Introduction to Options

Options are derivatives based on an underlying asset like stocks, exchange-traded funds (ETFs), indexes, or futures. In a nutshell, options are contracts in which the buyer and seller agree to buy or sell an underlying asset for a specific price before the contract expires.

Buying options contracts allows traders to pay a per-share fee (called the premium) to lock in the price for a specific security, and then buy or sell at that locked-in price even after the price of the underlying asset has changed. The price is locked in only until the expiration date of the options contract.

If the price of the underlying asset changes in a way that would be profitable for the options contract buyer, they can exercise the option, and buy or sell the shares at the agreed-upon price (called the strike price).

Options contract sellers agree to be on the other side of that transaction, furnishing the shares that the options contract buyer wants to buy (or purchasing the shares that the options contract buyer wants to sell) at the locked-in price. In return, the options contract seller receives the premium.

The process of matching options contract buyers and sellers is handled by a third party, and is called assignment.

If the price of the underlying asset changes in a way that is not favorable for the options contract buyer, the buyer can just let the option expire without exercising it. In this scenario, no shares change hands, but the seller still keeps the premium.

Why Trade Options?

There are a few main reasons that traders use options:

1. For speculating. Traders think they know whether a security will move up or down in price, and want to take advantage of those moves without investing in the full cost of owning the stock.

2. For generating income. Sellers of options contracts keep the premium, whether the buyer exercises their option or not, which can be a good source of income, as long as the seller makes sure to protect against downside risk.

3. For portfolio protection. You can use an options contract like an insurance policy, to protect stocks in your portfolio in the event of price declines, for just the cost of the premium.

Before you trade your first option, it’s necessary to know some of the basics. We'll explore what an options contract looks like, what the different components are, and the four basic types of options trades that can be made.

Anatomy of an Options Trade

A buy order for an options contract might look something like: 1 NVDA October 18, 119 call for $6.35

The six components of this trade are as follows:

• Quantity: 1 options contract is being purchased, representing 100 shares of the underlying asset.

• Underlying Asset: NVDA is the stock that will be bought or sold if the options contract is exercised.

• Expiration Date: October 18 is the expiration date of the contract; if the contract buyer wishes to exercise their option and buy 100 shares at the strike price, it must be done by October 18th.

• Strike Price: 119 is the strike price of the contract; this is the amount the contract buyer will pay per share of NVDA if they exercise the contract.

• Contract Type: Call is the type of options contract, which gives the contract buyer the right to buy NVDA shares at the strike price; if they wanted to buy the right to sell NVDA shares at the strike price, they would purchase a put option instead.

• Premium: $6.35 is the per-share premium/price of the options contract. Note: each contract controls 100 shares of the underlying asset, so the cost would be $635 plus any transaction fees.

Both buyer and seller agree to these terms when buying or selling an options contract.

Calls vs. Puts

There are two types of options contracts - calls and puts.

A call option is a contract to buy a stock or an underlying asset at a specific price.

When you buy a call option, you obtain the right (but not the obligation) to buy the underlying asset at a specific price, called the strike price, at any time before the contract expires.

When you sell a call option, you’re taking on the obligation to supply the underlying asset at the strike price if the buyer of the call contract exercises the option. In other words, you’ll be assigned.

In this scenario, the buyer feels bullish on the stock, purchases a call option, and waits for the price to go up before exercising the option to buy the underlying stock at the lower strike price.

The seller, by contrast, feels bearish on the stock. The seller hopes that the stock price goes down and the buyer does not exercise the contract, letting it expire and allowing the seller to keep the premium without having to sell any stock to the buyer at a lower price.

A put option is a contract to sell a stock or underlying asset at a specific price.

When you buy a put option, you obtain the right (but not the obligation) to sell the underlying asset at a specific price, called the strike price, at any time before expiration.

When you sell a put option, you take on the obligation to buy the underlying asset at the strike price if the buyer of the put option exercises the contract.

In this scenario, the buyer feels bearish on the stock, purchases a put option, and waits for the price to go down before exercising the option to sell the underlying stock at the higher strike price.

The seller, by contrast, feels bullish on the stock. The seller hopes that the stock price goes up and the buyer does not exercise the contract, letting it expire and allowing the seller to keep the premium without having to buy any stock from the buyer at a higher price.

Four Ways to Trade Options

When would you buy or sell a call option and when would you buy or sell a put option?

The table below shows four different ways to trade options, based on what direction you think the security's price will go and the risk/reward ratio you are comfortable with.

Buyers (whether of calls or puts) pay a premium in order to reduce the risk of larger losses if the stock price doesn't move the way they expect.

Sellers take on that larger risk for buyers, in exchange for the guaranteed income from the premiums they receive from the buyers. Sellers must hedge their risk in other ways, such as using a covered call strategy.

Let's look at each of these four options trading scenarios in more detail.

