Options Trading: A Basic Introduction
- Nisha Mehta, MD
- Apr 30
- 10 min read
In general, we’re fans of keeping investing in the stock market simple and believe that physicians can reliably reach financial independence by following basic budgeting rules and having a diversified investment portfolio. However, when markets become volatile, physicians who have extra cash to deploy often want to take advantage of market dips or large swings. One classic way to do this is to buy the dip. A more complicated - and riskier - way to do it is through options trading. If you have the stomach for it, or just want to understand options, we’ll cover the basics of options trading, why it is attractive to some investors, and a broad categorical overview of puts and calls, as well as some general principles and guidance from members of our physician communities to keep in mind to limit your risk.
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What is an option (options contract)?
Put simply, an option gives you the right to buy or sell an investment product such as stocks, ETFs, or indices at a previously agreed-upon price (the ‘strike price’) for a certain period of time until it expires (‘expiration date’). Options are also referred to as derivatives.
The idea here is that you don’t have to buy the stock outright at the beginning. Instead, you buy the right to buy the stock (the ‘premium’) if it goes up at an advantageous price (a ‘call’ option) or sell the stock at a price at an advantageous price if it goes down (a ‘put’ option). The return on investment (ROI) on this risk can be much higher percentage wise than the percentage increase or decrease in a stock, as the money you put in is only the price of the option, but the profit you make (if you make a profit) is in proportion to the difference between the strike price and the current price of the stock, minus the cost of the option.
Why engage in options trading?
There are many reasons why investors engage in options training. Some are looking to put downside protections into place, some are looking to make outsized returns on the fluctuation in a stock price, and others are looking to further diversify their options to make money within the stock market beyond just buying low and selling high.
These strategies are riskier than the tried and true set it and forget it type investment strategies we often discuss and love, but offer substantial benefits to those who are able to execute them well. Common reasons to explore options trading include:
Leveraging your speculative instincts about what you think is going to happen to a stock to profit from what happens to the stock price both when it goes up and down
Creating income from stocks you own, providing you are willing to sell instead of sticking to a buy and hold indefinitely strategy
The ability to hedge against a stock you own declining in value, thus limiting your downside risk
How does buying options actually work?
You pay a premium to buy an option
In order to buy an option, you will pay a premium, which is the amount you pay for the options contract. This is not a fixed cost - it also varies based on what you pick. When you go to buy an option, you’ll see a table of the options contracts available to you, and you will pick based on the strike price that you want and how long you want to hold the option. The price of the premium reflects the:
Intrinsic value: Value of the option based on the difference between the current stock price and the strike price
Time value: The value based on how much time you have before the expiration date (the longer you have, the more likely you’ll have to get a favorable outcome). Generally speaking, options lose value as they get closer to expiration, unless the stock price is changing rapidly in your favor
Volatility: Generally speaking, the more volatile a stock, the more expensive the option is. This makes sense because you take more risk on the price to purchase for the potential for more reward if the stock changes substantially in value.
Demand
Generally speaking, an options contract covers 100 shares, so you have to multiply the price times 100 to determine the cost of buying your option. There are exceptions to this but most of the time, you will be buying 100 shares.
Holding, selling, and exercising options
You are not obligated to ‘exercise’ the option to buy or sell; however, your premium is a sunk cost. Therefore, your risk, or skin in the game, is the amount you pay for the premium if you elect not to exercise the option.
You can also sell the options contract that you own without ever buying the stock, so if the premium for your option changes in your favor because the stock price has changed (for example, if a stock has already gone up in price during your prior to your expiration date), you can sell it for a profit as well.
Know that when you own an option to buy an asset, you don’t actually own the underlying asset until you exercise the option or sell the option, so you won’t get dividends or other benefits of owning the asset until then.
Logistics
You will need a brokerage account that is approved for options trading in order to be eligible to trade options. Furthermore, your account may restrict what types of options trades you can take part in based on an approval level it assigns you based on your portfolio and profile.
What types of options strategies exist (puts, calls, and otherwise)?
There are many different strategies of varying complexity and risk, but the more complex ones (and usually the riskier ones) are beyond the scope of this introductory article.
For now, know that there are two main categories of options contracts, calls and puts.
Call options:
A call is an option that allows you to buy a stock at the contracted strike price by the expiration date on the options contract.
You want to buy a call option when you think that the stock is going to go up in price.
Put options:
A put is an option that allows you to sell a stock at the contracted strike price by the expiration date on the options contract.
You want to buy a put option when you think that the stock is going to go down in price. This strategy can be used to hedge against or bet on a drop.
Buying and selling options contracts
You can also be the person on either end of the contract with buying and selling options contracts, further expanding your options strategies depending on whether you’re doing options trading as a hedge, to generate income, or as a way to engage in speculation in the stock market. Sometimes it can actually be more lucrative to sell the options contract than to exercise the option.
