A beginner's guide to trading options

Options trading for beginners: what to know

Options contracts are financial instruments that derive their value from an underlying asset. For the sake of simplicity, on this page we'll focus on options on equities — that is, options where the underlying asset is a stock — but keep in mind that other types of options are available. Each standard equity options contract represents 100 shares of the underlying stock, and any explanations or examples given will use this as their basis.

Options are derivative contracts that give you the right, but not the obligation, to buy an underlying asset (100 shares of a stock in the case of equity options) at a fixed price before or at a specific expiration date. The time until expiration can range from the same day (zero days to expiration, or 0DTE) to a year or more.

These contracts are conditional, as the right to open the stock position is typically only exercised when certain conditions are met. When the contract owner exercises their right, the counterparty must provide 100 long or short shares of the specific security per options contract.

The key components of an options contract include the underlying asset (the stock or other security the option is based on), the strike price (the price at which the option can be exercised), the expiration date (the last day the option can be exercised), and the premium (the price paid for the option).

There are two basic types of options. Call options give you the right to buy a specific asset at a certain price within a limited time. Put options give you the right to sell a specific asset at a certain price within a limited time.

Every options strategy, no matter how complex, is built upon four basic types of option positions: buying call options (typically used when expecting the underlying asset's price to rise); buying put options (often used when anticipating a decline in the underlying asset's value); selling call options (generally used when expecting the underlying asset's price to remain stable or fall); and selling put options (used when believing the underlying asset's price will stay steady or increase).

Options trading offers several strategic advantages including leverage to increase potential return (and risk — note this is only available on a margin account), hedging to potentially offset portfolio risk, non-linear exposure enabling you to trade ranges instead of a static direction, and extensive flexibility to suit different objectives. Remember that options are complex instruments and you should have a thorough understanding of how they work before you start trading them.

If you're ready to get started, you can open a US options and futures account with us, or practise on a demo account first.

How to trade options in 6 steps

1. Understand options basics
2. Open an options trading account
3. Create a trading plan
4. Do your research
5. Manage your risk
6. Open and monitor your position

Step 1: Understand options basics

Options contracts have two types of value. Intrinsic value is the real value to the option holder at expiration, linear with the stock price relative to the strike price. Extrinsic value is the premium associated with implied volatility and time value — the time value component gradually decreases, reaching $0 by expiration.

When it comes to 'moneyness', options can be in the money (ITM), where they have intrinsic value; at the money (ATM), where the strike price equals the current stock price; or out of the money (OTM), where they have no intrinsic value.

For example, if a stock is trading at $50, a call option with a strike price of $45 would be ITM, while a put option with a strike price of $55 would be ITM.

Understanding the 'Greeks' is also crucial for options trading. Delta measures the rate of change in the option's price with respect to changes in the underlying asset's price. Gamma measures the rate of change in delta with respect to changes in the underlying asset's price. Theta measures the rate of change in the option's price with respect to time. Vega measures the rate of change in the option's price with respect to changes in the underlying asset's implied volatility.

Traders with open positions can view their portfolio's overall beta-weighted delta, theta, gamma, extrinsic value, vega exposure and much more in our US options and futures platform.

Leverage in options trading

Options trading on a margin account offers significant leverage compared to trading stocks directly, meaning you can control a large amount of stock with a relatively small capital outlay. However, while leverage can amplify gains, it can also magnify losses. Always consider your risk tolerance when using leverage in options trading.

Step 2: Open an options trading account

To start trading listed options, you'll need to open a US options and futures account with us. This specialised account gives you access to our advanced trading platform for listed derivatives, developed in collaboration with tastytrade. Alternatively, you can open a spread betting or CFD trading account if you want to trade options contracts over the counter (OTC).

Our US options and futures platform offers real-time quotes and charting tools, risk management features, educational resources, and mobile trading capabilities.

Step 3: Create a trading plan

Developing a comprehensive trading plan is crucial before diving into options trading. Your plan should consider your risk parameters (what's your maximum position size and how much are you willing to risk per trade?), asset selection criteria (which underlying assets will you focus on — stocks, indices, ETFs?), trading style and strategies (will you focus on directional trades, income generation or volatility strategies?), understanding of implied volatility (how will you factor in market expectations of future volatility?), and trading psychology (how will you manage emotions and stick to your plan?).

Remember to grasp the difference between defined and undefined risk strategies. Defined risk strategies, like long calls and puts, have a known maximum loss. Undefined risk strategies, such as short calls and puts, have potentially unlimited losses.

Step 4: Do your research

Our US options and futures platform empowers you with tools to boost your market knowledge, including the Follow Feed (see what other traders are doing in real time), an in-platform video feed (access live trading content and expert analysis), preset market watchlists (stay updated on popular markets), and watchlist sort and filter capabilities (customise your market view).

When researching potential trades, consider technical analysis (study price charts to identify trends and potential trade entry and exit points), fundamental analysis (evaluate the underlying company's financial health and growth prospects), volatility analysis (assess current implied volatility levels compared to historical averages), and upcoming events (be aware of earnings reports, economic data releases or other events that could impact the underlying asset).

Step 5: Manage your risk

To help manage your risk, consider using smaller trade sizes, allocating a small percentage of your funds to options trading, limiting the number of your trades, choosing defined risk strategies as a beginner, and having a clear exit strategy for both profitable and unprofitable trades.

