Option Trading for Beginners: A Comprehensive Guide

Options trading can seem daunting to newcomers, but with a solid understanding of the basics, it can become a valuable tool for managing risk, generating income, and leveraging investment strategies. This guide provides a comprehensive overview of options trading for beginners, covering everything from the fundamental concepts to practical steps for getting started.

What Are Options?

Options are derivative contracts that grant the holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date). These contracts derive their value from the underlying asset, making them a versatile instrument for speculation, hedging, and income generation.

The time until expiration can vary, ranging from very short-term options expiring on the same day they are traded, known as zero days to expiration (0DTE), to longer-term options with expiration dates a year or more in the future.

When the contract owner exercises their right to buy or sell the underlying security, the counterparty is obligated to fulfill the contract, which typically involves providing 100 shares of the underlying security per options contract.

Calls and Puts Explained

There are two primary types of options:

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Call Option: A call option gives the buyer the right, but not the obligation, to buy the underlying asset at the strike price before or on the expiration date. Call options are typically used when an investor expects the price of the underlying asset to increase.
Put Option: A put option gives the buyer the right, but not the obligation, to sell the underlying asset at the strike price before or on the expiration date. Put options are typically used when an investor expects the price of the underlying asset to decrease.

Traders can choose between buying or selling call and put options, or using a combination of any option type as part of their strategy.

In relation to the underlying instrument, here is what long and short call and put options transition to when these options expire in the money (ITM) and convert to stock:

Options You Own

Bullish (you want the underlying price to increase): Long call option (right to buy 100 shares at your strike price if ITM at expiration)
Bearish (you want the underlying price to decrease): Long put option (right to sell, or short, 100 shares at your strike price if ITM at expiration)

Options You Are Short

Bullish (you want the underlying price to increase): Short put option (obligation to buy 100 shares at your strike price if ITM at expiration)
Bearish (you want the underlying price to decrease): Short call option (obligation to sell, or short, 100 shares at your strike price if ITM at expiration)

Why Trade Options?

Trading options offers several strategic advantages compared to trading stocks directly:

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Leverage: Options allow you to control a large number of shares with a relatively small investment, amplifying potential returns (and losses). Trading options using leverage means you get increased exposure to the stock price with less capital - putting forth only a percentage of the full stock trade value upfront when comparing an option to 100 shares of outright stock. With leverage, you could get a magnified return on capital.
Hedging: Options can be used to protect your portfolio from potential losses. Hedging to potentially offset risk in your portfolio on a short- or long-term basis.
Flexibility: Options strategies can be tailored to a variety of market conditions and investment objectives. Non-linear exposure to trade ranges instead of static direction. Extensive flexibility to suit different objectives.

Understanding Option Value: Intrinsic and Extrinsic

Every options contract has a value based on market conditions and the time associated with the contract itself, but all options contracts are made up of two types of value: intrinsic and extrinsic. The combination of intrinsic value and extrinsic value gives you the total option’s premium. But these two key parts of options prices differ in what they represent.

Intrinsic Value: The real value to the option holder at expiration that is linear with the stock price relative to the options strike price. Options that have intrinsic value are said to be in-the-money (ITM). This applies to calls below the stock price and puts above the stock price. Intrinsic value refers to the real value of an options contract at expiration - it is the difference between the underlying’s market price and the strike price, and it only applies to ITM options.
For example, a $90 strike call on a $100 stock price has $10 of intrinsic value. If we are looking at put option contracts, we can find the intrinsic value by subtracting the ITM put contract strike price from the stock price. For example, if we have a put strike at $130 and XYZ is trading at $115, there is $15 of intrinsic value in the put option. Intrinsic value can never be negative. So, if a long call strike price is higher than the underlying’s price, or the stock price is higher than the strike price in a long put, there is no intrinsic value. Instead, the option only has extrinsic value and is said to be out-of-the-money (OTM).
Extrinsic Value: Premium value associated with an option based on implied volatility and time value that goes to $0 by the expiration of the options contract. Most options have some extrinsic value if they are far from expiration, but options closest to the stock price tend to have the most extrinsic value. Extrinsic value is the difference between the total option premium and the intrinsic value if it exists - it is the combination of time value and implied volatility value. The more time there is to expiration, and/or the higher implied volatility is, the more extrinsic value the option will hold. Options near the stock price have more extrinsic value than ITM or OTM options, generally speaking. Extrinsic value applies to OTM, ITM and ATM options that have time left until expiration.
For example, if a $90 strike call on a $100 stock price has $10 of intrinsic value and the total option value is $12.50, that means there is $2.50 of extrinsic value in the option’s price.

