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Four Basic Options Trades
While there are many exotic-sounding variations, there are ultimately only four basic ways to trade in the options market. You can either buy or sell call options, or buy or sell put options. Regardless of which side of the trade you take, you’re making a bet on the price direction of the underlying asset. But the buyer and seller of options are seeking to profit in very different ways.
Key Takeaways
- There are four basic options trades: buying a call option, selling a call option, buying a put option, and selling a put option.
- With call options, the buyer is betting that the market price of an underlying asset will exceed a predetermined price, called the strike price, while the seller is betting it won’t.
- With put options, the option buyer is betting the market price of an underlying asset will fall below the strike price, while the seller is betting it won’t.
What Do The Phrases “Sell To Open,” “Buy To Close,” “Buy To Open,” And “Sell To Close” Mean?
Trading Call Options
A call option gives the buyer, or holder, the right to buy the underlying asset—such as a stock, currency, or commodity futures contract—at a predetermined price before the option expires. As the name “option” implies, the holder has the right to buy the asset at the agreed price—called the strike price—but not the obligation.
Every option is essentially a contract, or bet, between two parties. In the case of call options, the buyer is betting that the price of the underlying asset will be higher on the open market than the strike price—and that it will exceed the strike price before the option expires. If so, the option buyer can buy that asset from the option seller at the strike price and then resell it for a profit.
The buyer of a call option must pay an upfront fee for the right to make that deal. The fee, called a premium, is paid at the outset to the seller, who is betting the asset’s market price won’t be higher than the price specified in the option. In most basic options, that premium is the profit the seller seeks. It is also the risk exposure, or maximum loss, of the option buyer. The premium is based on a percentage of the size of the possible trade.
Trading Put Options
A put option, on the other hand, gives the buyer the right to sell an underlying asset at a specified price on or before a certain date. In this case, the buyer of the put option is essentially shorting the underlying asset, betting that it’s market price will fall below the strike price in the option. If so, they can buy the asset at the lower market price and then sell it to the option seller, who is obligated to buy it at the higher, agreed strike price.
Again, the put seller, or writer, is taking the other side of the trade, betting the market price won’t fall below the price specified in the option. For making this bet, the put seller receives a premium from the option buyer.
Some Options Trading Terms
There are several terms to know when executing these four basic trades. The phrase “buy to open” refers to a trader buying either a put or call option, while “sell to open” refers to the trader writing, or selling, a put or call option. “Sell to close” is when the option holder, the original buyer of the option, closes out either a call or put. “Buy to close” means the option writer is closing out the put or call option they sold.