There are specific iterations of all of these, with strategies including covered calls, protective pulls, cash secured puts, collars, straddles, and spreads, all of which are beyond the scope of this article but which we will cover in future articles. They all have specific use cases where they'd be beneficial, as well as varying levels of risk (for example, shorting can be extremely risky, as there is potential for unlimited downside).
When would you want to buy a call option?
You want to buy a call option when you think that the stock is going to go up in price, so that you can buy it cheaper than the future price and then have the ability to sell it for a higher price, thus making money on the delta, or difference.
Basic example of a call option:
Let’s say there is a stock for a hot company that you think is going to go up in price because of anticipated announcements in the next month. You purchase a call option with a strike price of $100 that expires in one month. Two weeks later, they announce a major partnership and the stock sails to $150. You exercise your call option and buy the stock at $100. You then turn around and sell the stock at the new $150 price. Your net profit is $50 - the amount you paid for the option.
Of course, if that never panned out and the stock stays the same or actually decreases in value, you just don’t exercise your option. In this case, you just lose what you paid for the option.
When would you want to buy a put option?
You want to buy a put option when you think that the stock is going to go down in price, so that you can sell it at a higher price than what the stock is worth. You might do this because you think that a stock pirce is going to go down, in which case if the stock price falls below the strike price you can either sell at a higher price than what it's worth, or sell the options contract itself for a profit. You may also do this for insurance reasons if you already own a stock and want to limit the downside potential while continuing to hold the stock. There are also riskier plays that play on market volatility, but these are beyond the scope of this introductory article.
Basic examples of a put option:
Let's say there's a stock currently priced at $100 that you think is going to go down due to upcoming regulation changes. You purchase a put option for $5 with a strike price of $90 that expires in two months, meaning that you spend $500 for a put option for 100 shares. Two weeks later, they announce bad news that sends the stock price falling to $80. You exercise your put option at $90, which gives you a profit of $10 per share, or $1000 for 100 shares. $1000 profit minus the $500 you paid for the option yields you $500 in net profit.
Now let’s say you actually own the stock valued at $100 already. You don't want to sell the stock because if the bad news doesn't happen you think the company will continue to do well, but you want to protect yourself against the scenario where the stock tanks. If you purchased that same put, when it goes down to 80, instead of losing $2000, you have the ability to sell at 90, thus only losing $1000 plus the $500 you paid for the option, thus losing $1500 instead of $2000. If the stock tanked further, the difference would be even larger, thus providing you a hedge.
Of course, if that never panned out and the stock stays the same or actually increases in value, you just don’t exercise your option. You are just out of the money you paid for the options contract.
In the Money / Out of the Money
These are two terms you’ll often hear if you start engaging in options trading that you should know. They refer to where your options stand at the moment in relation to the market.
In the Money
When you are ‘In the Money’ (ITM), your option now has intrinsic value because if you exercised it now, you would make money because of where the stock is currently priced relative to your exercise price.
Out of the Money
When you are ‘Out of the Money’ (OTM), it wouldn’t make sense to exercise your options because it’s not profitable at the moment. In this case, you’re still out of money because you have the sunken cost you put into buying the option at the premium price.
What about selling / shorting options?
In a short call, you are the one selling the options. This is very risky, as there is unlimited downside potential if you are not using a covered option that limits the downside. Here, you are are obligated to sell at the price of the option no matter what happens to the stock, so if there’s huge volatility, it could end up costing you a lot if the option turns out to be in the buyer of the option’s favor.
Tips from our community for getting started with options training
Learn first. Figure out what information you need to know to confidently make informed bets. While this is fundamentally risky, you can ensure it’s not purely speculative by following the stocks you’re interested in religiously. Listen for news, M&A chatter, earnings reports, and other data that makes you inclined to think a stock is going to go in a particular direction.
Practice, practice, practice. Before you actually place your first order, try to simulate a few situations and watch how they play out. Pick a few stocks and decide if you want to buy a put or a call and see what happens to them over the course of the exercise period.
Always know your downside potential and what price you’d need to break even on the purchase of the option.
Don’t go straight to riskier strategies like shorting. Try something straightforward with lower downside potential at the beginning.
Start with small bets/positions and put them in diversified less risky assets, before moving onto bigger and riskier bets. You don’t want to find yourself losing a large amount of money based on the performance of one company’s stock.
Use stop-loss orders, or set up alerts about major shifts or news to manage your risk.
Conclusion
Options trading is another way to play the stock market in a way that can generate outsized returns compared to the increase or decrease in the price of a stock, but it also comes with increased risk and downside potential. You should make sure you educate yourself thoroughly before investing in this way, and not risk more than you can afford. We will continue this series on options by discussing more complicated ways to engage in options trading in future articles.
Additional investing resources for physicians
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