Options Trading 101: Calls, Puts, and Basic Strategies

Introduction

Options trading is a way to buy or sell the right to trade an underlying asset, like a stock, at a specific price before a set date. Options are derivatives, meaning their value is derived from another asset, and they give investors flexible choices for speculating, hedging, and managing risk.

This matters because options can amplify gains and limit losses when used correctly, but they also introduce new types of risk, including time decay and leverage risk. Beginners who understand the basic building blocks can use options as part of a broader investment plan.

In this article you'll learn what call and put options are, how they work, why investors use them, basic strategies (buying calls, buying puts, and protective puts), and the key risks to watch. Real-world examples with tickers like $AAPL and $TSLA will make concepts concrete.

Key Takeaways

• Call options give the holder the right to buy an asset at a set price; put options give the holder the right to sell at a set price.
• Options let you express directional views with limited initial capital, but they include time decay and other risks.
• Basic strategies include buying calls for bullish bets, buying puts for bearish bets, and protective puts to hedge stock positions.
• Strike price, expiration date, and implied volatility are the main factors that determine an option's price.
• Avoid common mistakes: trading without a plan, ignoring time decay, and using excessive leverage.

What Is an Option?

An option is a contract that gives its buyer the right, but not the obligation, to buy or sell an underlying asset at a predefined price (the strike) on or before a specific date (the expiration). The seller (writer) of the option has the obligation if the buyer exercises the contract.

There are two main types of options:

• Call option: Right to buy the underlying asset at the strike price.
• Put option: Right to sell the underlying asset at the strike price.

The buyer pays a premium up front for this right. That premium is the maximum loss for a buyer; for a seller, the premium is the maximum guaranteed income but the potential loss can be much larger.

How Options Work, Key Terms

Before trading options, you should know a few essential terms that appear on option chains and pricing models.

• Strike price: The price at which the option holder can buy (call) or sell (put) the asset.
• Expiration date: The last day the option can be exercised. Options lose value as they approach expiration (time decay).
• Premium: The price of the option contract, paid by the buyer to the seller.
• Intrinsic value: The in-the-money portion of an option (for calls, current stock price minus strike if positive).
• Time value: The portion of the premium above intrinsic value, reflecting time until expiration and volatility.
• Implied volatility (IV): The market's forecast of how much the underlying might move. Higher IV means higher premiums.

Why Investors Use Options

Investors use options for several reasons: leverage, cost-effective exposure, hedging, and income generation. Each use has trade-offs.

• Leverage: Options allow you to control shares for a fraction of the cost of buying the stock outright. This can magnify gains and losses.
• Hedging: Options can protect positions, e.g., a protective put provides downside insurance for stock holdings.
• Speculation: Traders use options to bet on price moves without owning the stock.
• Income: Selling options can generate premium income, but it increases risk and obligations.

Basic Options Strategies

For beginners, start with single-leg strategies: buying calls, buying puts, and protective puts. These are straightforward and limit downside for buyers to the premium paid.

Buying Calls (Bullish)

Buying a call means you expect the stock to rise above the strike price plus the premium before expiration. The maximum loss is the premium paid; the upside is theoretically unlimited.

Example: You buy a one-month call on $AAPL with a $150 strike for a $3 premium. If $AAPL rises to $160 before expiration, the call's intrinsic value is $10, and your profit (ignoring fees) is $10 - $3 = $7 per share.

Buying Puts (Bearish)

Buying a put is a way to profit if the stock falls. You pay a premium and gain value as the underlying price drops below the strike. Maximum loss is limited to the premium.

Example: You buy a put on $TSLA with a $600 strike for a $15 premium. If $TSLA falls to $540, the put has an intrinsic value of $60 and your profit is $60 - $15 = $45 per share.

Protective Puts (Hedging)

A protective put is when you own the underlying stock and buy a put to limit downside. It acts like insurance: you keep upside potential while setting a floor on losses.

Example: You own 100 shares of $SPY bought at $420. You buy a $400 strike put that expires in three months for a $6 premium. If $SPY falls below $400 before expiration, the put protects you from further losses below that level, minus the premium paid.

