What is options trading? A beginner’s guide

The types of options

Call options vs. put options: Side-by-side comparison

To help make these concepts as clear as possible, here’s an in-depth comparison between call and put options:

American vs European options

There are also two different “styles” of options, American and European, wherein the main difference is exercise timing. You can exercise an American‑style option at any time up to and including its expiration date, while a European‑style option can only be exercised on its actual expiration date.

As such, American-style options provide more control and flexibility, whereas European-style options are generally simpler to price and manage, making them popular for broader market instruments like equity indexes.

Despite their names, these option styles are not exclusive to geographic regions. In Canada, most listed options are American-style, but you can find European-style ones as well. It’s always a good idea to double-check the style of any option you trade to avoid costly mistakes.

To see how these concepts apply at the broader market level, index options are a useful example. In this video, you’ll learn how index options encapsulate broad market sentiment, offering exposure to the market’s direction through a single, efficient, and liquid product.

How does options trading work?

Each options contract typically represents 100 shares of the underlying asset. These contracts trade on exchanges when markets are open, and their prices fluctuate throughout the trading day.

Option prices shift based on two key components:

• Intrinsic value: the financial advantage of exercising the option now
• Time value: the value an option has from having time left for the asset’s price to change

Several factors influence these value metrics, including volatility, time until expiration, interest rates, and the underlying asset’s price. In a nutshell, higher volatility and longer timeframes tend to push option prices higher, while time decay gradually lowers value as expiration approaches.

Options for a given asset are quoted in an options chain, which lists out the available calls and puts, with columns for key components like strike price, premium, and expiration date. Quotes also include bid and ask prices, which show the prices at which you can buy or sell the option.

Here’s a visual breakdown of how an option quote appears when trading:

Once you buy an option, you can choose to hold it, sell it, or exercise it if permitted. If an option is exercised or expires in the money, the writer must fulfil their obligation of buying or selling the underlying asset, a process known as “assignment.” If the option is out of the money, it expires worthless.

Overall, the trading process can get tricky, but modern platforms make it easier to manage. BMO InvestorLine, for example, offers tools that help investors manage options positions more efficiently, including real-time margin buying power that automatically updates with precise, up-to-the-minute data. It also allows investors to roll, adjust, or close positions directly from their holdings to help save time when managing active trades.

Why trade options?

Options trading comes with unique advantages that can appeal to both novice and seasoned investors:

1. Leverage: With a smaller upfront investment (the premium), you can control a larger position in the underlying asset.
2. Risk management: Options can act as a hedge to protect your portfolio, like buying a put option on a stock you own to offset potential losses.
3. Profit in any market: Unlike stock investing, you can profit from rising, falling, and sideways market movements, diversifying your risk across different scenarios.
4. Income generation: Writing options lets you collect premiums, providing a potential source of income in addition to returns from your underlying assets.

If you’re new to options, investing through BMO gives you access to strong educational support that can help build your confidence as you learn different strategies.

How to trade options

Now that you know what options trading is and how it works, you might be wondering how to get started. The process is relatively straightforward:

Step 1: Open a brokerage account that supports options trading. You may need to apply for options trading approval. 

Step 2: Choose the underlying asset, such as a stock, ETF, or index, that you want to trade options on.

Step 3: Research the market and select a strategy. If you’re using a BMO InvestorLine Self-Directed account, built-in tools like Strategy Builder can help you evaluate different strategies with visual profit/loss scenarios. You can choose to:

• Buy a call or put
• Write (sell) a call or put

Step 4: Set up the trade by selecting strike price, expiration date, and quantity in the options chain. Remember that one contract typically represents 100 shares.

Step 5: Place the order:

• Select “Buy to open” if you’re buying an option
• Select “Sell to open” if you’re writing an option

Step 6: Monitor and manage your position until you close it or it expires.

While options trading is accessible, it should be approached with careful planning and strategy. The good news is that, depending on your brokerage account, you can leverage features designed to help you make the right decisions. BMO InvestorLine’s Position Type View, for example, can help you visualize how your option positions relate to one another, making it easier to track and manage complex strategies.

Options Trading example

Let’s dive into a detailed example to understand the potential of options trading:

Imagine stock XYZ is currently trading at $50 per share. You believe the price will increase, so you purchase a call option with the following terms:

• Strike Price: $55
• Premium: $2 (total cost: $200, as one contract represents 100 shares)
• Expiration Date: 30 days till expiry

Scenario 1: Stock price rises

If stock XYZ’s price rises to $65 before the option’s expiration then this call option contract would be ‘In The Money’, or ITM, because the underlying price ($65 per share) is greater than the contract’s strike price ($55 per share). There are two scenarios to consider.