Our US options and futures platform provides several tools to help you manage your positions, including customisable portfolio metrics, liquidity indicators, email communications for upcoming events such as expiration dates and earnings reports, and risk management features like stop-loss and take-profit orders.

It's crucial to have an exit strategy for both profitable and unprofitable trades. This might include taking profits at predetermined levels, cutting losses at a certain percentage, or adjusting positions based on changes in the underlying asset or implied volatility. Options trading carries significant risks — always ensure you fully understand these risks and never trade with money you can't afford to lose.

Step 6: Open and monitor your trade

When selecting an options strategy, consider your directional assumption (bullish, bearish or neutral), the timeframe (expiration date) and the strike price. For instance, if you're bullish on a stock currently trading at $100, you might buy a call option with a strike price of $105 expiring in one month — giving you the right to buy the stock at $105, even if it rises above that price.

Common options strategies include the long call (buy a call option when you're bullish on the underlying asset), long put (buy a put option when you're bearish), covered call (sell a call option on stock you own to generate income), bull call spread (buy a call and sell another with a higher strike price to potentially reduce cost and risk), and bear put spread (buy a put and sell another with a lower strike price to potentially reduce cost and risk).

When placing your trade, pay attention to the bid-ask spread (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept), volume and open interest (these indicate the liquidity of the options contract), and implied volatility (higher implied volatility generally means higher options premiums).

Once you've opened an options position, you have three choices when your option is in the money: close the position (sell the option to realise your profit or limit your loss), roll the position (close the current option and open a new one with a different strike price or expiration date), or let the option expire (if it's in the money, it will be automatically exercised, or you can manually exercise it).

For example, if your $105 call option is now worth $3 and the stock is trading at $110, you might choose to close the position for a profit. Alternatively, if you believe the stock will continue to rise, you could roll the option to a later expiration date or a higher strike price.

Options trading examples

Long call option example (bullish outlook)

Imagine you're looking at stock XYZ trading at $49. You decide to buy a call option with a $50 strike price for $2 per share ($200 per contract). If XYZ's price rises to $60 by expiration, you could buy 100 shares at $50 each. This $10 difference between the market price and strike price gives you $1,000 of intrinsic value.

At expiration, your call option would be worth $1,000. Ignoring fees and commissions, you'd see a net profit of $800 (option value of $1,000 minus your $200 initial cost). You could either sell the option to realise this profit or exercise it to get 100 shares at $50 each, with an effective cost basis of $52 per share due to the option premium.

Your maximum loss for a long call option is limited to the initial premium you paid. This loss occurs if the option expires out of the money. However, you can also experience losses before expiration if the stock price doesn't rise sufficiently or quickly enough.

Short call option example (bearish outlook)

With XYZ trading at $49, you sell a $50 strike call option for $2 ($200 per contract). If XYZ's price rises to $60 by expiration, you'd face a loss of $800 if you closed the position, as the option would now be worth $1,000. However, you'd retain the $200 premium you received initially, partially offsetting your loss.

Conversely, if XYZ's price remained below $50 at expiration, you'd realise the maximum profit of $200 (the initial premium you received). You could either let the option expire worthless or buy it back to close the position and eliminate any assignment risk. Remember that short calls carry theoretically unlimited risk, as there's no limit to how high a stock price can rise.

Long put option example (bearish outlook)

Consider XYZ trading at $50 per share. You buy a $45 strike put option for $1 ($100 per contract) with 30 days until expiration. If XYZ's price drops to $30 by expiration, your put contract would be worth $1,500 ($15 x 100 shares per contract). Ignoring fees and commissions, your net profit would be $1,400 ($1,500 value minus $100 initial cost).

However, if XYZ's price remained above $45 at expiration, you'd lose your entire initial outlay of $100. Even if the stock price dropped slightly to $47, it wouldn't be enough for your put to gain intrinsic value, rendering it worthless at expiration.

Short put option example (bullish outlook)

Imagine you're selling a $50 strike put option on XYZ for $2 ($200 per contract) when the stock is trading at $55. If XYZ's price drops to $51 by expiration, you'd realise the maximum profit of $200, as the option would expire worthless. This demonstrates how you can profit from short options even when slightly directionally incorrect — short puts are considered neutral to bullish trades.

If your goal was to get shares at a lower cost basis than the current market price, you'd achieve this if the stock dropped to $45. You'd then own shares at an effective cost of $48 ($50 strike minus $2 premium), lower than the $55 price when you sold the put. Your maximum loss for a short put is the strike price multiplied by 100, minus the premium received.

Profiting from a neutral directional assumption

Options trading enables you to profit even when prices remain within a specific range. A short strangle, which combines a short OTM put and a short OTM call, exemplifies this. If XYZ stock was trading at $100, you might sell a $95 put and a $105 call in the same expiration cycle.

If you collected $3.50 from each option ($700 total), you'd realise maximum profit if both options expired worthless. Your breakeven points would be $88 and $112, as the $700 premium would offset potential intrinsic value on either side.

If XYZ's price rose to $120 and you closed the trade at expiration, you'd lose $800 — your short call would have $15 of intrinsic value while your short put would be worthless, though the $700 premium you collected would partially offset this loss. Unlike individual short puts or calls, your strangle creates a truly neutral trade but introduces risk on both sides — any significant move in either direction can be problematic.