Understanding Leverage and Risk

Leverage is a key attraction of options: a small premium can control a large position. But leverage cuts both ways, percentage losses can be large, and options can expire worthless.

Key risk factors:

• Time decay: Options lose time value every day, accelerating as expiration approaches.
• Volatility changes: Drops in implied volatility can reduce option prices even if the stock doesn't move.
• Liquidity and spreads: Wide bid-ask spreads increase trading costs, especially in smaller or less-traded options.
• Selling options: Writers face potentially large or unlimited losses depending on the contract.

Risk management techniques include limiting position size, choosing appropriate expirations, and using stop-loss rules or hedges.

Reading an Option Chain

An option chain lists available call and put contracts for a stock with different strikes and expirations. Key columns include bid, ask, last price, volume, open interest, and implied volatility.

1. Choose an expiration: Shorter expirations are cheaper but lose value fast.
2. Select a strike: In-the-money options have more intrinsic value; out-of-the-money are cheaper but need a larger move to profit.
3. Check liquidity: Look for higher volume and open interest to reduce trading costs.

Example: On an option chain for $AAPL, a $150 call expiring in one month might show a bid of $2.90 and an ask of $3.10. A retail trader buying would likely pay near the ask, so plan accordingly.

Real-World Examples

Example 1, Speculating with a Call: Suppose $NFLX trades at $350 and you are bullish for the next two months. Buying a $380 call for a $5 premium is cheaper than buying 100 shares for $35,000. If $NFLX rises to $420, the call's intrinsic is $40 and profit is $35 per share after subtracting premium.

Example 2, Hedging a Long Position: You own 200 shares of $AAPL at $175 and want downside protection for earnings in six weeks, so you buy two $165 puts for $3 each. The cost is $600 total (2 contracts x 100 shares x $3). If $AAPL collapses to $140 after earnings, the puts limit your loss below $165, minus the $600 insurance cost.

Example 3, Volatility Impact: Two identical calls with different implied volatilities will have different premiums. If $AMD and $INTC have similar prices but $AMD has higher IV due to an upcoming earnings event, AMD calls will cost more because the market expects larger moves.

Common Mistakes to Avoid

• Trading without a plan: Entering options trades without defined goals, timeframe, and exit rules. How to avoid: write a simple plan before each trade and stick to it.
• Ignoring time decay: Holding short-dated options expecting large moves without accounting for accelerated time decay. How to avoid: choose expirations wisely and monitor theta (time decay).
• Over-leveraging: Using too much capital on options positions that can expire worthless. How to avoid: size positions conservatively, typically a small percentage of portfolio value.
• Not checking liquidity: Trading options with wide bid-ask spreads increases cost. How to avoid: favor contracts with higher open interest and volume.
• Confusing implied and realized volatility: Assuming high IV guarantees a move. How to avoid: understand IV is the market's expectation, not a certainty, and compare IV to historical volatility.

FAQ

Q: What is the difference between American and European options?

A: American options can be exercised any time before expiration, while European options can only be exercised at expiration. Most U.S. equity options are American-style.

Q: Can options expire worthless?

A: Yes. If an option is out-of-the-money at expiration, it expires worthless and the buyer loses the premium paid. This is a primary risk for buyers.

Q: How many shares does one option contract represent?

A: In U.S. equity markets, one standard option contract typically represents 100 shares of the underlying stock, so consider this when calculating cost and risk.

Q: Do I need a margin account to trade options?

A: Not always. Buying options usually requires only a cash-secured account. Writing uncovered (naked) options typically requires a margin account and higher approval levels due to increased risk.

Bottom Line

Options are powerful tools that offer flexibility for speculation, hedging, and income. For beginners, focus on understanding call and put basics, how premiums are priced, and the role of time and volatility.

Start small with single-leg strategies like buying calls, buying puts, and protective puts. Practice with a paper trading account, read option chains carefully, and manage risk through position sizing and clear exit plans.

Options can enhance your toolkit as an investor, but they require disciplined planning and respect for their unique risks. Continue learning, use small trades to build experience, and prioritize education over quick profits.