What Are Options: A Complete Guide for Beginners

106K viewsDec 22, 2025

What Are Options? Everything You Need to Know before Trading

Curious about trading options? We’ve got you covered!

Here is your complete guide to options and how some traders use them as a tool to build their portfolio and trading strategy. Read on to uncover an insightful look into the mechanics, risks, and potential benefits associated with options.

What is An Option?

To put it simply, an option is a contract that allows a trader to buy or sell a specific stock at an agreed-upon price by a specific date -- but only if they want to or if it meets certain conditions. In other words, when you buy an option, you are basically purchasing the right to buy or sell a stock, but you're not required to do so. Conversely, from the seller's perspective, they are obligated to either sell or buy the stock if the buyer exercises their option.

Here are some terms you should know:

The stock specified in an options contract is known as the underlying asset. (You may see options referred to as a derivative because they derive value from the underlying asset.)
The strike price is the agreed-upon price that the underlying asset will be bought/sold for.
The date specified in an options contract is the expiration date. After that date, the option expires and is no longer valid.
A premium is the amount a trader pays to buy an options contract. This is considered the option's price and fluctuates daily. The buyer would pay this amount to hold the option and the seller would receive this amount when writing (selling) the option.
Important to remember: Underlying assets for options can be bonds, currencies, or commodities as well, but for now, we are focusing on what are options in stocks.

How Do Options Work?

There are two parties involved in each options contract:

1. The trader or institution who creates or “writes” the options contract

2. The trader who purchases the contract

When purchasing an options contract, traders have two main choices:

Allow the contract to expire without taking action, which might result in it becoming worthless.
Execute the contract and buy/sell the underlying asset. This can occur either on or before the expiration date.

When writing an options contract, sellers should be aware that if the contract is exercised by the buyer, they are obligated to buy/sell the underlying stock. It's worth noting that many brokers automatically exercise options that expire in-the-money (ITM).

Good to know: Options contracts are typically sold in groups of 100 shares of the underlying stock.

4 Options Trading Levels

If you’re new to options trading, understanding the four different options trading levels is key. Many brokerages assign options trading levels from 1 to 4 based on your experience, your financial status, investment objectives, as well as risk tolerance.

Level 1 allows for covered calls and cash-secured puts—generally lower-risk options trading strategies useful for beginners.
Level 2 opens the door to buying long calls and puts, offering potential for profit in both bullish and bearish markets.
At Level 3, traders can execute more advanced strategies like spreads, combining multiple contracts to reduce cost but also limit upside.
Level 4 is the most complex and riskiest, allowing for naked options, where you sell options without owning the underlying asset. Each options trading level offers more flexibility, but also greater potential risk, so it’s important to progress with caution.

Types of Options

There are only two types of options contracts — calls and puts.

A call option gives the holder the opportunity to buy the underlying stock on or before the expiration date, while the writer is obligated to sell the stock if the option is exercised.
A put option gives the holder the chance to sell the underlying stock on or before the expiration date, with the writer obligated to buy the stock if the option is exercised.

When deciding between a call or put option, traders have to consider data and how they expect the market to perform. The main strategies with both types of options are:

Buying a call option when the underlying asset is expected to increase in value
Buying a put option when the underlying asset is expected to decrease in value

Call Options

When you buy a call option, you have the right to buy the underlying stock at the specified strike price on or before expiration, while the writer of the call option is obligated to sell the stock at the specified strike price if the option is exercised by the buyer.

If a trader expects the price to rise, they may go with a long call strategy. A long call would give them the ability to buy the stock at a lower price than the going value (assuming the option is in the money) and their maximum loss would be the premium they paid for the options contract.

Call options contracts generally increase in value when the underlying stock price rises.

Call Option Example

Company A is currently selling for $5 a share and a trader buyer buys a call option with a $7 strike price and an expiration date a month in the future. Their premium is $1 per share, so they pay $100 since options are usually bought in groups of 100.

If the price for Company A stocks rises to $10 a share the next week and the trader decides to exercise the contract early. They would then purchase 100 shares at $7 for a total of $700. The trader would have invested a total of $800, including the premium, and can sell their new stocks at the current $10 share price, for a net gain of $200. Note that the other option would have been to sell the appreciated contract back to the market, if the holder didn't want to own the underlying shares.

