Options Trading

Type: Concept

Category: Finance

Difficulty: Beginner

Reading time: 6 min

Definition

An option is a contract between two parties: the buyer receives the right, but not the obligation, to buy or sell an underlying asset at a fixed price (the strike price) before or on an expiration date. The seller receives a cash payment (the premium) in exchange for taking on the obligation to fulfill the contract if the buyer exercises their right.

Options trading encompasses the full range of strategies built from these contracts — from conservative income generation (selling covered calls on stock you own) to directional speculation (buying calls or puts to profit from anticipated price moves) to complex multi-leg hedging structures. Because one option contract controls 100 shares of the underlying stock, options provide leverage: a small move in the stock can produce a large percentage gain or loss in the option.

There are two types: calls (right to buy) and puts (right to sell). Every strategy in options trading is a combination of buying or selling calls or puts.

Why it matters

Key takeaways

• Options give the buyer a right with no obligation — if the trade goes against you, you can walk away and lose only the premium paid.
• Four main uses: income (covered calls), portfolio protection (protective puts), hedging (index puts), and directional speculation (buying calls or puts).
• 1 option contract = 100 shares — always use 100 as the multiplier when calculating premium cost or proceeds.
• Options are wasting assets: time value erodes steadily to zero at expiration. Buyers fight time decay; sellers benefit from it.
• Approval tiers at brokerages (Level 1 through Level 4) determine which strategies you can use — covered calls are Level 1, naked calls are Level 4.
• The key to most options strategies is choosing the right underlying stock first — the option follows wherever the stock leads.

The four roles in options trading

click to zoom

The four strategic uses of options — organized by goal and risk level

Read it as: Choose your row by goal. Covered calls and protective puts (green) are the conservative entry points — they reduce risk or generate income. Speculation (amber) can amplify both gains and losses.

Where it goes next

Related

Book Overview: Understanding Options 2E Michael Sincere's complete guide to options from vocabulary through advanced multi-leg strategies. Covered Call The Level 1 income strategy — selling calls on stock you own to collect premium. Implied Volatility The market's expectation of future price movement — embedded in every option premium. Delta The most important Greek for retail traders — how much the option moves per dollar of stock movement. Time Decay (Theta) The relentless erosion of option time value — the central asymmetry between buyers and sellers.