Buying a Call Option

Buying a call (sometimes referred to as a "long call") is similar to buying a stock. If you expect the price of a stock to rise in the next few months, you could buy a call option instead of buying the stock outright. This gives you the right to buy the underlying stock at the strike price specified in the options contract.

If the stock price rises before the options contract expires, you can exercise the option and acquire the stock at the lower strike price, then sell the stock at the higher market price. If the stock price falls (or rises by less than the per-share premium you paid), you can choose not to exercise the option, letting it expire worthless. In that case, you would basically lose the premium that you paid for the contract.

Below is a typical risk graph for a long call.

The x-axis of the risk graph shows the underlying stock price. The y-axis shows the potential profit or loss at that underlying stock price. The areas below the x-axis (in red) represent potential losses at various stock prices, and the areas above the x-axis (in green) represent potential gains.

Let's look at a specific example of buying a call option on GM for a premium of $2.83/share ($283 total, since an options contract generally covers 100 shares), and a strike price of $53.

The max risk (maximum potential loss) with this options contract is the cost of the premium, regardless of how low the stock price goes. This is because if the stock price goes below the strike price of $53, the option holder would just not exercise the option to purchase shares for $53/share.

If the stock price rises to $55.83 (the strike price plus the per-share premium price), then the option holder would break even. Any stock price above $55.83 would result in a profit if the call option is exercised. The max reward (maximum potential profit) is theoretically unlimited, although it is unlikely the stock price will rise drastically before the contract expires.

Buying a call option is a speculative trade and isn't ideal for beginner options traders. The stock price will have to rise, sometimes significantly, before the contract expires, in order to turn a profit. In the example above, the price of GM would have to go up more than $2.83 per share within the 50 days remaining on the contract for the trade to be profitable.

Buying a Put

Buying a put option (sometimes referred to as a "long put"), gives you the right to sell the underlying stock at the strike price specified in the options contract.

If the stock price falls before the options contract expires, you can acquire shares of the stock for a lower price, then exercise the option and sell the stock at the higher strike price. If the stock price rises (or falls by less than the per-share premium you paid), you can choose not to exercise the option, letting it expire worthless. In that case, you would only lose the premium that you paid for the contract.

Below is a typical risk graph for a long put.

Let's look at a specific example of buying a put option on GM for a premium of $2.71/share ($271 total, since an options contract generally covers 100 shares), and a strike price of $54.

The max risk (maximum potential loss) with this options contract is the cost of the premium, regardless of how high the stock price goes. This is because if the stock price goes above the strike price of $54, you would just not exercise the option to sell shares for only $54/share.

If the stock price drops to $51.29 (the strike price minus the per-share premium price), then you would break even. Any stock price below $51.29 would result in a profit if the put option is exercised. The max reward (maximum potential profit) is theoretically unlimited, although it is unlikely the stock price will fall drastically before the contract expires.

Long puts can be used to protect stocks you already own in your portfolio in the event of a decline in price. Some traders will purchase a long put at a higher strike price at the time they purchase the actual stock. If the price of the stock continues to go up, they let the put option expire worthless and keep their stock. If the price goes down, they exercise the put option and sell their stock at the higher strike price.

Selling a Call

When you sell a call option (sometimes referred to as a "short call"), you’re selling someone the right to buy your underlying shares. This means that if the call option buyer exercises their right to buy the underlying shares, you (the option seller) will be obligated to sell the underlying stock to them at the strike price.

If the stock price rises above the strike price before the options contract expires, the call option buyer may choose to exercise the option, and you would be obligated to sell them 100 shares of the underlying stock. If you do not already own those shares, you may need to purchase them at a higher price in order to provide them to the buyer at the lower strike price. When you sell a call option without owning those shares already, that is referred to as a "naked call" or "uncovered call", and it can be quite costly.

Below is a typical risk graph for an uncovered short call.

As you can see, the profit is limited to the premium, no matter how low the stock price falls. If the stock price rises, the potential losses are theoretically unlimited. If the contract buyer exercises their option and you don't already own those shares, you would need to buy 100 shares at the current stock price to sell to the contract buyer at the lower strike price.

A "covered call", where you already own shares of the underlying stock at the time you sell the call option, is a much less risky and more beginner-friendly strategy. You can factor in the price you paid for the shares when choosing the strike price for the call option, and sell those shares to the buyer if they exercise the option.

If the stock price falls, the call option buyer will likely let the option expire worthless, in which case no shares change hands and you keep the premium.

Let's look at a specific example of a covered call, selling a call option on GM for a premium of $1.75/share ($175 total, since an options contract generally covers 100 shares), and a strike price of $55. This graph assumes the call option seller already owns 100 shares of GM purchased at $54/share, in order to have shares to sell if the call option buyer exercises their contract.

Owning those shares flips the risk graph around for selling a covered call. Now the best outcome for both the call option buyer and the call option seller is for the stock price to go up.