If the stock price had dropped, the trader would let the contract expire worthless and would only lose the $100 they spent on the premium.

Put Options

When you buy a put option, you have the right to sell the underlying stock at the strike price on or before expiration, while the writer of the put option is obligated to buy the stock at the strike price if the option is exercised by the buyer.

A put strategy would give a trader the chance to sell a stock at a higher price than the going value (assuming the option is in the money), and the maximum loss would be the premium they paid for the option contract. Put options generally increase in value when the underlying stock price decreases.

Put Option Example

Suppose Company X is trading at $10 per share, and a trader anticipates a decrease in its value. They purchase a put option with a $9 strike price, expiring in a month, paying a $1 premium per share, totaling $100 for the contract.

If Company X's stock price drops to $5, the trader may choose to exercise the put option. However, exercising would require selling 100 shares, which could pose challenges for beginner investors. Alternatively, they could close the trade by selling the option back into the market if its value has appreciated, potentially yielding a profit without the complexities of short selling.

In the event of unexpected price increases, the trader can let the contract expire, limiting their loss to the $100 premium spent.

Call options vs. put options: what's the difference>>

Stock Options

Stock options are derivative contracts tied to individual company shares, providing traders with opportunities to profit from price movements without owning the actual stock. These options come in two varieties: calls and puts. Call options allow buyers to purchase shares at a set price, while put options enable them to sell shares at a predetermined level.

One significant advantage of stock options is their leverage potential. For example, controlling 100 shares of a $50 stock would usually require $5,000, but an option contract for those shares might cost just $200. This leverage amplifies both potential gains and losses.

Stock options are also commonly used as employee compensation, with incentive stock options (ISOs) and non-qualified stock options (NSOs) being the most prevalent types. While both give employees the right to purchase company stock at a set price, they differ in important ways. ISOs can offer favorable tax treatment if certain holding and eligibility requirements are met, but they come with stricter rules and limitations. NSOs are generally more flexible and can be granted to a wider range of recipients, but the gains from exercising them are typically taxed as ordinary income.

The liquidity of stock options varies by company, with large-cap stocks like Apple or Microsoft typically having the most active options markets. This liquidity helps tighten bid-ask spreads and better pricing for traders.

Index Options

Index options provide exposure to broad market movements rather than individual stocks. These options track major indices like the S&P 500 (SPX), Nasdaq-100 (NDX), and Dow Jones Industrial Average (DJX). Unlike stock options, index options are cash-settled, meaning no physical delivery of shares occurs at expiration.

One key advantage of index options is their usefulness for portfolio hedging. Institutional investors frequently use SPX puts, trying to protect against market downturns. The diversification inherent in indices makes these options less volatile than single-stock options, though they still offer significant profit potential.

European-style exercise is common with index options, meaning they can only be exercised at expiration. This differs from American-style options (like most stock options), which can be exercised anytime before expiration. The SPX options are particularly popular due to their tax advantages - they qualify for 60% long-term and 40% short-term capital gains treatment regardless of holding period.

Trading volume in index options has grown substantially in recent years, with SPX options now accounting for billions in notional value traded daily. This liquidity makes them attractive to both retail and institutional traders.

Zero Days to Expiration (0DTE) Options

0DTE options represent one of the most dynamic and fastest-growing segments of the options market. These contracts expire on the same day they're traded, offering traders the ability to capitalize on short-term market movements. Initially available only on major indices like the SPX, 0DTE options now exist for many individual stocks and ETFs.

The appeal of 0DTE options lies in their sensitivity to price movements and volatility. Because they have minimal time value remaining, their prices can swing dramatically with even small moves in the underlying asset. This creates opportunities for substantial gains but also carries significant risk.

Market makers have adapted to the 0DTE phenomenon by adjusting their hedging strategies. The increased trading volume in these ultra-short-dated options has contributed to higher intraday volatility, particularly around market open and close. Some recent market data shows that in May 2024, 0DTE options made up over 60% of total SPX options volume.

Successful 0DTE trading requires precise timing, disciplined risk management, and an understanding of gamma exposure. Many traders use them for earnings plays, economic data releases, or technical breakout strategies. However, they are extremely risky and not appropriate for all options traders.

