Now that you know that options are contracts that give you the right to buy or sell a stock at a specific price before a certain date, the next thing is to learn how they work.
Options work by allowing you to control 100 shares of stock for just a fraction of what it would cost to buy those shares – if you’re deciding to buy options.
In parallel to that, if you’re deciding to sell options – they work by turning sitting capital into a revenue machine.
You can use options to protect your current stock holdings from big losses, make money when stock prices go up or down, or control more shares than you could afford to buy directly.
The key is to understand that you’re buying or selling the right to do something, not the actual stock itself.
Options trading might seem complicated at first, but the basic idea is simple.
1) You’re making a bet on where you think a stock price will go and when it will get there.
2) There are strategies where you can flip this script too and earn for counting on the opposite – where the stock price won’t go and until when.
There’s literally no restriction and the possibilities to earn money are many.
I’ve mentioned them in the article before here -> A beginner’s guide to options trading.
The key parts of an option trade:
To understand how options work, you have to understand the key parts of an option trade:
1) the call and put side
2) selling and buying an option
3) strike price, expiration date and premium
To explain how these work as simply as possible, you can’t learn each part separately, so we are going to explain the first two together and leave out the last part for now.
Remember this differentiation because it will be helpful later on.
Buying Vs Selling Options: Understanding Both Sides Of The Trade
When you trade options, you can be either a buyer or a seller. Each side has different advantages and disadvantages.
In short:
Buying = more directional oriented trades
Selling = more conservative oriented trades
|
What You’re Betting |
Want Stock To: |
Action |
|
Stock will rise |
Go UP past strike |
Buy call |
|
Stock will fall |
Go DOWN past strike |
Buy put |
|
Stock will stay flat/low |
NOT go above strike |
Sell call |
|
Stock will stay flat/high |
NOT go below strike |
Sell put |
Buying options is pretty straightforward and that’s what most people understand (you just bet on the direction) but here’s something not understood well enough – the “selling add-on”.
What do these “add-ons” unlock? Basically a new dimension to trading:
For the third example from the table above (selling a call):
- Earn money if stock WON’T go UP to a certain price you choose
- Earn money if stock IS at your goal price and you want to exit the trade you’re already in (and get paid a little extra for that)
For the fourth example from the table above (selling a put):
- Earn money if you think the stock WON’T FALL below the price you choose
- Earn money if you think the stock will fall below your price (If IT DOES fall to your target price this results in getting a cheaper entry price than you expected (get paid for a trade + buy at discount) – this is useful if your goal is getting a stock at a “discount”
That’s cool, but how does it actually look?
Buying a call picture:
Buying a put example picture:
Selling a call example picture:
Selling a put example picture:
When do I use which tactic?
Check out this subarticle that goes in depth about this topic and explains it simply.
Calls Vs Puts: A Complete Guide To The Two Option Types
Options trading revolves around two basic types: calls and puts.
Each gives you different rights and works in opposite ways.
Both call options and put options can be bought or sold depending on your trade idea and it’s crucial that you study calls, puts, buying and selling together.
Call options give you 4 possibilities to trade:
1) By buying a call (you’re bullish) – if in profit during the trade, if you’re satisfied with it, you can sell the right to someone else if you don’t want to own the stock to which your option trade is “connected to”.
(Selling the right means that you’re willing to close the trade earlier for a profit, basically like cashing in your check)
2) By buying a call (you’re bullish) – if you choose to stay in the trade until the end (until expiration).
You can own that stock with a lower entry price, therefore being able to sell it for profit whenever you want later on.
You pay a small fee called a premium for this right (to enter this trade).
Typically, you would buy a call if you think the stock price will go up.
3) By selling a call – you can collect income on the stock that you own by choosing a price that is very unlikely to be reached.
(This is like collecting rent).
4) By selling a call – if you think it’s time to part ways with a stock you own, to exit that “trade” or a position you can select a price that is likely to be reached and exit with even more profit. (Imagine getting paid to exit a trade in Forex/Crypto – cool right?)
In this version of call options where you sell it – you get paid immediately.
That premium you were paying to buy a call? You receive it instead.
Typically, you would sell a call if you think the stock price won’t go that much up.