If the stock price rises above the strike price of $55 before the contract expires, the call option buyer will likely exercise their option. You will sell them your shares at the strike price of $55, making a $1/share profit on those shares that you purchased for $54/share. You will also keep the premium ($1.75/share), for a max reward (maximum potential profit) of $2.75/share, or $275.

If the stock price falls below the strike price of $55, the call option buyer will not exercise the option to buy shares for $55/share. In this scenario, you keep the premium and retain the shares to sell at a later date. However, you will incur losses on the shares themselves if the stock price drops below the price you purchased them for. Theoretically, your max risk (maximum potential loss) is the share purchase price minus the premium ($52.25/share), although this worst-case scenario would only happen if the stock price went to $0, which is unlikely.

Selling a call on stocks you don’t own (a naked or uncovered call) is not a strategy for beginners. Selling a call on stocks you own (a covered call) reduces your risk potential and is suitable for beginner options traders.

Selling a Put

When you sell a put option (sometimes referred to as a "short put"), you are selling someone the right to sell you the underlying shares at the strike price before the contract expires. This means that if the buyer of the put contract exercises his/her right to sell the underlying shares before the contract expires, you as the buyer, are obligated to buy the underlying shares at the strike price of the contract.

If the stock price falls before the options contract expires, the trader buying the put option may choose to exercise the option, and you would be obligated to buy 100 shares of the underlying stock from them at the strike price. If you have not already taken a short position on those shares, you may need to purchase all 100 shares at the higher strike price, which can require a lot of cash. When you sell a put option without having shorted those shares already, that is referred to as a "naked put" or "uncovered put".

If the stock price rises, the trader buying the put option may let the option expire worthless, in which case no shares change hands and you keep the premium.

Below is a typical risk graph for a short put.

Let's look at a specific example of selling a put option on GM for a premium of $1.36/share ($136 total, since an options contract generally covers 100 shares), and a strike price of $52. 

The max reward (maximum potential profit) with this options contract is the premium, regardless of how high the stock price goes. This is because if the stock price stays above the strike price of $52, the put option buyer will not exercise the option to sell their shares for only $52/share. Once the option expires worthless, the put option seller will keep the $1.36/share premium and not have to buy any shares.

If the stock price drops to $50.64 (the strike price minus the per-share premium price), then the put option buyer would break even. If the stock price goes below $50.64, the put option buyer might choose to exercise the option and the put option seller would be obligated to buy the shares at the higher strike price to fulfill the contract. The max risk (maximum potential loss) is the strike price minus the premium ($50.64), although this worst-case scenario would only happen if the stock price went to $0, which is unlikely.

Like selling naked calls, selling naked puts is a strategy for veteran options traders. The potential losses can be substantial, depending on how low the price falls before the buyer exercises their option.

The Bottom Line

Options contracts allow traders to pay a small premium for the right to lock in the price of a specific security for a limited amount of time. The contract gives the buyer the option to buy shares at the price specified in the contract (for call options contracts) or to sell shares at the specified price (for put options contracts).

If the security's price changes in a way that is favorable for the options contract holder, they can exercise the option before the contract expires and take advantage of the favorable pricing set in the options contract.

The seller of the options contract receives the premium whether the contract buyer exercises the option or not. Being the seller of the options contract carries more risk if the price of the underlying asset does not go the way they expect. If the contract buyer exercises the option, the contract seller may be forced to sell shares (in the case of call options contracts) or purchase shares (in the case of put options contracts) at unfavorable pricing to satisfy the contract. The potential losses for the contract seller can be substantial.

Buying a call, buying a put, selling a call, and selling a put are the four basic ways to trade options. Once you understand the potential risk and reward tradeoffs for each of these four strategies, you can use them in different ways to achieve your options trading goals, whether you're interested in speculation, income generation, or portfolio protection.

Researching Options Contracts with StockCharts

Viewing Options Chain Information

The Options Summary shows options chain information for US stocks. To access the Options Summary, choose Options from the Charts & Tools menu, then enter the symbol you want to view options info for.

 Click here to view a live version of this Options Summary

Options chain information is also available on the Options tab in both StockChartsACP and the SharpCharts Workbench. In addition, members can view options information for the symbols in their ChartList using Options View.

Viewing Profit & Loss Graphs

Members who have subscribed to the OptionsPlay add-on can use the OptionsPlay Explorer to research options trade ideas for a specific ticker symbol, and view Profit & Loss graphs like the ones shown above.

Once the add-on has been purchased, the OptionsPlay Explorer can be accessed while viewing options chains in SharpCharts, StockChartsACP, Options Summary, or Options View.

The OptionsPlay add-on also includes the StockCharts-exclusive OptionsPlay Strategy Center, which makes it easy to access options trade ideas that fit your individual trading preferences.