Weekly and Monthly Options

Weekly options have transformed options trading by providing more frequent expiration opportunities beyond the traditional monthly cycle. These contracts expire every Friday, offering traders greater flexibility in timing their positions. Monthly options continue to trade alongside weeklies, expiring on the third Friday of each month.

The introduction of weekly options has been particularly beneficial for:

Earnings traders who can align positions with specific event dates
Theta decay strategies that benefit from accelerated time erosion
Traders looking to reduce overnight risk by holding positions for shorter periods

Weekly options are widely used for short-term trading and can offer flexibility for strategies that respond to near-term market movements.

Monthly options, including longer-term contracts such as LEAPS (Long-term Equity Anticipation Securities) with expirations of up to several years, are often chosen for positions with a longer investment horizon. Longer-dated options generally show less sensitivity to day-to-day price changes but usually carry a higher premium because of their extended time frame.

The choice between weekly and monthly options depends on a trader's time horizon, risk tolerance, and specific strategy objectives. Many active traders use a combination of both in an effort to optimize their positions.

Learn more about weekly and monthly options>>

Options Contracts: Terms to Know

There are a few different elements of the options contract that you should know before you begin trading options. As you begin to understand each part and how they interact, you can potentially build a stronger strategy.

Underlying Asset

Every option derives its value from an underlying asset - the security that the contract is based upon. This foundation determines all key option characteristics:

Stock options typically use:

Individual company shares (e.g., AAPL, TSLA)
Major ETFs (SPY, QQQ)
Market indices (SPX, NDX)

Critical asset considerations:

Liquidity: Tight spreads in active underlyings
Volatility: Impacts premium pricing
Dividends: Affect call/put valuations
Corporate Actions: Splits, mergers require adjustments

Key differences:

Single stocks show company-specific risk
Indices provide diversified exposure
ETFs combine features of both

The underlying behavior directly influences:

Strike price selection
Expiration choice
Strategy suitability

Understanding these relationships is essential before trading any options contract.

Premium

The options premium, also known as the option's price, is what a trader pays for an options contract, assessed per share. Since options contracts usually cover 100 shares, multiplying the premium by 100 gives the total contract cost. For instance, if a contract has a $1 premium per share, the total investment would be $100 for the contract. This price can fluctuate based on market conditions.

From a seller's perspective, receiving the premium is the initial income earned from writing the option contract. While buying options limits the theoretical maximum loss to the premium paid, sellers may face additional risks if the option is exercised or assigned, potentially leading to greater losses than the initial premium received.

Strike Price

When an options contract is written, it specifies what price the underlying assets will be bought/sold if the contract is exercised. This amount is called the strike price.

Expiration Date

An options expiration date is the date the option ceases to exist (expires) and marks the deadline for the contract holder to exercise and buy/sell the underlying stock, set at the contract's inception. For American options, traders can exercise before or on the expiration date. The decision often hinges on the option's moneyness — whether it's in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). If a trader lets the option expire without action, they forfeit its value, typically losing the premium paid. Therefore, understanding the option's moneyness is crucial in determining whether to exercise, close the position, or allow it to expire worthless, based on market conditions.

How to Read an Options Chain

Options chains organize all available contracts by expiration and strike price, serving as essential trading tools. These matrices reveal critical market data through several key dimensions:

Key analytical elements include:

Pricing structures (premiums, time decay)
Moneyness positioning (in the money, at the money, out of the money)
Trading activity (volume/open interest patterns)
Volatility metrics (including implied volatility and historical volatility comparisons)

Becoming proficient at chain analysis helps traders:

Evaluate relative value across strike prices
Detect liquidity and sentiment signals
Implement trading strategies

The following sections systematically break down each component, from fundamental moneyness concepts to advanced volatility analysis, transforming complex data into clear, actionable market intelligence.

Learn how to read an options chain>>

Options Pricing

An option’s price (premium) has two components: intrinsic value (the amount by which the option is in the money) and extrinsic value (time value plus factors such as implied volatility and dividends).