Put options also give you 4 possibilities to trade, in other words – the right to sell a stock at a specific price:
1) By buying a put – you can bet on a stock to fall down and earn profit if it falls without actually owning the stock
2) By buying a put – you can use it as a protection if you think the stock you’re owning will fall a large amount, typically during a shaky market because of certain news.
Just like calls, you pay a premium for this right.
You would buy a put if you think the stock price will fall.
3) By selling a put – you can get paid for choosing the price at which stock won’t certainly fall to.
4) By selling a put – you can get paid for wanting to buy the stock at lower price once/if it falls to that price.
Talk about wanting to buy a stock, buying it at discount and paying for it less in the process.
As already mentioned, in this version of put options where you sell them – you get paid immediately.
In general, you would sell a put if you think the stock price will fall.
To sum up, we’ve covered that you can buy calls or puts and that you can also sell calls or puts to other people.
This relationship works in a way where buyers pay the premium and sellers receive that same premium.
A quick intro to the next topic is the third part that we left to discuss on it’s own.
Both call and put options have a strike price and an expiration date.
The strike price is the set price around which you bet on a certain scenario that I already mentioned.
The expiration date is when your right ends or simply said – how long you’re in that trade.
The key difference between calls and puts is direction.
Calls profit when prices rise. Puts profit when prices fall.
This makes them useful tools for different market situations.
Both types expire worthless if the stock doesn’t move enough in your favor.
In that case, you lose only the premium you paid if you’re the buyer and if you’re a seller – you keep that profit if nothing happens.
Understanding Strike Price, Expiration Date & Premium: The 3 Core Concepts
Every options contract has three key parts that work together. These are the strike price, expiration date, and premium. You need to understand all three to trade options successfully.
Strike Price
The strike price is the set price where you can buy or sell the stock.
This price stays the same no matter how the stock moves.
This is simply the level of price at which you’re betting on a certain scenario (it will go above it, it will stay below it, it will go below it, it will stay above it)
For example, if you buy a call option with a $50 strike price, you can buy the stock at $50 once the option trade expires.
This is beneficial if the stock price goes up to $60 in the meantime.
Expiration Date
Your options contracts have an end date called expiration. After this date, your option becomes worthless if you don’t use it.
Options can expire in days, weeks, months, or even years.
Longer expiration dates cost more if you are buying options because you have more time for the stock to move in your favor.
Longer expiration dates pay you more if you are selling options because there is more time for something to go wrong and that’s the risk you’re getting paid for.
Premium
The premium is what you pay to buy the option contract. This is your cost and maximum risk as a buyer.
The premium is also what you receive if you sell the option contract.
The premium has two parts:
- Intrinsic value: How much the option is worth right now
- Time value: Extra cost for the time left until expiration
Don’t bother remembering these two for now, this course later on explains this.
How They Work Together
These three concepts connect directly.
The strike price determines if your option makes money.
The expiration date sets your time limit.
The premium shows your cost or profit.
When you pick options, you choose the strike price and expiration date that fit your plan.
The market sets the premium based on these choices.
How To Read An Options Chain: Strike, Expiration & Bid-Ask Explained
An options chain shows all available call and put options for a stock. It displays key information you need to make trading decisions.
Strike prices appear in columns down the middle.
These are the prices at which you can exercise your option.
Calls let you buy at the strike price. Puts let you sell at the strike price.
Expiration dates show when your option contract ends.
You can choose from different dates, usually listed at the top of the chain.
Longer time periods cost more.
The bid price is what buyers will pay for the option.
The ask price is what sellers want to get paid.
You pay the ask when buying and receive the bid when selling.
|
Element |
What It Shows |
|
Strike Price |
Price to buy/sell the stock |
|
Bid |
What buyers will pay |
|
Ask |
What sellers want |
|
Volume |
Contracts traded today |
Volume tells you how many contracts traded that day.
Higher volume means more activity and easier trading.
Open interest shows total contracts outstanding.
This helps you see which strikes are popular.
Volatility – options with high volatility cost more because the stock moves around a lot.
This affects your potential profit and loss.
This metric is worth keeping an eye on when trading since it directly affects you purchase/income.
In other words – how much you pay for an option trade if you’re buying it or how much you earn from an option if you’re selling it.
Spread – the difference between bid and ask prices is the spread.
Narrow spreads mean lower trading costs for you.
