OPTIONS TRADING
EXPLAINED

Ready to learn about options? In this article, we’ll walk you through some of the basic terminology and strategies surrounding options.

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Options offer ways for traders to develop more sophisticated trading strategies. The first part of incorporating them into your decision-making involves understanding what options are and what they can do.

How to understand options

Ever go to book a plane ticket, but you’re not 100% sure you’re going to be able to take that trip? Prices look good, and you don’t want to risk them going up, but you’re not quite ready to put $500 down to reserve your seat, yet.

Some airlines will offer you something called a “flight hold,” which reserves your right to purchase your ticket at the current price, no matter how much the price increases in the future. Some of these holds last up to two weeks, and they cost a fraction of the price of a ticket.

Buying an option on a stock gives you the right, but not the obligation, to buy or sell a stock (usually 100 shares at a time) at a particular price — even if that price changes for the general public.

Options terminology

Like any corner of the market, options come with their own set of vocabulary. To get a sense of what everyone’s talking about when engaging with options, the following terms are a good place to start:

• Call: An option which gives you the right to buy an asset at the strike price. You’d buy a call option if you believe the asset’s price will go up.
• Put: An option which gives you the right to sell an asset at the strike price. You’d buy a put option if you believe the asset’s price will go down.
• Spread: A combination of two or more options for the same stock. This can be a combination of calls, puts, or both.
• Strike price: The predetermined price at which you can buy or sell the asset. 
• Exercise: The process of turning an option into shares or using the right to sell shares at the strike price.
• Premium: The price you pay for the option contract. 
• Expiry date: The date at which the option expires. 
• Intrinsic value: The difference between the current market price and the strike price if an option is in-the-money.
• Time Value: The additional value of an option based on the time remaining until expiry.
• Out-of-the-money: An option with a strike price that has not been surpassed by the current stock price.
• In-the-money: An option with a strike price that has been surpassed by the current stock price.
• The Greeks: The measurements of change which are used to help determine the market price of an option.

How do options work?

So, how does one actually make — or lose — money, using options?

The first way is through calls. 

A call is the right to buy shares at a particular price. When you purchase a call, you are expecting the price of the shares to go up. For example, you might buy a call with a $100 premium that reserves your right to buy shares at $10. If the price then goes up to $15, you’d make about $5 on each of your 100 shares — $500 — minus the original cost of the option — the $100 premium — leaving investors with a $400 profit.

Another way investors use options is to trade volatility. Purchasing options when implied volatility is low can result in a profit if an event takes place that causes volatility to increase — for example, if a major geopolitical shock takes place. If news events cause volatility levels to increase, and the strike price of an option becomes more likely to be reached, then the option becomes more valuable. If a trader doesn’t want to hold the option until its expiry, they can sell it in the market at the new higher price and bank a profit.

You can also trade options to capture an expected price move in an underlying asset. This will determine what kind of option you decide to purchase and, in turn, how you make (or lose) money.

The second way is through puts, which reserve your right to sell shares at a particular price. Let’s go back to our previous example. If you reserve the right to sell your 100 shares at $10, and the price goes down to $5, you could sell at the higher price — the strike price — buy back at the lower price — the current market price — and again make $5 per share. That gross profit of $500 needs to factor in the original cost of the option ($100) which leaves a net profit of $400.

The last way to trade options that we’ll address is called a spread, and it involves investing in two or more options at once. There are many types of spreads, almost all of them with funny names (verticals, butterflies, condors, straddles, strangles, rolls, and more). Typically, you’ll trade two options in a spread, which can help protect against risk, or change the likelihood of profit given various price movements. For instance, a vertical spread involves simultaneously buying one option and selling another. This can be done with several objectives in mind, such as trying to capture a profit or protecting your portfolio against risk.

In most cases, your losses will be limited to the premium you pay for the option — although there are some cases where you may be exposed to greater loss than your initial investment. Although these instances are rare, they can occur.

What are naked options?