Intrinsic Value:

Calls: Stock price> Strike price
Puts: Strike price> Stock price

Extrinsic Value includes:

Time until expiration (theta decay)
Implied volatility (vega)
Interest rates (rho)
Dividends

Key pricing dynamics:

In-the-money options include both intrinsic and extrinsic value; deeper ITM and nearer to expiration generally means a larger intrinsic value, while longer maturities leave more extrinsic value.
At-the-money options have intrinsic value close to zero, so the premium is mostly extrinsic, with the mix driven by time to expiration and implied volatility.
Out-of-the-money options have zero intrinsic value by definition; the entire premium is extrinsic.

The time value of options decays fastest as they near expiration, making short-term options more sensitive to time erosion. Understanding this helps traders select appropriate expirations and manage theta risk in strategies like calendar or diagonal spreads.

Options Moneyness

In-the-Money (ITM) Options

ITM options have intrinsic value. For calls, this means the stock price exceeds the strike price; for puts, the stock price is below the strike. ITM options have higher deltas (closer to 1 for calls or -1 for puts), meaning their prices move nearly dollar-for-dollar with the underlying stock. Deep ITM options behave similarly to stock positions but with the added benefits of leverage and defined risk.

At-the-Money (ATM) Options

ATM options have strike prices closest to the current stock price. These options contain only extrinsic value and are most sensitive to changes in implied volatility. ATM options are popular for straddles and strangles, as they provide more balanced exposure to potential upside and downside moves. Their gamma is highest, meaning the delta changes rapidly as the stock price moves. This makes ATM options appealing to buyers who expect price movement but are uncertain about the direction.

Out-of-the-Money (OTM) Options

OTM options have no intrinsic value - calls have strikes above the stock price, and puts have strikes below. These options are cheaper but require a more substantial price movement to become profitable. OTM options have lower deltas but higher potential returns if the move occurs.

They're often used for:

Low-cost speculative plays
Lottery-ticket style trades
Covered call writing (selling call options against an equivalent number of underlying shares — 1 contract per 100 shares)
Protective put strategies (buying put options against an equivalent number of underlying shares)

The probability of OTM options expiring worthless is higher, which is why sellers often target these options to collect premiums. However, when they do pay off, the returns can be exponential.

Option Volume and Open Interest

Option volume and open interest are also important liquidity indicators. Volume shows contracts traded daily, with high volume indicating active interest and tight spreads. Open interest tracks outstanding contracts, growing when new positions open and shrinking when they close. Rising open interest signals fresh capital entering, while declining interest suggests positions being unwound.

Key insights:

Heavy volume at specific strikes may reveal institutional activity
Growing far-dated open interest indicates longer-term sentiment
High open interest at strikes can create "pinning" near expiration (when the underlying price gravitates toward a strike due to hedging and position adjustments by market participants)

Traders use these metrics to:

Identify potential support/resistance levels
Gauge market sentiment
Spot unusual activity

Most platforms display this data via heat maps, highlighting concentrations of trading activity across strikes and expirations for quick analysis.

Implied Volatility (IV)

Implied volatility (IV) reflects the market's expected price swing magnitude, derived from option prices. High IV suggests anticipated significant moves, while low IV forecasts stability.

IV critically impacts premiums through:

Volatility smile (a pattern where implied volatility is higher for deep ITM and OTM options than for ATM options)
Mean-reversion tendencies (IV often moves back toward its historical average after rising or falling sharply)
Event-driven spikes (earnings, economic data)

Trading strategies adapt to IV:

Buying options when IV is low (cheap premiums)
Selling when IV is high (rich premiums)
Employ volatility spreads (iron condors/straddles)

The "IV crush" occurs post-event when volatility collapses, rapidly eroding option values regardless of stock movement. Understanding IV helps select appropriate strategies and manage risk exposure effectively across different market conditions.

Implied Volatility (IV) Rank & Percentile

IV Rank and Percentile measure how the current IV compares historically. Rank scores 0-100 based on 52-week range, while Percentile shows what percentage of days had a lower IV.

Practical applications:

Rank>50 = expensive options (favor sellers)
Rank <30 = cheap options (favor buyers)
Percentile adds context to Rank readings

These metrics help:

Time premium sales in high IV regimes
Spot mean-reversion opportunities
Adjust strategies to volatile environments

For example, 75 IV Rank with 80% Percentile indicates top-quartile expensive options, generally well-suited for premium-selling strategies. Most modern trading platforms now incorporate these tools directly in their analytics, allowing quick volatility assessments across different expirations and strikes.