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Key Components of an Option Contract

Options contracts are structured with specific terms, including the underlying asset, the strike price, the expiration date and the premium. These terms define the rights and obligations of the buyer and seller. An option's strike price and expiration date determine when and where your option can be converted to 100 shares of long or short stock depending on the option type.

Underlying Asset: The stock, index, ETF, or other asset that the option contract is based on. Stock symbol refers to what's used to identify the underlying asset attached to an options contract.
Strike Price: The price at which the option holder can buy (call) or sell (put) the underlying asset. An option’s strike price is the price at which you choose to potentially enter a stock position when an option is ITM and converts to 100 shares of long or short stock.
Expiration Date: The date on which the option contract expires. Expiration date is the date on which the option will expire. The expiration date is the last day on which the contract holder can exercise their right to exercise the option or trade the option to close or adjust the position.
Premium: The price of the option contract itself, paid by the buyer to the seller. Premium is the cost to buy the option's contract itself (and the amount the seller receives).

Options have a higher chance of being exercised when they are in the money, i.e., have intrinsic value. Most options are American style options that can be exercised at any time, but some options are European style and those can only be exercised at expiration.

Strike Price and Market Price Relationship

Call and put options have different ITM implications depending on where the stock price is, so it is important to understand how this plays a role in your strategies:

Call Options:
- If the strike price is above the market price, the call option is out-of-the-money (OTM).
- If the strike price is below the market price, the call option is in-the-money (ITM).
Put Options:
- If the strike price is above the market price, the put option is in-the-money (ITM).
- If the strike price is below the market price, the put option is out-of-the-money (OTM).

Options that have a strike price close to the stock price also have more extrinsic value, as there is more uncertainty whether the strike will expire ITM or OTM. Options that are far OTM or deep ITM have less extrinsic value as there is more certainty that the option will remain OTM or ITM.

Expiration dates play a role in an option’s extrinsic value as well - the more time associated with an options contract, the more extrinsic value there will be, and vice versa. If an option expires ITM, the contract is converted into 100 long or short shares of the underlying depending on the option type.

Equity and ETF (Exchange Traded Funds) options at expiration: tastytrade exercises any long options that are at least $0.01 ITM and remain ITM through expiration, as stock prices can move after the options market closes and push ITM options back OTM in after-hours trading. Long options that are not at least $0.01 ITM and remain OTM expire worthless. Most short options are exercised automatically if they are ITM at expiration. There is a chance of OTM short options being exercised if they are close to the stock price and move ITM after the market closes.

While options are typically offered monthly, with the expiration date on the third Friday of the month, highly active products like SPY or SPX even offer daily expiration dates for maximum flexibility. Many underlyings also offer a wide selection of expiration dates spanning over a year, commonly referred to as “LEAPS.”

Options Assignment vs Exercise in American Style Options

Assignment refers to when a short option converts to its resulting position.

For a short ITM call, this is 100 shares of short stock.
For a short ITM put, this is 100 shares of long stock.

You are obligated to the long option holder’s exercise decision when you are short.

Exercise refers to when a long option converts to its resulting position.

For a long ITM call, this is 100 shares of long stock.
For a long ITM put, this is 100 shares of short stock.

