What Is Options Trading? How To Bet on Stock Price Changes

Options trading is a strategy that advanced investors use to increase the value of their portfolios. 

It allows you to bet on whether a stock’s price will increase or decrease. If you’re right, you can buy the stock at a cheap discount or sell it at a price that can mitigate risk in your portfolio.

While options can help your portfolio, they also come with risks. Understanding what options are and how they work can help you decide whether or not to include them.

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What Are Options?

Options are contracts for assets like stocks, funds, commodities, and indexes. They give investors the right to buy or sell shares of that asset for a specific price during a specific period. 

Instead of owning the asset outright, an option is a derivative of that investment, usually in a contract. This contract is an agreement that tells an investor how they can buy or sell the underlying asset.

There are two main types of options:

• Calls allow the buyer (or the “holder”) to buy an underlying asset for a specific price within a set period.
• Puts allow the buyer to sell the underlying asset at a specific price before the period ends.

Investors who buy calls typically expect the underlying asset to increase, while investors who buy puts expect prices to fall. 

Buyers pay a premium for buying or selling stocks within the contract's parameters.

Options have expiration dates, which limit a contract's validity. When the contract expires, it no longer exists and loses all value.

Options trading is similar to betting. It allows you to bet on stock price changes and capitalize on those changes. It’s a way to increase your leverage and amplify the gains in your portfolio.

RELATED: What To Look for When Buying Stocks

How Does Options Trading Work?

An options contract represents 100 shares of an asset, like a stock. Instead of paying for 100 shares, you pay a premium for an options contract. The option represents a bet on the future price of the stock.

For example, let’s say you want to buy 100 shares of Tesla stock. If Tesla is trading at $200 per share, you would have to invest $20,000 in Tesla.

Instead of buying Tesla stock, you can buy an options contract for it. You pay a premium of $1.25 per share, or $125 for the contract. 

If you think Tesla’s stock will rise to a certain price by the expiration date, a call option will give you the opportunity to purchase the stock at that rate. If you exercise the option, the price you pay when you purchase the stock is called the strike price. 

Alternatively, if you already own Tesla stock and think the price will go down, you can buy a put options contract to sell at a specific price. This is a strategy some investors use to hedge against future losses in their portfolios.

Intrinsic value vs. time value

Options prices are typically determined by intrinsic value and by time value. 

• Intrinsic value represents the actual monetary value of a contract. If you purchase an option with a strike price of $100 and the stock’s price is actually $125, the intrinsic value of the options contract is $25.
• Time value represents the amount of time left on an options contract. As an option approaches its expiration, its time value will go down. A six-month option, for example, will be more valuable than a one-month option because there’s more time left for market changes to occur.

Options can be traded without owning any stock. This allows you to capitalize on changes in the market without putting too much of your own money at risk. The key is to do so before the contract expires.

Options are appealing because they can limit losses. If you purchase a call option on Tesla stock and the price goes down, you only lose the value of your premium — which in the example above is $125.

But losses can still happen. If the writer who issues the contract doesn’t buy or sell before the market moves, they can experience tremendous losses. Timing is everything with options, yet timing the market is very difficult.

How To Trade Options

1. Open the right brokerage account

To start trading options, find a broker that offers them. Webull is popular because it provides low-fee trading for investors who are just getting started with options. 

Once your account is active, you’ll need to activate options trading. You can do this under your account settings. After you’ve been approved, deposit money into your account to begin trading. 

READ MORE: How To Use Webull: A Beginner’s Guide to Setting It Up

2. Research

Because options trading is an advanced strategy, you’ll need to do a fair amount of research. Study companies you’re interested in trading options for and assess the current macroeconomic landscape. 

Webull makes this easy by allowing you to create watchlists in the app.

Evaluate whether purchasing an option even makes sense right now. Consider opening a paper trading account to practice options trading before putting real money on the line.

3. Place your trade

Place your trade once you have a company you’d like to invest in. You can select a limit order or market order. 

A limit order is better because it gives you more control over the purchase price. 

RELATED: Types of Trades: 3 Ways to Buy and Sell Stocks in Your Portfolio

4. Track performance

Track the performance of your option and exercise it or trade it when it makes sense.

Remember, options trading is kind of like gambling. You’re betting on a stock’s price fluctuation and because an option is a derivative product, you don’t own any actual stock. 

Never invest more than you are willing to lose, especially when it comes to trading options.

Pros and Cons of Options Trading

Before you begin options trading, these are a few points you’ll want to consider.

Pro: Buy stocks at a lower price 

Think of an options contract as a way to get a discount on a stock. 

If you know a company well and anticipate the stock’s price will change, you can use an option to lock in the privilege of purchasing the stock at a lower price in the future.

Pro: Can increase returns in a short period

Incorporating options into your portfolio can be a good strategy if you think a stock’s price will increase in the short term. 

This can be a low-cost way to help you increase the value of your portfolio.

Pro: Diversify risk

Because options are an affordable way to purchase assets like stocks or commodities, they allow investors to diversify the types of assets they hold in their portfolios. 

This can help you increase exposure to other industries or certain companies.

Con: Significant upfront time to learn

Options trading is an advanced trading strategy. If you’re just getting started with investing and are new to options, you’ll want to learn how they work.

Con: More likely to qualify for short-term capital gains taxes

Selling an asset is considered a taxable event by the IRS. And when you sell the asset determines the amount of taxes you’ll pay on it. 

Because options trade on short time horizons, you’ll want to consider tax implications before trading. If you don’t, your profit could go straight to Uncle Sam during tax season.

Con: Market volatility

Trading options is a form of speculation that allows you to profit when you guess the future price of an asset correctly. 

Some people are good at this but even the most seasoned investors can never time the market correctly. The market ebbs and flows and there’s no way to time it just right.

RELATED: Active vs. Passive Investing: Which Is Best?

FAQs

Should beginners do options trading?

Probably not. Options trading is better for advanced traders. 

Is options trading better than stocks?

Options trading can be better than stocks, depending on your goals. If you want to increase your leverage without purchasing a stock outright, an option can be a way to capture gains when a stock’s price fluctuates.

Unlike stocks, options do come with an expiration date. If you want to invest in a company for a longer period, an option might not be the best way to do so.

TL;DR: Should I Try Options Trading?

Options trading is a sophisticated investment strategy that comes with significant risks. Before diving in, consider your financial knowledge, risk tolerance, and investment goals. 

While options can diversify your portfolio and potentially increase your returns, they require advanced understanding, careful research, and a willingness to accept potential losses.

For more investing tips, check out these episodes of the Erika Taught Me podcast:

• Investing in the Stock Market Explained: A Guide for Beginners
• How To Invest for Beginners (Step by Step)
• Investing Advice from the Most Powerful Woman on Wall Street

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