Put/Call Ratio

The put/call ratio (total put volume divided by call volume) gauges market sentiment:

Above 1 = bearish (more puts)
Below 1 = bullish (more calls)
Extremes signal potential reversals

Variations provide nuance:

Equity-only ratio (retail sentiment)
Index ratio (institutional bias)
Single-stock ratios

Key interpretations:

Spikes in the ratio can often indicate a surge in put buying, which can signal fear or capitulation in the market
Sustained low put to call ratio readings suggest heavy call buying, which might precede market pullbacks if sentiment becomes overly bullish
Divergences between equity/index ratios suggest rotation

While valuable, the ratio works best combined with:

Volatility index readings
Market breadth
Technical analysis

Advanced traders also monitor open interest ratios for longer-term sentiment analysis. The metric serves as a useful contrarian indicator at extremes but requires context for proper interpretation.

American vs. European Options

The difference between American and European options has nothing to do with location, only the timing of the option.

With American options, the contract holder can exercise the option at any time before the expiration date. However, European options can only be exercised on the expiration date.

American options may command higher premiums due to their flexibility, allowing for early exercise. However, exercising an in-the-money (ITM) option prematurely isn't often advantageous for most traders. It could result in forfeiting remaining extrinsic value and assuming the risk of holding the underlying stock (in the case of a call option). Thus, while some traders may value the option to exercise early strategically, many opt to capitalize on the option's time value and market conditions instead of exercising prematurely.

Learn more about American and European options>>

Options Risk Metrics: Understanding the Greeks

When it comes to risk metrics used with options, you may be thinking, “It’s all Greek to me!” Let’s look at what these risk metrics are and how you can use them with your strategy.

In the options market, the term “the Greeks” is used to describe the variables used to measure different factors that might affect the price of an options contract. They are called this because they are usually associated with Greek symbols. The most commonly used are Delta, Theta, Gamma, Vega, and Rho.

Fun fact: Vega is not actually a real Greek letter, but is now an accepted term in options trading.

Delta

Delta measures how sensitive the option’s price is in relation to the underlying asset’s price. This sensitivity is calculated by measuring how much an option’s price changes with a $1 change in the underlying asset price.

For call options, delta has a range between zero and one. The range for put options is between zero and negative one.

Delta can also be used for more advanced strategies that are beyond a beginner’s level, so we won’t explore them here.

Theta

Theta measures how much an option’s price would decrease as it gets closer to its expiration date if every other factor remained the same. The rate of change between the option price and time is called time sensitivity.

Theta’s value is negative for long calls and long puts. Short calls and puts have a positive theta.

Good to know: When trading traditional stocks and not options, theta is zero because there is no expiration date and no time decay.

Gamma

Gamma helps determine how stable the option’s delta is. The variable measures stability by calculating how much the delta would shift if there was a $1 change in the underlying asset’s price.

The higher the gamma, the greater the instability. And increased instability means the delta is more likely to change drastically, even with small movements in the underlying asset’s price.

Time is a significant factor for gamma because options contracts are more sensitive to price changes the closer they get to expiration. So, the closer to the expiration date, the higher gamma tends to be.

Options with a longer expiration will typically have a lower gamma value because they are less sensitive to changes in the delta.

Vega

Vega measures how sensitive an option is to volatility and shows how much the option's value may change when there is a 1% increase or decrease in the underlying asset’s implied volatility.

Volatility has a major impact on the value of options. A higher implied volatility usually means that the underlying instrument is more likely to experience extreme value fluctuations, which can lead to increased uncertainty.

The higher the volatility, the higher the value of the option. The lower the volatility, the lower the value of the option, all things remaining equal. Because of this correlation, options with longer expiration periods will have a higher vega because the price will not be as easily influenced by fluctuations in the underlying asset value.

Long option calls always have a positive vega value. Short options have a negative vega value.

Rho

Rho measures how sensitive options contract prices are to the risk-free interest rate changes. This value shows how the option’s value will change when there is a 1% change in the interest rate.

Typically, Rho will have a positive value for long calls and a negative value for long puts. Rho is positive for short puts, and negative for short calls.

If interest rates are low, price differences between call and put options are typically rather small. The gap between the two tends to increase as the interest rates rise, generally making calls more expensive and puts cheaper, all things remaining equal.