When you are long, you have a right to exercise the option and convert it to shares, or not. The decision to exercise long options rests with the long option holder, which they can do any time up until expiration day. At expiration, long options auto-exercise when they expire ITM by $0.01 or more.

Think of riding in a car when considering the differences between long or short options contracts. When you are short an option, you are at the mercy of what the long holder decides, like being the passenger in a car. When you are long an option, you are the driver in this example.

How to Trade Options: A Step-by-Step Guide

As a beginner in options trading, you can kickstart your journey by following these steps:

Understand the Basics of Options Trading: This is a steppingstone to advancing your market awareness, and this may help you manage your portfolio risk better. Understanding options, strategies, and associated risks is crucial before you start trading. Each options strategy can be boiled down to the four foundational option contract exposures:
- Long calls - Options purchased to speculate on bullish price movement
- Long puts - Options purchased to speculate on bearish price movement
- Short calls - Options sold to speculate against bullish price movement
- Short puts - Options sold to speculate against bearish price movement
Remember, options contracts are conditional in nature. They allow you to speculate on the price of an underlying security-whether it will rise, drop, or stay the same. There are several strategies that can be utilized in options trading that profit from bullish moves in the underlying, bearish moves in the underlying, or no movement at all. Options strategies can be flexible to fit various account sizes, risk tolerances, and periods of high and low volatility, among other factors.
Concisely, long options are defined risk, directional trades - you need the stock to move in your favor, or the extrinsic value of that option will decay over time and the option will lose value. Each day the underlying does not move in the option owner’s favor, the more the underlying needs to move in favor of the option owner to offset the option’s extrinsic value decay.
Short options are more neutral trades because you are betting against the stock price movement. If the strike remains out-of-the-money (OTM) at expiration, the trader can realize max profit by keeping the credit initially received from selling the option. Short options trades are undefined risk in nature, meaning the risk depends on where the stock price is in relation to the strike price - Short puts have risk of the stock going to $0, and short calls do not have a risk-cap as there is no limit to how high a stock price can go.
Traders can also deploy multi-leg strategies for more complexity. Regardless of the trader’s intention, understanding these four basic option types is crucial, as many options strategies may be comprised of calls and puts that are long or short.
Create an Options Trading Account: Open a trading account with a brokerage that offers options trading. Before you can start trading options, you’ll have to prove you know what you’re doing. Compared with opening a brokerage account for stock trading, opening an options trading account requires larger amounts of capital. Brokerage firms screen potential options traders to assess their trading experience, their understanding of the risks and their financial preparedness. These details will be documented in an options trading agreement used to request approval from your prospective broker.
You’ll need to provide your:
- Investment objectives. This usually includes income, growth, capital preservation or speculation.
- Trading experience. The broker will want to know your knowledge of investing, how long you’ve been trading stocks or options, how many trades you make per year and the size of your trades.
- Personal financial information. Have on hand your liquid net worth (or investments easily sold for cash), annual income, total net worth and employment information.
- The types of options you want to trade. For instance, calls, puts or spreads. And whether they are covered or naked.
Based on your answers, the broker typically assigns you an initial trading level based on the level of risk (typically 1 to 5, with 1 being the lowest risk and 5 being the highest). This is your key to placing certain types of options trades.
Develop a Trading Plan: Planning your trading strategy thoroughly before jumping into options trading helps you stay focused on your goals to reach your objectives, and it is vital in your trading journey. It is also a way in which you can manage your risk effectively.
Some of the many factors that you need to consider when setting up your trading plan include:
- Methods of managing risk, like using the bracket order system to enter stop-loss and profit target resting orders
- How to choose assets, trading style and strategies that fit your trading plan
- Implied volatility and what might influence it-binary events, supply and demand, macroeconomic events, and more
- Understanding trading psychology and how it might affect your decision-making process
Grasping the difference between defined and undefined risk enables you to better understand the relative risk and reward as well as the buying power requirement.
Identify a Trading Opportunity: Research is an important part of selecting the underlying security for your options trade. Assess company fundamentals from the Snapshot, Fundamentals, and Earnings tabs. It's important to have a clear outlook-what you believe the market may do and when-and a firm idea of what you hope to accomplish.
The Options Analyzer tool enables you to see potential max profits and losses, break-even levels, and probabilities for your strategy. The Options Income Backtester tool enables you to view historical returns for income-focused options trades, as compared to owning the stock alone. Start with nine pre-defined strategies to get an overview, or run a custom backtest for any option you choose. Use the Options Income Finder to screen for options income opportunities on stocks, a portfolio, or a watch list. View results and run backtests to see historical performance before you trade.
Select positions and create order tickets for market, limit, stop, or other orders, and more straight from our options chains.
Choose to Buy or Sell Options: Which direction you expect the underlying stock to move determines what type of options contract you might take on:
- If you think the stock price will move up: buy a call option or sell a put option.
- If you think the stock price will stay stable: sell a call option or sell a put option.
- If you think the stock price will go down: buy a put option or sell a call option.
When buying an option, it remains valuable only if the stock price closes the option’s expiration period “in the money.” That means either above or below the strike price. (For call options, it’s above the strike; for put options, it’s below the strike.) You’ll want to buy an option with a strike price that reflects where you predict the stock will be during the option’s lifetime.
You can’t choose just any strike price. Option quotes, technically called an option chain or matrix, contain a range of available strike prices. The increments between strike prices are standardized across the industry - for example, $1, $2.50, $5, $10 - and are based on the stock price.
Every options contract has an expiration period that indicates the last day you can exercise the option. Here, too, you can’t just pull a date out of thin air. Your choices are limited to the ones offered when you call up an option chain.
Monitor and Manage Your Position: Ready to trade? Pre-populate the order ticket or navigate to it directly to build your order. Need some guidance? Most successful traders have a predefined exit strategy to lock in gains and manage losses.
From the options trade ticket, use the Positions panel to add, close, or roll your positions.

