Options Trading Basics
Options are contracts that give you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific date.
Options trading allows investors to hedge portfolios, generate income, or speculate on price movements with limited risk. Every option contract has a strike price (the price at which the underlying can be bought or sold), an expiration date (the last day the contract is valid), and a premium (the market price of the option). A standard equity options contract represents 100 shares of the underlying stock.
There are two fundamental types of options. A call option gives the holder the right to buy the underlying asset at the strike price, while a put option gives the holder the right to sell the underlying at the strike price. Buyers pay a premium for these rights, and sellers (writers) collect the premium in exchange for taking on the obligation to fulfill the contract if assigned.
Key Option Metrics
When evaluating options, you'll encounter several key metrics. Intrinsic value is the difference between the underlying price and the strike price for in-the-money options. Time value represents the additional premium beyond intrinsic value, reflecting the possibility of the option moving further in-the-money before expiration. Implied volatility measures the market's expectation of future price swings and directly impacts option premiums. For example, with SPY trading at $450, a $440 call option has $10 of intrinsic value, while a $460 call has zero intrinsic value but may still carry time value depending on time to expiration.
Moneyness and Expiration
Options are categorized by moneyness. An in-the-money (ITM) call has a strike below the underlying price; an ITM put has a strike above it. At-the-money (ATM) options have strikes near the current price. Out-of-the-money (OTM) calls have strikes above the current price; OTM puts have strikes below it. As expiration approaches, time value decays at an accelerating rate, a phenomenon known as theta decay. An ATM SPY option with 30 days to expiration might be worth $3.00, but with only 7 days left, the same strike might trade for $1.20, assuming no change in the underlying price.
FAQs
What is the minimum capital required to trade options?
You need a margin or option-approved brokerage account. Many brokers require at least $2,000 for a margin account and approval levels vary based on experience and strategy complexity.
Can I lose more than my investment buying options?
No. As a buyer, your maximum loss is the premium paid. As a seller (writer), losses can be substantial, especially on uncovered (naked) calls where theoretical risk is unlimited.
What happens if I hold an option to expiration?
If the option expires in-the-money, it is automatically exercised and shares are delivered or cash settles. If out-of-the-money, the option expires worthless and you lose the entire premium paid.