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How Do Options Work?

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If you’re new to trading, you’ve probably come across a lot of words that don’t seem to make a lot of sense. Are you interested in options? If so, you’re in luck. Benzinga has put together this guide to help you understand how options work, options examples and more. 

Options Defined 

If you’re trying to figure out if trading options is right for you, you should first understand what options are. An options explanation can turn into something complicated very quickly, so let’s simplify. As with most investing products, an option is a contract. It is exactly how it sounds. This specific type of contract gives you the right to buy or sell an asset at a specific price by a specific date. It’s essentially a contract that is giving you the option to follow through. 

How Do Options Work? 

Again, as with most investment products, you’re going to want to determine the probability of the future prices of certain assets. You can assume that the more likely it is that something will happen, the more expensive a related option would be. 

The basic steps of trading an option are:

  • Identify the asset you want to buy or sell.
  • Enter a contract to determine a premium, cost and expiration date.
  • If you’re the buyer, you pay the premium cost.
  • Monitor the asset and decide whether you want to follow through on the contract to buy or sell. 

Here are some key factors to understand about options:

  • Options are typically sold in increments of 100. So you should be sure to multiply the premium of your contract by 100 to get the total cost of your option.
  • The more time you have in your contract, the more valuable your option could be. This is because the more time there is, the more chance there is for the price to change.
  • If you’re the buyer of an option, you are not obligated to go through with buying. However, you will not get the premium back if you choose not to follow through. The only risk to entering the options contract is losing the amount you spent on the premium. So be sure you’re comfortable with losing the cost of your premium if it comes to that.
  • On the other hand, sellers may be required to make good on the options contract to sell. Sellers have greater risk and can lose much more than the cost of the options contract premium. 

Types of Options

If you want to trade options, you’ll need to understand the different types of options. Even though the options we talk about below seem like they’re related to geography, understand that geography has nothing to do with it. 

American options: These options can be exercised at any time between the date you purchase your option and the expiration date that is set on your option. This option type typically has a higher premium since it is allowing you to exercise your option at any time.

European options: Unlike American options, European options can only be exercised as the expiration date gets closer. 

Exotic options: This type of option offers more variation. The payment structure and expiration dates can be different than the American or European options. If you’re looking for a more customizable option, this is what you’ll probably want to look for. 

You’ll also need to understand the difference between call and put options:

  • A call option gives you the right to buy a stock. 
  • A put option gives you the right to sell a stock. 

Call Option Example 

You might be asking “how do call options work?” Let’s say there’s a new business opening up in your town. It seems like it’s going to be a profitable business with a lot of potential. You’re considering offering to buy the business with the hopes of getting in at the start of something big. Of course, this is a risk on your part. 

Even though the business shows a lot of potential, there’s no way to know how things will turn out. This is where call options would benefit you. If you could buy a call option on the business, you could offer to purchase the business at $500,000 sometime in the next 5 years. 

Now, the current owner of the business would want to know you’re serious. So imagine that they would require a down payment of $50,000. If this were an options contract, that down payment would be referred to as the premium. The premium is the price of the option contract. 

Now let’s fast forward 2 years. The business is booming, and it is now worth closer to $1 million. You decide at this point that you want to go ahead and exercise your option to purchase the business for $500,000. You can do this even though it is less than the current value of the business because you locked in the price with your down payment. 


Start of Contract2 Years Later
Value of BusinessUndetermined$950,000
Your Price$50,000 down payment$500,000

Put Option Example 

You might want to have an option to sell your asset at a set price if you fear that your asset’s worth might plummet. This will allow you to protect yourself from losing a larger amount of money. 

So how do put options work? Let’s say that you fear that your stock in Apple is about to become much less valuable. So you decide to take out the option to sell it, just in case. It’s currently trading at $3,000, so you decide to take out the option to sell it at $2,700 at any time in the next 3 years. 

You’ll have to pay the premium, let’s say that’s $300 in this case. So if you decide not to sell, you’ll lose this $300 but you’ve probably gained much more by keeping your stock. If you’re right and the stock plummets, you can sell it for the $2,700 you locked in, even if it’s only selling at $2,200 when you sell it.


Start of Contract2 Years Later
Stock Price$3,000$2,200
Your Price$300 down payment$2,700

Best Options Brokers 

If you want to trade options, you’re going to need to find a broker. There are lots of brokers out there, but not all of them have the capability to trade options. Even if they do, you’ll want to consider if the trading platform is geared specifically for trading options. When choosing your broker, there are some things you should consider:

  • What are the platform and data fees this broker offers?
  • What commissions does this broker charge?
  • Does this trading platform offer the educational resources and guidance I need to feel comfortable?

Let’s take a look at some of the brokers and what they can offer you.

For beginners: If you’re just entering the world of options trading, TD Ameritrade is a good broker to look into. This broker has a $0 account minimum, so you can test out whether options trading is right for you without dumping a lot of money into it. Its Trade Architect platform will give you a simple and easy-to-navigate trading environment. You can also take advantage of its virtual trading feature, which lets you get a feel for the market without putting your hard-earned money at risk. If you need help, you can access customer support by phone 24/7.

