4 Ways to Trade Options

While there are many exotic-sounding variations, there are ultimately only four basic positions to trade in the options market: You can either buy or sell call options, or buy or sell put options. In establishing a new position, options traders can either buy or sell to open. Existing positions are canceled by either selling or buying to close.

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 stand to profit in very different ways.

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 its 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.

To Open vs. to Close

There are additional 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 that establishes a new position. Buying to open increases the open interest in a particular option, and increasing open interest can signal greater liquidity and point to market expectations. "Sell to close" is when the holder of the options (i.e., the original buyer of the option) closes out their call or put position by selling it for either a net profit or loss. Note that options positions will always expire on the expiration date for a particular contract. At that point, in-the-money options will be exercised and out-of-the-money options will expire worthless. There is no need to sell to close if an options position is held to expiration.

A trader may also "sell to open," establishing a new position that is short either a call or a put. A short put is actually taking a long position in the underlying market because put options rise in value as the underlying price declines. When you sell an option "naked" (i.e., unhedged), the option seller (known sometimes as the writer) is exposed, in theory, to unlimited risk. This is because the seller of an option receives the premium at the time of the trade, but if a short call position sees a rapidly rising underlying market, they can quickly see losses mount. "Buy to close" means the option writer is closing out the put or call option they sold.