An Introduction to Options Trading

An option contract is a versatile financial instrument classified as a “derivative.” By purchasing an option contract, you gain the right – but not the obligation – to buy or sell an underlying asset under specific terms. These terms include a predetermined price (known as the strike price) and a set expiration date. As the contract approaches maturity, you have the flexibility to execute it if the market conditions are favorable, potentially yielding significant returns, or allow it to expire without further commitment if the conditions aren’t in your favor.

A financial advisor can help you identify options trading opportunities, assess risks and incorporate options into a broader portfolio strategy.

What Is Options Trading?

While traders can base an option contract on virtually any tradable asset, the most common come in two forms:

Commodities option, trading tangible assets and raw materials
Stock options, trading shares of a corporation

An options contract grants you the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. Your potential profit at expiration depends on the difference between the market price of the asset and the contract’s strike price. This connection to the underlying asset is why options are referred to as derivatives – they derive their value from the performance of another financial instrument.

The contract’s value largely lies in the flexibility it offers. You can decide to execute the transaction only if it proves profitable at expiration. For instance, suppose you hold an option to purchase 1,000 ounces of coffee on January 1 at $1.10 per ounce. On the expiration date, you can evaluate the market price and choose whether to exercise the option, ensuring the transaction benefits you financially.

Calls and Puts

There are two types of options contracts: call and put.

Call Options – This contract gives you the right to buy an underlying asset at a specific price and date. Call options are profitable if the asset price rises. For example, in the example above where you have a call option for coffee at $1.10 per ounce on Jan. 1, the option will be profitable if coffee costs $1.20 on Jan. 1, because your contract lets you buy coffee for $0.10 less than it’s worth on Jan. 1.
Put Options – This contract gives you the right to sell an underlying asset at a specific price and date. Put options profit if the asset’s price declines. For example, say you have a put option for coffee at $1.10 on Jan. 1. If the price of coffee declines to $0.90 on Jan. 1, your contract will give you the right to sell it for $0.20 more than it’s worth on Jan. 1.

A contract that expires in a profitable position is called “in the money.” Unprofitable contracts are “out of the money.”

You can buy – or “write” – an option contract for virtually any tradable asset, but most are written for either commodities or stocks. In a commodities contract, the option addresses goods traded on mercantile exchanges. These are physical goods and raw materials such as lumber, iron, coffee and gold.

A stock contract, more commonly known as a stock option, gives you the right to buy or sell shares of stock. These are very common as a perk of employment for corporate officers. Companies will often give executives stock options as part of their compensation, in which they have the option to buy the company’s stock for a given (typically low) price after a number of years of employment.

How An Option Contract Works

Every option contract has four specific components:

Asset – The underlying asset being traded and in what quantity.
Expiration Date – The date on which the contract expires.
Strike Price – The price at which you trade the contract’s underlying asset on the expiration date.
Contract – The position of the option contract, whether a put or a call.

So, in our sample contract, we would have the following elements:

Asset – 1,000 ounces of coffee
Expiration Date – Jan. 1
Strike Price – $1.10
Contract – A put contract

This sample contract would give you the right to buy 1,000 ounces of coffee on Jan. 1 for $1.10 per ounce. Say that on January 1 the price of coffee has gone up to $1.20 per ounce, a difference of $0.10. You would make $100 (1,000 ounces times $0.10).

Options can resolve in two different ways.

Physical Settlement – Under this contract, you have the right to actually buy or sell the underlying asset. For example, in our sample contract involving coffee beans, a physical settlement contract would have you actually buying 1,000 ounces of coffee beans at the time of the contract’s expiration. This is uncommon with commodities, but very common with stock options.
Cash resolution – In a cash resolution, traders don’t actually exchange the underlying assets. Instead, when a contract expires, traders exchange the cash value of the underlying assets. So, in our sample involving coffee beans, if you exercised your option at the contract’s expiration date you would receive a payment based on the difference between the contract’s price and current price of coffee.

Profits and Premiums

The cost of an option contract is known as its “premium.” This premium is determined by traders based on two factors: the likelihood of the contract expiring in the money and the number of units of the underlying asset it represents.

For instance, consider a coffee contract with a premium of $0.05 per ounce. If the contract covers 1,000 ounces, the total cost would be $50 ($0.05 multiplied by 1,000).

Essentially, options represent a wager between two traders on future price movements. When a trader sells a call option, they’re betting that the asset’s price will stay below the strike price. Conversely, when selling a put option, they believe the asset’s price will remain above the strike price. The premium reflects how confident the seller is in this prediction – the higher the premium, the greater the perceived likelihood that the contract will expire in the money.

Contracts with low probabilities of expiring in the money, often referred to as “long shot” contracts, typically have lower premiums.

For traders, profit depends on the difference between the cost of the contract and the gains from exercising it. For example, if you buy a contract to purchase coffee at $1.10 per ounce on January 1 with a $0.05 premium, and coffee prices rise to $1.30 at expiration, your profit per ounce would be $0.15 (the $0.20 difference between the market and contract price, minus the $0.05 premium).

It’s important to note that premiums are an upfront expense. If you choose not to exercise the option, the premium is a sunk cost. However, this cost also defines your maximum potential loss – you cannot lose more than the premium paid.

Bottom Line

With options trading, you can go long or short.

Options are a financial product that give you the right to buy or sell an underlying asset at a specific price, on a specific date. They’re built around giving you the option to pass if the contract expires in an unprofitable position. If you would make money, you can exercise your contract. If you would lose money, you can simply walk away.

Tips for Investing

Consider talking to a financial advisor about whether options are a good way to mitigate risk in your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Options are based on a form of product called a futures contract. Learn more about where options came from and how futures work here.