We think this quiz on how options trading works will serve to increase your investing knowledge, so you can profit more through making better buying decisions

Stock options are investment products that give you the right, but not the obligation, to buy a stock for a fixed price, within a fixed time period.

Do you know how options trading works? Test your knowledge below in our quiz on options trading.

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A. True or False: Stock options generate a lot of broker commissions.

You are correct if you answered “True.”

Buying stock options generates a lot of brokerage commissions, which is why some young, aggressive brokers recommend them for their clients.

In stock options, you’ll pay a higher-percentage commission on your outlay. Also, your stock options will have a limited life, expiring in a fixed period of weeks or months. Then you’ll pay another commission to replace them.

Stock-options trading is a great deal for brokers, because options investors pay much higher commissions than stock investors; they also pay commissions more frequently. That’s why options trading is generally a bad deal for investors.

 B. How options trading works: What is the commission outlay you could expect to pay in trading options?

1. 3% to 10%
2. 1% to 2%
3. 18%-20%
4. No commission required

You are correct if you answered 1.

In stock options, you’ll pay a higher-percentage commission on your outlay, perhaps 3% to 10%.

C. Which of the following is not true with regards to how options trading works?

1. The buyer pays the seller a fee in exchange for specific rights to the stock, and the seller assumes certain obligations.
2. Options do not trade through stock exchanges.
3. Each options contract is for 100 shares of stock.
4. Each contract has a limited life span, and the expiry date is the date on which the contract expires.

You are correct if you answered 2.

An option is a contract between a buyer and a seller, based on an underlying security, usually a stock. The buyer pays the seller a fee, or premium, in exchange for certain rights to the stock. In exchange for the premium, the seller assumes certain obligations.

Options trade through stock exchanges, with prices quoted each day in the financial section of newspapers. Each options contract is for 100 shares of stock. So, one contract quoted at $5 will cost you $500 (before commissions).

Each contract has a limited life span, or time to expiry—usually less than nine months. The expiry date is the date on which the contract expires.

D. “Market makers” do which of the following:

1. Sell options to traders
2. Buy options from traders
3. Trade both sides of the market
4. All of the above
5. None of the above

You are correct if you answered 4.

Options players often wind up buying from or selling to options “market makers.” These market makers are full-time, highly skilled professionals who are employees of or partners in options-brokerage firms. They don’t pay commissions in any real sense; instead, they share in the commissions that their firms receive.

Market makers trade both sides of the market—that is, they write new options contracts whenever they think they can profit by doing so. They don’t guess right every time, of course. They do guess right (or close enough) much more often than options players who are non-professionals.

E. True or False: Trading options is a smart move in retirement.

You are correct if you answered “False.”

Stock options are not a smart idea if you’re headed into retirement. As mentioned, stock options are expensive to trade and you pay commissions each time you buy or sell stock options. Commissions eat up a large part of any profits you may make with stock options. That’s especially the case if you trade in small quantities.

Stock options can also be rendered worthless. Unlike common stocks, an option has a limited lifespan. You can hold common stocks indefinitely in the hope that their value will increase. Indeed, stockholders can wait out temporary downturns in the hope of eventually realizing a profit. But every option has an expiration date.

If an option is not sold or exercised prior to its expiration date, it expires and is worthless. For this reason, an option is considered a “wasting asset.” Part of the price you pay for an option is for “time” it affords you. With each day that passes, you lose more and more of this “time” premium.

Use our three-part Successful Investor approach to make better stock picks—and avoid options

Of course, a handful of options investors do make money—after all, somebody has to win the lottery. But on average, you just can’t make enough of a profit to pay the commission costs and leave yourself with any significant gains. That’s why most options investors wind up losing money.

Rather than trade options, at TSI Network, we recommend using our three-part Successful Investor philosophy to build a portfolio of stocks as follows:

1. Invest mainly in well-established companies;
2. Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
3. Downplay or avoid stocks in the broker/media limelight.

Have you made a profit with stock options? What do you think was the secret to your success?