For advanced and active traders: If you’re trading more frequently, you might run into some higher costs. One of the brokers that strives to combat this issue is eOption. This broker specializes in options trading and offers some of the lowest commissions among its competitors. Account minimums with eOption start at $500.

For top-notch trading platforms: E*TRADE’s Power E*TRADE platform is considered the gold standard of options trading platforms. It offers virtual trading to allow you to test out your investment strategies. The platform is also free for all E*TRADE users, making it easy for you to hop in and get a feel for the platform and options trading. 

Commissions
$0 for stocks and ETFs broker assited orders an additional $6
Account Min
$500 to open an account
Get started securely through eOption’s website
Commissions
$0 for stocks and ETFs broker assited orders an additional $6
Account Min
$500 to open an account
1 Minute Review

eOption is a stock, fund and option trading platform that focuses on low-cost options trading. Its options trading is very affordable at just $0.10 per contract and $1.99 per transaction. The broker also offers a comprehensive options trading course that’s free and educational for both novice investors and advanced traders alike. eOption’s platform is less usable than its competitors, especially for new traders.

Futures and forex trades aren’t currently available, daily market updates are full of jargon and the platform includes very few intuitive features and explainers. Customer service options are also lackluster, and mutual fund transactions are expensive. While eOption might be a great choice for options traders, we recommend other platforms for beginner traders primarily interested in stock and ETF investing.

Best For
  • Options traders looking for low-cost options contracts
  • Beginner and advanced traders looking for options education
  • Advanced traders who don’t need a lot of platform guidance
Pros
  • Unbeatable options contracts pricing
  • Mobile app that mirrors capabilities of desktop app
  • Free and comprehensive options education
Cons
  • Confusing platform has limited assistance tools
  • Expensive mutual funds and bond trading
  • Limited stock and general investing education
  • Lackluster customer service options
TradeStation
Commissions
$0
Account Min
$0
Get started securely through TradeStation’s website
Commissions
$0
Account Min
$0
1 Minute Review

TradeStation is for advanced traders who need a comprehensive platform. The brokerage offers an impressive range of investable assets as frequent and professional traders appreciate its wide range of analysis tools. TradeStation’s app is also equally effective, offering full platform capabilities.

Best For
  • Advanced traders
  • Options and futures traders
  • Active stock traders
Pros
  • Comprehensive trading platform and professional-grade tools
  • Wide range of tradable securities
  • Fully-operational mobile app
Cons
  • Confusing pricing structure to leave new traders with a weak understanding of what they pay
  • Cluttered layout to make navigating TradeStation’s platform more difficult than it should be
TD Ameritrade
Commissions
$0 $6.95 for OTC Stocks
Account Min
$0
Get started securely through TD Ameritrade’s website
Commissions
$0 $6.95 for OTC Stocks
Account Min
$0
1 Minute Review

This publicly listed discount broker, which is in existence for over four decades, is service-intensive, offering intuitive and powerful investment tools. Especially, with equity investing, a flat fee is charged, with the firm claiming that it charges no trade minimum, no data fees, and no platform fees. Though it is pricier than many other discount brokers, what tilts the scales in its favor is its well-rounded service offerings and the quality and value it offers its clients.

Best For
  • Novice investors
  • Retirement savers
  • Day traders
Pros
  • World-class trading platforms
  • Detailed research reports and Education Center
  • Assets ranging from stocks and ETFs to derivatives like futures and options
Cons
  • Thinkorswim can be overwhelming to inexperienced traders
  • Derivatives trading more costly than some competitors
  • Expensive margin rates
Commissions
$0
Account Min
$0
Compare Brokers securely through eTrade’s website
Commissions
$0
Account Min
$0
1 Minute Review

E*TRADE is an online discount trading house that offers brokerage and banking services to individuals and businesses. One of the first brokers to embrace online trading, E*TRADE not only survived both the dot-com bubble and Recession — it thrived. You can choose from two different platforms (one basic, one advanced). E*TRADE is a suitable broker for traders of most skill levels, whether you want to buy mutual funds and hold them for decades or dabble in options swing trading. E*TRADE offers a library of research and education materials to help you out.

Best For
  • Active traders
  • Derivatives traders
  • Retirement savers
Pros
  • Sophisticated trading platforms
  • Wide range of tradable assets
  • Exceptional customer service
Cons
  • Limited currency trading
  • Higher margin rates than competitors
  • No paper trading on its standard platform

Know Your Options in Options 

As with any investment product, you should know that trading options certainly comes with its own risks. To get a feel for whether or not trading options is right for you, it might be a good idea to find a trading platform that allows you to give virtual trading a try first. 

If it all seems confusing, don’t feel bad! Take a look at the options examples above to get some real-world examples to help put things into perspective. To get continued support, you’ll want to find a broker who can work with you to help you understand options trading and how to get the most from your investments. 

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