A deeper analysis of how the options market works brings in additional elements, such as the concept of “naked” options. This term describes instances where more experienced traders and institutional firms (such as brokers) act as a market maker and sell options to other traders, but don’t own the underlying stock.

Taking a step back and considering the opposite of naked options — “covered options” — can help to explain. 

For example, say Trader A owns 100 shares of NVIDIA Corp and sells one call contract against their shares. The call is “covered” because Trader A has the stock on hand to deliver in the event that the option is exercised and shares get “called” away. Remember, since Trader A sold the call option rather than bought it, they have the obligation to deliver the appropriate amount of stock at the agreed price (the strike price), provided the buyer of the call option — let’s call them Trader B — chooses to exercise it (which is the buyer’s right, not the seller’s). 

Trader A would have a naked call position if they had sold the call, but did not own the necessary shares of the underlying security — in this case, 100 shares of NVDA. This is considered a dangerous options position, because theoretically, there is no limit to how high stock prices can go. If Trader A has sold the call naked — meaning the position is “uncovered” — then, they could lose a great deal of money if the stock goes on a strong rally. 

How to use options as a hedge

There are many ways that you can use options to enhance or protect your portfolio. One of the more conservative ways is to use options as a hedge.

For example, say you bought 100 shares of a stock. You think it’s going to go up (which is why you bought the shares in the first place), but you’re just not sure. You could hedge that position by buying a put, which covers the same amount of shares. If the strike is a long way from the current trading price, then you can expect to pay a smaller premium to secure the “insurance” offered by those options. Conversely, if the strike price is close to the current trading price, this “insurance premium” will cost more — but it will also offer more protection. 

That way, if the price of the stock — and, therefore, your entire stock investment — does drop, potential profits in the put can help offset some or possibly most of the losses in the stock investment. In the end, you might still lose a little, but it won’t be as much as you would have lost with just the stock investment.

Why trade options?

Hedging is only one of several reasons to trade options. Another is that they offer a way to incorporate leverage into your strategies. This is because the initial outlay — the premium — is small in terms of the potential overall exposure gained should your options come into the money. And while options do have the potential to be high-risk, deploying the proper options strategy for an investor’s specific goal can help to maximise the risk-reward opportunity. Which demonstrates how option strategies can suit a wide variety of different market conditions and risk tolerances.

Final thoughts

If you consider yourself a speculative trader or you like being a little more hands-on with your portfolio, options can potentially enhance or protect your investment strategy. Options trading involves risks, including the potential loss of your entire investment. It’s crucial to understand the mechanics of options and the factors that affect their value before trading.

Learn more about the different ways to trade options by visiting the eToro Academy.

FAQs

Can you lose more than your initial premium?

If you are buying put or call options, then, most of the time, the most you can lose on an unsuccessful trade is the initial premium. That is, when your options expire worthless and out-of-the-money. But it is important that you check all of the T&Cs of your options trades to ensure that this is the case.

How do options compare to CFDs?

Options and CFDs are both derivative instruments and both offer a way to gain exposure to the financial markets, but there are also some differences between the instruments. Most CFDs have no expiry dates, so you can leave a position open for as long as you want, whereas options have a limited lifespan and their value can be impacted by time decay. As more traders use CFDs, they tend to be more widely available and cover a wider range of markets. CFDs also have a Delta of 1, a $1 change in the price of an underlying asset will result in a $1 change in the price of the CFD, whereas the Delta on options is variable. 

Are options regulated?

Some options markets are regulated and some are not. Options which are listed on a regulated exchange fall into the first bracket, but it is also possible to trade OTC (over-the-counter) options, which are private agreements between two individuals and which are not regulated.

What do I need to consider when starting to trade options?

It is important to understand the mechanics of options before you start trading them and when booking your first trades prioritising risk management over potential gains. One tip is to start with small investments and gradually increase your exposure as you gain experience. It could also be worth seeking guidance from an independent financial professional.