Options trading might sound complicated at first, but it's worth exploring for its unique potential to enhance your trading strategy. In this guide, we'll break down the basics of options, explain how they work, and discuss why traders use them to diversify their portfolios.
What Are Options, and Why Trade Them?
Options are financial instruments known as derivatives, meaning their value is tied to an underlying asset. When you trade an option, you’re not directly buying or selling the asset itself—instead, you’re trading a contract that gives you the right, but not the obligation, to buy or sell the asset at a specific price by a specific date.
Options can be traded on a variety of assets, including:
Stocks
ETFs
Indices
Foreign currencies
why trade options?
So, why trade options instead of just buying shares or futures? For one, options provide flexibility and leverage. With options, you can potentially control a large number of shares with a relatively small amount of capital.
Let’s say you believe the S&P 500 (SPY) will rise in value within the next month. For example, by November 22nd, you think SPY will be trading at $590 or higher.
Here are your two main choices:
1. Buy shares directly
If you want to buy 100 SPY shares at $590 each, you’d need $59,000.
2. Buy a call option
Alternatively, you could buy a call option. This would give you the right to purchase 100 shares of SPY at $590 per share by November 22nd—but instead of paying $59,000 upfront, you’d pay a fraction of that cost, say $621 (the premium).
What’s the Advantage?
The main advantage of buying a call option is leverage. With a smaller initial investment (the premium), you can potentially benefit from the movement of 100 shares without tying up tens of thousands of dollars.
For example:
If SPY rises above $590 by the expiration date, you could sell the option for a profit.
If SPY doesn’t hit $590, your loss is limited to the premium you paid ($621).
This flexibility and lower capital requirement are what make options appealing to traders.
What is the Difference Between Buying and Selling Options?
Options trading revolves around two key actions: buying and selling options. Whether you are buying a call, selling a put, or engaging in any other option strategy, the underlying concept is that there’s always a counterparty—a trader selling you the option or buying the option from you. Let’s break this down with an example of buying a call option and selling a put.
Buying a Call Option on SPY
Imagine you’re very bullish on the S&P 500 (tracked by SPY) and believe its price will rise. You decide to buy a call option. By doing so, you’re paying a premium to another trader who is selling you the call.
In the Money (ITM) vs. Out of the Money (OTM):
When buying a call, if the SPY’s price is above the strike price at expiration, the option is "in the money" (ITM), and you’ll make a profit. If the SPY’s price is below the strike price, the call expires worthless, and you lose the premium you paid.
For instance, let’s say SPY is trading at $590, and you buy a call option with a strike price of $590, expiring in one month. If SPY rises to $600 by expiration, your option is ITM, and you can sell the call or exercise it for a profit. However, if SPY stays below $590, you lose the premium you paid for the option.
Buying options involves paying for leverage, and it’s essential to note that most options expire OTM, resulting in a loss of the premium.
Selling a Put Option on SPY
Now, consider a scenario where you’re moderately bullish or neutral on SPY and believe it won’t drop significantly in the near term. Instead of buying a call, you decide to sell a put option.
Earning Premiums:
When you sell a put, you collect the premium upfront. If SPY’s price stays above the strike price, the option expires worthless, and you keep the premium as profit.
For example, if SPY is trading at $590 and you sell a put with a $565 strike price, expiring in one month, you’re essentially betting that SPY won’t fall below $565. If SPY stays above $565, you keep the premium without any further obligations.
Assignment Risk:
If SPY’s price drops below $565, you’re obligated to buy 100 shares of SPY at $565 per share, regardless of the market price. This requires significant capital and is why selling options often involves a higher barrier to entry.
Selling options, particularly cash-secured puts, is often viewed as a strategy with a built-in edge. Since most options expire worthless, sellers benefit from consistently collecting premiums over time.
How Can I Sell Options Without Tying Up Too Much Capital?
Selling options can be a profitable strategy, but many traders are concerned about the capital required to execute these trades. One way to sell options with reduced capital requirements is by using a bull put spread, a common strategy that allows you to collect premium while limiting your risk.
What Is a Bull Put Spread?
A bull put spread is an options trading strategy used when you have a moderately bullish outlook on an underlying asset. It involves selling one put option while simultaneously buying another put option with a lower strike price (further out of the money). This creates a "spread" that caps your maximum loss, thereby lowering the collateral required.
Here’s a step-by-step breakdown:
1. Sell an Out-of-the-Money Put:
This is the first step to collect premium. You sell a put option with a strike price that is below the current market price of the underlying asset. Since this option is closer to the current price, you receive a higher premium.
2. Buy a Further Out-of-the-Money Put:
To limit your downside risk and reduce the collateral needed, you buy another put option with a strike price lower than the one you sold. This put will be cheaper, as it is further away from the current price.
