Individual retail traders are most likely to trade "listed" options, also called exchange-traded options. These are standardized option contracts that are traded on exchanges. Listed options are available on many stocks, ETFs, indexes, bond futures, commodity futures, and currency futures. There are even options on things like interest rates, inflation rates, and the weather. The benefits to exchange-traded options are standardized contracts, liquidity, quick access to prices, and the use of clearing houses by exchanges.
Each listed option is standardized for the same quantity of the underlying asset. In the U.S., for example, one stock option is based on 100 shares of an underlying stock, and one futures option is based on one futures contract. Options come in two varieties, calls and puts, and you can buy or sell either type. You make those choices - whether to buy or sell and whether to choose a call or a put - based on what you want to achieve.
For both calls and puts, several strike prices are usually available at regular price intervals. There are also several different durations (expiration dates) available, following a set pattern. In stocks, for example, one set of options expires in 30 days or less, another set of options expires in approximately 31 – 60 days, another set expires in approximately 3 – 6 months, and so on, going out as far as 2 years or more.
By standardizing options contracts, the exchanges make them useful to a large group of investors. This is what allows a liquid market with frequent trading to exist. Since the markets are constantly moving, options prices are continuously quoted and changing.
Market makers at the options exchanges are always publicly posting prices at which they are willing to buy and sell each option. They stand ready to take the other side of your trade, and thus "make a market" in the options they are responsible for. Once an order is received, the market maker seeks an offsetting order or immediately fills the order from its own inventory. This process takes place in mere seconds, and allows both option holders and option writers to open and close options positions at any time.
The use of a clearing house, such as the Options Clearing Corporation, means you do not need to worry about the trustworthiness of the other party to the transaction. Clearing houses stand in the middle of all futures and options contracts, acting as the buyer to every seller and a seller to every buyer. They guarantee both sides of the transaction.
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If an option holder exercises his option, the clearing corporation assigns any party holding a short position on a random, arbitrary basis. An option buyer never finds out, nor does he care, who sold the option to him. An option seller never finds out, nor does he care, who bought the option from him.
If you buy options, you start out with what's known as a net debit. That means you've spent money you might never recover. To make a profit you must sell the option back at a higher price (or exercise it and buy or sell the underlying at an equivalent discount to the current market price).
If you buy a call, you have the right to buy the underlying instrument at the strike price on or before the expiration date. If you buy a put, you have the right to sell the underlying instrument on or before expiration. In either case, as the option holder, you also have the right to sell the option to another buyer anytime during its term. On expiration day, you have the right to exercise it or to let it expire worthless.
As a seller, on the other hand, you begin with a net credit because you collect the premium right away. If the option is never exercised, you keep the money. If the option is exercised and you are assigned, you still get to keep the premium, but are obligated to buy or sell the underlying stock at the strike price. An option writer has no control over whether or not a contract is exercised, so they need to be aware that exercise is always possible at any time until the expiration date.
When you sell a call as an opening transaction you're obligated to sell the underlying at the strike price if you're assigned. When you sell a put as an opening transaction you're obligated to buy the underlying if assigned. Just as the buyer can sell an option they are holding at any time, an option writer can purchase an offsetting contract at any time to close the position (provided you have not been assigned) and end their obligation.
There are so many listed options available - and so many ways to trade them - you might not know where to begin. But getting started is easier than you think. You first need a clear idea of what you hope to accomplish, since options can play a variety of roles in different portfolios. Only after setting your goals will you be able to decide what type of assets to trade and the most appropriate option strategies for you to choose. No one objective is better than another, just as no single option strategy is better than another - it depends on your goals.
