What Is Options Trading?

By Markets Fool.com

Broadly speaking, options trading refers to the practice of buying and selling options contracts. These contracts give the buyer the right -- but not the obligation -- to buy or sell a stock or other asset at a predetermined price, within a predetermined time period.

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Calls and puts: The basics

There are two basic forms of options: calls and puts. A call option gives you the right to buy shares of stock at a certain price, known as the strike price, while a put gives you the right to sell shares to theoption's writer at a set price. Options are valid for a predetermined length of time, and you can buy options with expirations measured in days, or you can buy options that expire several years in the future.

When you look at an options chain (a list of the options available for a particular stock), the prices are quoted on a per-share basis. However, it's important to realize that each options contract is typically for 100 shares of the underlying stock. For example, if you want to buy call options on Stock X expiring in July, and see that the price is listed as $2.50, you'll need to spend $250 per contract.

You have the right to exercise an option at any point before expiration, which means that you would actually buy or sell the shares of the underlying stock. In practice, however, options are rarely exercised early.

There are two components to an option's price, or premium -- intrinsic value and time value. Intrinsic value is how much you would make if you sold the option, while time value is the premium you pay for what the underlying stock could do. For instance, if an options contract with a strike price of $45 is trading for $8 and the underlying stock trades at $50, $5 of the option's price would be intrinsic value (the value of the stock beyond the strike price) and the other $3 would be time value. The option is said to be in the money if it has intrinsic value, and out of the money if it does not.

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Investors can buy or sell options, depending on their objectives and their forecasts. For example, if you sell a call option on a stock, you're generally betting that the price will go down and the option will expire worthless.

As a final point, when talking about options, we generally state the underlying stock, the option's expiration date (usually just the month, unless they're weekly options), followed by the strike price, and whether it's a call or put. For example, I own call options to buy Twitter shares at any time before Jan. 20, 2017 for $10, so I would write that I have "TWTR Jan 2017 $10 calls."

An example of an options trade

Let's say that I think Apple is going to perform well for the remainder of 2016, but I don't want to spend nearly $10,000 to buy 100 shares. Instead, I can buy a January 2017 $75 call option. This only costs $25 as of this writing, or $2,500 to buy 100 shares. (Apple stock was in the neighborhood of at $98.75 on Monday.) If the stock heads higher, I get to take advantage of the upside on 100 shares for a fraction of the price of ownership.

There are a few ways this trade could play out. On the positive end, Apple could rise in price. For example, if Apple was trading for $120 when the options expired, my option would be intrinsically worth $4,500, and I'd pocket an 80% gain. On the other hand, if Apple drops, the value of my option contract could fall rapidly. As a worst-case scenario, if Apple closed below $75 when the options expired, the contract would be worthless and I would lose my entire $2,500 investment.

In a nutshell, this strategy provides me with unlimited reward potential if I'm right, and it doesn't take too much of a gain to produce a hefty return. However, a negative move in the stock could be devastating to the option's value. It's also important to mention that since I would own an options contract instead of actual stock, I would have no rights to any dividends Apple pays between now and expiration, which should be considered when calculating a profit or loss on an options trade.

Options strategies: Basic and complex

In addition to simply buying call and put options, there are many strategies options traders can use, ranging from the simple to the exotic. Here are some of the more common options trades you can make, along with some links to detailed explanations of some of these:

  • Covered call: This is where you buy shares of stock, and sell call options against them. This has the effect of generating extra income from a stock position and protecting against a drop in the share price.
  • Married put: You own shares and purchase a put option in order to protect yourself against losses.
  • Call spread (bullish): Buying call options at one strike price while selling call options at a higher strike price. Best for profiting from a modest rise in the stock's price.
  • Put spread (bearish): Buying put options at one strike price and selling puts at a lower strike price. The opposite goal of a bull call spread.
  • Collar: Buying an out-of-the-money put option and selling an out-of-the-money call option simultaneously. Usually used to lock in profits without selling an investment.
  • Long straddle: Buying a call and put option with the same strike price and expiration date. This strategy is useful if you think a stock will make a substantial move, but you don't know if it will be up or down.
  • Long strangle: Buying a call and put with the same expiration but different strike prices. Generally profitable if the underlying stock's price makes a large move in either direction.
  • Butterfly spread: A relatively complex strategy involving a combination of a bull spread and a bear spread.
  • Iron condor: Creating a long and short strangle strategy at the same time. The most complex strategy on this list.

Keep in mind this isn't an exhaustive list. In addition to opposite strategies for many of these (such as a short straddle), there are many other potential options trading strategies you could use.

How to use options trading in your investment strategies

Despite their reputation as being inherently risky, options can actually be an effective part of a long-term investor's strategy. As a personal example, I've sold covered calls against stock positions I own, and sometimes purchase deep-in-the-money options as a stock replacement strategy. While certain reckless options trades, such as buying options that are far out of the money, are almost never a good idea, there are some ways investors can actually reduce their risk with options.

The article What Is Options Trading? originally appeared on Fool.com.

Matthew Frankel owns shares of Apple and Twitter. Matthew Frankel has the following options: long January 2017 $20 calls on Twitter and long January 2017 $10 calls on Twitter. The Motley Fool owns shares of and recommends Apple and Twitter. The Motley Fool has the following options: long January 2018 $90 calls on Apple and short January 2018 $95 calls on Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.