Option 1: Sell the option contract

The value of the option contract itself will have increased since the right to purchase shares of Stock XYZ for $55 per share when Stock XYZ is trading for $65 per share is valuable. You could simply sell the option contract. For example, let’s say the option contract is now priced at $10 on the market. Your overall profit would be $800 (less trading commissions). Here’s how that would be calculated:

• Initial Cost of Option Contract: -$200 ($2 contract price x 100)
• Total Sale Value of Option Contract: $1,000 ($10 contract price x 100)
• Net Profit: $800 ($1,000 - $200) less commissions

Option 2: Exercise the option contract

If you exercise the option contract then you would be obligated to buy 100 shares of Stock XYZ for $55 per share. You could then continue to hold the 100 shares of Stock XYZ, or you could sell them at the current market price of $65 per share to lock in your profit. If you did so, your total profit would be $800 (less trading commissions). Here’s how that would be calculated:

• Initial Cost of Option Contract: -$200 ($2 contract price x 100)
• Exercise Option to Buy Stock XYZ at $55 per share: -$5,500 ($55 x 100 shares)
• Sell Stock XYZ at $65 per share: +$6,500 ($65 x 100 shares)
• Net Profit: $800 ($6,500 - $5,500 - $200)

Here’s the corresponding break-even graph for this call option scenario:

Scenario 2: Stock price stagnates

If stock XYZ remains at $50 by the expiration date, the option is considered out of the money (OTM). You could let the option expire, and your total loss would be limited to the premium paid ($200). Alternatively, you can sell the option contract before expiry to reduce your loss.

Scenario 3: Stock price falls

If stock XYZ’s price drops to $45, the option remains out of the money. Again, your total loss is limited to the premium of $200, avoiding further losses that direct stock ownership might incur. You still have the ability to sell the option contract before expiry to reduce your loss.

By limiting your potential loss to the premium paid, options trading provides a cost-effective way to speculate on price movements while managing risk.

Risks of options trading

While options trading offers significant opportunities, it also involves inherent risks you should be aware of:

• Complexity: Understanding the nuances of options can be challenging for beginners.
• Potential for loss: If an option expires worthless, the buyer loses the entire premium paid.
• Time decay: Options lose value as they approach their expiration date, which can erode profitability.
• High volatility: Market fluctuations can lead to rapid changes in an option’s value.

Options trading strategies for beginners

→ Long calls

A “long call” strategy involves buying a call option in anticipation that the underlying security’s price will rise. If the price does move higher, the investor has two ways to potentially profit before the option expires: they can choose to exercise the call and buy the stock at the (lower) strike price, or they can sell the option contract itself—at a higher price—to capture the increase in its market value. This approach allows confident investors to benefit from upward price movements while limiting their downside risk to the premium paid.

→ Covered calls

A covered call strategy involves owning an asset and selling a call option on it to collect a premium. Ideally, the asset price remains below the call option’s strike price, allowing the option to expire worthless. In that scenario, the investor keeps both their shares and the premium received.

Writing a call without owning the shares (a “naked” call) can expose the investor to serious risk, as they may have to buy shares at a much higher market price. So, a covered call can help mitigate risk and generate extra income, although it also limits potential gains if the underlying asset price climbs above the strike price.

→ Long put

The “long put” strategy is when an investor buys a put option with the hopes that the underlying security decreases before the contract expires. Investors like to use this method because they can take advantage of stock decreasing without having to face major risks.

→ Cash-secured puts

A cash-secured put strategy involves writing a put option while setting aside enough cash to buy the underlying shares if you are assigned. If the asset stays above the strike price, the option expires worthless, and you keep the premium. If assigned, you must buy the shares, but there are no issues around affordability as you have the money at hand. Plus, they are effectively discounted as your net cost is reduced by the premium you received. 

→ Protected puts

Sometimes called a “synthetic call option,” a protected put strategy is when an investor buys a put option that is at-the-money (ATM) while also owning underlying securities in that contract. It’s often called a “married put” when you buy the asset and put at the same time. In other words, the protected put strategy revolves around hedging.

For example, if you owned Stock XYZ and bought a put option on it, this would be a hedge because while the stock may go down in value, the put option may conversely increase in value, offsetting the loss.

Wrapping up

Options trading can be a profitable investment strategy, but it can also be risky and complex. Beginning with lower stakes and simple strategies is a great way to get started, but it’s important to always consider your financial situation and risk tolerance.

If you want to explore more about options trading, BMO has several educational resources in multiple formats, whether you’re just starting or advancing your skills. There is also an in-depth course on options for beginners you can take for free.

Once you feel ready, getting started with BMO InvestorLine  is easy. With real-time margin buying power and industry-leading tools, you can access a fully integrated and guided options trading experience that supports you as you build strategies. Happy trading!