission, you deposit cash in your brokerage account to pay for your option orders.
Pricing an Order
Most brokers offer online screens on which you can place orders. You can look up the price of a put or call by researching the underlying stock and viewing its “option chains." A chain lists the puts and calls by expiration date and strike price. Options prices are per share. For example, a call on XYZ Corp. that expires in 30 days and has a strike price about equal to the stock’s market price might have a per-share premium of $2. Since the call represents 100 shares, the total premium is $200 plus commissions. Discount brokers charge a few dollars for an option trade.
Placing an Order
The broker's buying screen offers you several methods to purchase an option. You will be entering a “buy-to-open” order -- this means you are establishing a “long”, or ownership, position. If you place a "market order," your purchase kicks in instantly at the current market price. A "limit order" becomes active if the option price falls below your chosen threshold. For example, if you place a $1.50 limit on your XYZ call purchase, the options exchange will hold the order until the option price hits $1.50 or less, at which point it becomes a market order. Limit orders guarantee you won’t overpay, but they risk going unexecuted if the option never reaches the limit. You can also specify whether your order is good only for the day or good until cancelled.
Disposing of an Option
Once you purchase your option, you hope it gains value so you can sell it at a profit through a “sell-to-close” order. If the option loses all of its value, you let it expire -- this requires no action. If you wish to own the underlying stock, you can enter an “exercise” order on a call to purchase 100 shares at the strike price, but you must have cash in your brokerage account to pay for the shares. If you exercise a put, you can sell 100 shares at the strike price. This is the only case in which you have to own the stock, since you need to deliver it to the put seller when you exercise the option.
- Options Industry Council: What Is an Option?
- Optiontradingpedia: Options Accounts Trading Levels
- Learn Stock Options Trading: Learn How to Read a Stock Option Chain
- Optiontradingpedia: Types Of Option Orders - Introduction
- Optiontradingpedia: Exercise an Option
- Seeking Alpha: Why Are Options So Much Riskier Than Stocks?
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.