Here’s a beginner explainer on trading options

If you've jumped on the options trading bandwagon within the last year, you're not alone. In fact, the popularity of investing in options — or contracts allowing you to bet on which direction you think a stock price is going — hit a record high in 2020 with 7.47 billion contracts traded. That marks a 52.4% increase from the year prior, according to The Options Clearing Corporation.

Both seasoned and new investors are embracing options trading, helping contribute to its explosive growth. These two groups are realizing the flexibility that options provide: investors can lock in a price of a stock without having the obligation to buy.

"Options trading can be a great way to grow your income, limit your risk and hedge against market fluctuations at the same time," says Stephen Callahan, vice president of client services at Firstrade, a fintech brokerage offering options traders zero commissions, zero options-contract fees and no deposit minimums, maintenance or inactivity fees.

For these reasons, options can be complementary to stocks in your portfolio. When investors combine the two together, they have more possibilities than if they traded stocks alone. Options can act almost like an insurance policy, Callahan explains. For example, if a stock you own decreases in value, buying certain kinds of options can help cancel out any potential losses on your shares.

"Options can lower your breakeven point, reverse your strategy without selling your stock and even potentially let you set a purchase price for a stock below its current market price," adds Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research.

Despite its popularity, the reality is options trading is not that straightforward and you have to be pretty tactical when getting involved. Select breaks down below what active investors need to know before giving it a try.

An option is a contract giving the investor the right (or option) but not the obligation to buy or sell a specific stock or ETF, at a specified price (also known as the "strike price") for a specified period of time, ranging from days to years. When that specified time ends and the option expires, it no longer has value and no longer exists.

"Unlike shares of stock, an option does not represent ownership in the underlying company," Frederick says. "Because it's a contract, it represents the potential for ownership, but it must be exercised to make that happen."

The two types of options

Before trading options, you'll need to get a grasp of its lingo, and that includes understanding its two varieties: calls and puts. Frederick breaks them down for us:

• Call options: These give the holder (buyer) the right to buy a specified number of shares (usually 100) of a stock or ETF at the strike price, at any time until the contract expires.
• Put options: These give the holder the right to sell a specified number of shares of a stock or ETF at the strike price, at any time until the contract expires.

This is a basic explainer of options, but getting involved also means understanding the different long and short positions that an investor can take. While a stock position can often be held for a very long period of time, all options eventually expire. As their expiration date approaches, options will generally lose value and can end up being worthless. Market volatility near expiration can also raise an investor's risk of an option not being worth anything when it expires.

Whether to choose a call or a put option, and whether to buy or sell, depends on what you want to achieve as an options trader, says Callahan. "It's never a good idea to just pick an option for your portfolio without doing your research and [deciding] whether or not it aligns with your investing goals," he explains.

Options trading is known to be quite risky, in part because of how complex it can be to understand. This is why it's crucial that investors know how options work before getting involved. Investing your money in something you don't understand is never a smart financial move.

The risk you take on as an options investor ultimately depends on your role in the contract (which side you're on) and your strategy, as there are multiple strategies you can implement using different combinations of options.

"The options markets offer bullish and bearish strategies, hedging and speculative trading opportunities and varying degrees of potential for risk and profit," Frederick says. "Options strategies may be based on time value, volatility or even interest rates."

That being said, options investors can lose as little as a small prepaid amount of the premium when a trade moves against them and seems set to expire out of the money, or they can experience as unlimited losses — their initial investment, plus infinitely more — depending on the strategy used.

Because options strategies can involve substantial risk, you'll find some brokers implement strict guidelines and qualification criteria that require investors to meet certain requirements.

To better comprehend the world of options trading, there are plenty of resources that can help educate eager investors. The SEC's Office of Investor Education has a good explainer on options terminology that walks readers through an example of a basic stock option contract quote. There are also options-trading courses such as those offered on Udemy and Skillshare.

"Option trading is not for everyone, especially inexperienced investors," Frederick says, pointing out that some strategies require a substantial outlay of capital and some carry significant downside risk.

As a caveat to this, however, not every option strategy is highly complicated or exceedingly risky. "Some of the more basic strategies are relatively straightforward and can provide an effective way for investors to try to generate income or hedge against risk — sometimes both at the same time," Frederick adds.

Like all investment choices you make, you should have a clear idea of what you hope to accomplish before trading options.

"Options can play a variety of roles in different portfolios, and picking a goal narrows the field of appropriate strategies you might choose," Callahan says.

Say 'Investor A' decides to trade options because he wants more income from the stocks he owns and 'Investor B' decides to trade options because she wants to protect her stocks from a market downturn. These are two different objectives that require two different options strategies to reach their goals.

According to Callahan, 'Investor A' might investigate strategies such as writing covered call options, or selling someone else the right to purchase a stock he already owns at a specific price and time frame, while 'Investor B' might think about purchasing puts, or options, on an index that tracks the type of stocks in her portfolio.

Before deciding to enter into any option strategy, Frederick suggests doing some simple calculations to find the maximum gain, maximum loss and breakeven points of that strategy, which will be a good test of your risk tolerance. Options profit calculators let you view the returns and profit or loss of different stock options strategies.

When you're ready to start options trading, choose a broker that offers low per-contract fee for options, as well as research and tools that can help guide what strategies you choose along the way.

Robinhood stands out for offering free-commission options trading, in addition to the standard zero-commission stock trades. Its basic level, however, does not offer the type of fundamental research that other big-name brokers like Charles Schwab and Fidelity Investments offer, both which charge $0.65 per options contract.

Now that you have an idea of what options are, their two different types (calls and puts) and their risk level, hopefully you can make an easier decision if they're right for you.

While you may feel eager to jump on the options bandwagon, the most important takeaway is that you know what you're getting into beforehand.

"We believe investor education, ranging from beginner to advanced topics, is more important than ever given increasing client sophistication and elevated interest in opening new options accounts," Frederick warns.

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