Getting Down to the Basics of Options Trading

Basic options trading strategies to help investors add stock options to their investing arsenal. Discover the building blocks of puts and calls.

Print
https://tickertapecdn.tdameritrade.com/assets/images/pages/md/Building blocks: Learn the basics about options trading
4 min read

Key Takeaways

  • Review your portfolio and financial goals.
  • Determine your outlook for the market or a particular security.
  • Assess whether there's a place for options in your investment strategy.

Are you thinking about adding options to your investing arsenal? If so, it's important to educate yourself about what they are and how they work before you jump in. Options can be versatile and flexible, with opportunities designed for any type of market movement—up, down, or sideways. However, they're a bit less straightforward than traditional investments, and they come with their own lingo, which can take some getting used to. And, admittedly, options involve significant risks and aren't suitable for everyone.

Check out this high-level overview to help you decide if using options is right for you.

The Building Blocks

Options are contracts that give the owner (holder) the right to buy or sell an underlying asset, like a stock, at a certain price (the strike or exercise price) on or before a certain day (the expiration date). A standard contract is 100 shares and the price to purchase it is called the premium.

There are two types of options: calls and puts. And each transaction involves a buyer and seller who have different outlooks on the market and different rights and obligations.

A Closer Look at Calls

Let's look at why someone might consider buying or selling a call option.

Buyer of Call Option
Seller of Call Option
Rights/ObligationsHas the right (but not obligation) to buy a stock (or other security) at an agreed upon price before a certain dateMust sell the stock at the agreed upon price if the contract is exercised 
Market OutlookRising (Bullish)Falling (Bearish)
Potential BenefitsCan purchase shares of a stock below the market priceEarn a premium for the contract and won't have to sell the stock if contract isn't exercised 
Potential RisksLose the money you paid for the contract because you don't exercise it  Have to sell the stock at a price below market value; risk may be unlimited if you don't already own the stock because you'll have to first buy it at market value, which could be significantly higher than the strike price, in order to fulfill your obligation

So how does a call option work? Think of it as an extension of a buy and hold investment strategy except you need to select a strike price and expiration date. For example, let’s say XYZ stock is trading around $20. You’re very bullish on XYZ so you buy 1 XYZ Call with a strike price of $25 expiring in January 2019. The option premium for the contract is $5. Your maximum loss is the amount you pay for the contract, $500 ($5 option premium x 100 shares) and your maximum gain is unlimited since there is no cap on how much the stock price could increase, not accounting for transaction costs. The breakeven point is $30 ($25 strike price + $5 option premium paid), so you are hoping that XYZ’s stock price rises above $30 before or on the expiration date.

Puts in Practice 

Now let's look at why someone might consider buying or selling a put option.

Buyer of Put Option
Seller of Put Option
Rights/ObligationsHas the right (but not obligation) to sell a stock (or other security) at an agreed upon price before a certain dateMust buy the stock at the agreed upon price if the contract is exercised 
Market OutlookFalling (Bearish)Rising (Bullish)
Potential BenefitsCan sell shares of a stock above the market priceEarn a premium for the contract and won't have to buy the stock if contract isn't exercised 
Potential RisksLose the money you paid for the contract because you don't exercise itHave to buy the stock at a price above market value 

So how does a put option work? Let’s say ABC stock is trading around $20, but you think the company’s sales are going to decline and the stock will go to $10. You buy 1 XYZ put with a strike price of $20 expiring in January 2019. The option premium is $2. Your maximum loss is $200 ($2 option premium x 100 shares) and your maximum gain is $1800 ($20 strike price - $2 option premium x 100 shares) if the stock goes to $0, not accounting for transaction costs. The breakeven point is $18 ($20 strike price - $2 option premium), so you are hoping that the price of XYZ stock falls below $18 before or on the expiration date.

The Key: Education 

The basic call and put options described above are just the beginning. There are many different ways you can use options. Some are more complex than others. Understanding how options work and the potential benefits and risks of exercising contracts and transferring rights in a security (assignment) are essential for deciding what role calls and puts might play in your investment strategy. Depending on your risk tolerance and goals, options could be a way to potentially enhance your portfolio.     

Call Us
800-454-9272

Naked option strategies involve the highest amount of risk and are only appropriate for traders with the highest risk tolerance.

adChoicesAdChoices

Market volatility, volume, and system availability may delay account access and trade executions.

Past performance of a security or strategy does not guarantee future results or success.

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.

The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.

This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.

TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.

Scroll to Top