Options trading can be an appealing way to build wealth or manage risk, especially if you’re looking beyond just investing in stocks, bonds, and other assets in your portfolio. But options trading can be a complex and challenging endeavor. The key to success in options trading is understanding the basics, including knowing what options are and the risks and rewards involved.
SoFi has created this options guide to provide you with information and resources on the basics of options so you can start to develop a trading strategy that fits your goals and risk tolerance.
Options are contracts giving the purchaser the right to buy or sell a security, like a stock or exchange-traded fund (ETF), at a fixed price within a specific period of time.
An option is a contract between the holder and the writer. The holder (buyer of the contract) pays the writer (seller of the contract) a price – the premium – for the right to buy or sell the underlying asset. Option holders can buy or sell the underlying security by a specific date (called expiration date) at a set price (called the strike price). If the option holder exercises the contract on or before the expiration date, the option writers must deliver the underlying asset.
As mentioned above, when you buy an options contract, you have the right to buy or sell the underlying asset at a specified price within a certain time frame.
There are two main types of options: call options and put options. A call option gives the holder the right to buy an underlying asset, like a stock, at the strike price, while a put option gives the holder the right to sell an underlying asset at the strike price. In general, if you think the underlying asset price will go up, you would buy a call option. But if you believe the underlying asset price will go down, you would buy a put option.
Options are derivatives, meaning an option contract’s value is derived from the value of an underlying asset, like a stock or bond. Options are also leveraged instruments, which means investors can potentially earn higher returns or experience significant losses using relatively small amounts of capital.
Since options contracts fluctuate in value, many traders can buy or sell the contracts before expiration for a profit or loss, just like they would trade a stock or bond. This process of buying and selling options contracts is known as options trading.
Options Greeks, also known as the Greeks, are important in options trading because they provide traders with a way to gauge the value of options contracts. Here’s a look at the most common Greeks used by traders:
• Delta is an assessment tool used to measure risk sensitivity. Delta estimates how much an option’s price changes when the underlying asset price changes. Specifically, it measures the option’s price change in relation to every $1 change in the underlying asset.
• Gamma measures the change in the delta with respect to the change in the underlying asset price. If delta measures how an option’s price changes in relation to the underlying asset’s price, then gamma measures how delta itself changes in relation to a change in the asset’s price.
• Theta measures the change in the option price with respect to time. It gives investors a sense of how much an option’s price decreases the closer it gets to expiration.
• Vega measures an option’s sensitivity to changes in the underlying asset’s implied volatility. When an underlying asset of an options contract has significant and frequent price changes, it has high volatility, which also makes the option contract more expensive.
Many investors get interested in options trading because it can be a way to generate income, speculate on the price movements of securities, as well as a way to hedge against losses. However, with these possibilities, they are downsides to options trading too. Before diving into the world of options contracts and options trading, it’s essential to understand the benefits and risks of this investment strategy.
Some of the main advantages of options trading are:
• Options give you the chance to make money whether the market is going up, down, or sideways.
• Options may be an inexpensive way to participate in the market without tying up as many funds as stock or bond trading requires.
• Options provide investors with leverage, which can help magnify returns.
Some of the main drawbacks of options are:
• Options trading is a complex and risky strategy and one that requires a great deal of knowledge and experience to succeed.
• Options involve a great deal of leverage, which can amplify losses if the trade goes against the trader.
• Options contracts are not always as liquid as other securities, making them harder to buy and sell.
When it comes to options trading, there is a lot of jargon that investors need to know to navigate this investment strategy successfully. Here’s a look at some popular options trading terminology.
Time decay is the loss of an option’s value as it gets closer to expiration. Time decay accelerates, meaning the time value declines more quickly as the expiration date gets closer because investors have less time to profit from the contract.
Implied volatility measures the expected volatility of a security’s price. While implied volatility shapes the price of an option, it does not guarantee that the price activity of the underlying security will indeed be as volatile or as stable as the expectation embedded in its implied volatility.
Having a long position generally means you expect the price of an asset to go up – you are bullish. An investor in a short position benefits from a decline in the price of an asset, meaning you have a bearish outlook.
An option’s intrinsic value is the payoff the buyer would receive if they exercised the option right now. In other words: the intrinsic value is how profitable the option would be, based on the difference between the contract’s strike price and the market value of the underlying security. An option’s time value is not as straightforward. Time value is based on a formula that includes the expected volatility of the underlying asset and the amount of time until the option contract expires.
Buy to Open and Buy to Close are options orders used by traders. Investors who want to initiate a new call or put options contract (rather than buy an existing one) use a buy to open. A buy to close order, on the other hand, occurs when an options writer wants to exit an existing option contract and buys the put or call option contract they initially sold.
Index options are options contracts on an underlying asset whose value is based on a financial market index, like the S&P 500 index or other benchmark indices. Traders of index options are making bets on the direction in which an index will move.
More: What Are Index Options?
Trading options can appeal to investors who think an asset’s price will go up or down or want to attempt to offset risk in their portfolio. But options trading can be difficult and risky. Individuals new to investing may prefer a simpler way to build an investment portfolio. With a SoFi Invest® brokerage account, you can trade stocks and exchange-traded funds with no commissions for as little as $5.
Options trading strategies are the plans that traders use to determine when to buy and sell options contracts. Traders can use several different option trading strategies to make money in the markets, and each has its own strengths and weaknesses.
Once you get an understanding of the basics of options trading and strategies, you may be interested in learning more tools and concepts that can help you generate income, hedge positions, or speculate. For more advanced options topics, check out the articles below.