Options Trading Strategies

Once you've mastered options trading basic concepts, you may be interested in more advanced options trading strategies. As you become more comfortable with options trading, your investing efforts may include some other commonly used techniques.

Covered Calls: A covered call strategy has two parts: You purchase an underlying asset. Then, you sell call options for the same asset. As long as the stock doesn't exceed the strike price, you can realize profits by selling call options for your assets. On the flip side, even if the stock price does rise above the strike price, you would be obligated to sell to the buyer at the strike price if they exercised the contract. Frederick says most covered calls are sold out of the money, which generates income immediately. If the stock falls slightly, goes sideways, or rises slightly, the options will expire worthless with no further obligation, he says. If the stock rises and is above the strike price when the options expire, the stock will be called away at a profit in addition to the income gained when the options were sold.
Married Puts: A married put strategy involves purchasing an asset and then purchasing put options for the same number of shares. This approach gives you downside protection by allowing you the right to sell at the strike price.
Long Straddle: A long straddle strategy involves buying a call and put option for the same asset with the same strike price and expiration date at the same time. You can use this approach when an investor is unsure which way prices for the underlying asset are likely to move.

Risk Management in Options Trading

As with any other investment strategy, options trading has its lists of potential benefits and risks, and it's important to understand these to try to avoid making costly mistakes.

Defined and Undefined Risk: Grasping the difference between defined and undefined risk enables you to better understand the relative risk and reward as well as the buying power requirement. Defined risk refers to strategies where the maximum amount you could lose is limited.
Leverage: While leverage can amplify returns, it can also magnify losses. Buying an option that expires OTM results in 100% loss of the initial investment. Compared to buying and selling shares of a stock outright, options offer significant leverage, but potential losses are also amplified since buying an option that expires OTM results in 100% loss of the initial investment.
Time Decay: Options lose value as they approach their expiration date, a phenomenon known as time decay.
Volatility: Changes in volatility can significantly impact option prices.

Advantages and Disadvantages of Options Trading

Here are some of the reasons investors consider options for their portfolios:

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