The difference in strike prices creates a defined range of risk, allowing you to enter the trade with significantly less capital compared to selling a single naked put.
Example of a Bull Put Spread:
Let’s say the stock price of an asset is $579, and you are moderately bullish. You could construct a bull put spread as follows:
Sell a 571 Put:
This option is closer to the current price and pays a premium.
Buy a 570 Put:
This option is further out of the money and cheaper to purchase.
By doing this:
You collect premium from selling the 571 put.
You limit your downside risk by buying the 570 put.
If the price remains above the higher strike price (571 in this case) by expiration, both options expire worthless, and you keep the net premium as profit.
Risk and Reward:
Max Profit:
The net premium collected when you sell the put and buy the lower strike put.
Max Loss:
Limited to the difference between the two strike prices, minus the premium collected.
for example:
Max Reward: $240 Max Risk: $760
In this case, you risk $760 to potentially make $240, creating a controlled risk strategy.
Why Use a Bull Put Spread?
Reduced Collateral: Since your risk is capped, the margin requirements are significantly lower than selling naked puts.
Controlled Risk: You know the maximum possible loss before entering the trade.
Collect Premium: By selling options, you profit from time decay and stable or rising prices.
This strategy allows traders with smaller accounts to collect premium consistently while managing their downside risk effectively.
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WeBull is a popular US-regulated brokerage frequently recommended for options trading. Known for its user-friendly interface and diverse range of tradable assets, WeBull is a go-to platform for many traders seeking to trade options, ETFs, stocks, and even futures.
Why Consider WeBull?
Intuitive Design: The platform offers a sleek and straightforward interface that makes it easy to map out trades, even for beginners.
Variety of Products: Traders can access options, stocks, ETFs, and futures on the platform.
Regulated Broker: As a US-regulated brokerage, WeBull provides a secure and reliable trading environment.
Options for Traders Outside the US
While WeBull primarily caters to US-based traders, it is also available to individuals in select countries, such as the UK and the Philippines. Prospective users should confirm their country’s eligibility before creating an account.
For those in regions where WeBull is unavailable, Interactive Brokers is another widely recognized platform. Interactive Brokers supports traders from many countries and offers a comprehensive range of products. While its interface may be less intuitive than WeBull’s, it remains a reliable option for international trading.
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Our website contains affiliate links to brokers. If you sign up and make a deposit through our link, we may earn a commission at no additional cost to you. This helps support our content and website. However, this has no bearing on our reviews and comparisons. We strive to provide fair and balanced information to help you make the best decision for your needs.
Why Does My Broker Not Allow Certain Strategies?
Sometimes traders encounter restrictions when trying to place certain options trades, such as selling naked puts or executing spreads. These limitations are often due to the broker's requirements around risk management, compliance, and regulatory considerations.
Tiered Levels for Options Trading
Most regulated brokerages, including platforms like WeBull, use a tiered system for options trading based on your experience, risk tolerance, and account status. This system ensures traders understand the risks before accessing more complex strategies.
1. Know Your Customer (KYC):
Brokers are required to evaluate your trading knowledge and financial situation to determine the appropriate risk level. This is part of the compliance process to protect you as a trader.
2. Option Levels:
Brokers classify options strategies into different levels. For example:
Level 1: Basic strategies, like selling cash-secured puts (requires sufficient cash in your account as collateral).
Level 2: Includes buying calls and puts.
Level 3: More advanced strategies, such as credit spreads (e.g., bull put spreads) and other defined-risk trades.
To gain access to higher option levels (like Level 3), you need to apply within your broker's platform. The process usually involves answering questions about your trading experience and risk tolerance.
Example: WeBull Options Tiers
On WeBull, you might encounter the following restrictions:
If you want to sell cash-secured puts, you need enough collateral (e.g., $10,000 in cash).
To trade credit spreads (like the bull put spread mentioned earlier), you need Level 3 approval.
If you cannot execute a trade, it is often because your account does not yet qualify for the required options level. To resolve this:
Apply for a higher options level through your broker's portal.
Search online for instructions (e.g., "How to apply for Level 3 options on WeBull").
Why Do Brokers Require This?
Brokers are obligated to ensure that traders understand the risks associated with options. By restricting certain strategies to experienced or approved traders, they help manage risk for both you and themselves.
Before trading options, make sure to:
Understand the strategies you want to use.
Ensure your account has the appropriate approval level.
Assess your risk tolerance and trading knowledge.
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Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and is not suitable for everyone. You may lose more than you invest. Price and performance data is provided for informational purposes only and is not investment advice. Past performance is not indicative of future results.
There is a significant degree of risk involved in trading securities. With respect to foreign exchange trading, there is considerable risk exposure, including but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. The vast majority of retail client accounts lose money when trading in CFDs. You should consider whether you can afford to take the high risk of losing your money.
