In this article, we'll cover the basics of options, why an investor would use them, and how they work.
What Are Options?
An options contract gives the buyer the right, but not the obligation, to buy or sell something at a specific price on or before a specific date.
(Note: We are going to stick with American options here, where you can exercise your option at or before the expiration date. With European options you can only exercise your option on the expiration date.)
Let’s say a stock is trading at $50 and I believe the stock will rise dramatically over the next couple of months. I could either buy the stock for $50 per share or I could buy an option to buy the stock at a later date. We’ll walk through the dynamics of this and why you might want to do that.
Call vs Put Option
There are two types of options, call options, and put options.
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A call option gives the purchaser the right to buy the underlying stock at the pre-set price at or before a specific date.
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A put option gives the purchaser the right to sell the underlying stock at the pre-set price at or before a specific date.
Buying or Selling Options
Another important thing to note is that just as there are buyers and sellers of stocks, there are buyers and sellers of options. If you buy a call option from someone else, they are selling or “writing” that call option. There are strategies for both buying and selling options depending on your preferences and risk tolerance.
Core Components of Options
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Strike Price: This is the pre-set price that the buyer of the option can buy or sell the underlying stock at. For example, I can buy a call option that allows me to buy a stock at $50, the strike price.
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Expiration Date: The date the contract expires. Exercise rights depend on the option's style and contract terms. An out-of-the-money option generally expires worthless; an in-the-money option may be exercised automatically under the applicable procedures. Broker deadlines can differ from the expiration time.
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Option Premium: This is how much the option purchaser needs to pay to enter into that contract and how much the seller of the option gets paid.
Example: The Value of Options
Earlier on, you may have been asking, “why don’t I just buy or sell the stock?” Well, options provide an alternative way to both hedge risk and generate profits. Let’s take a simple example to understand how options can generate a larger profit than buying the underlying stock. Say a stock is trading at $50 and I think it’s going to go up to $60 in the next month.
A standard U.S. equity option usually represents 100 shares. Adjusted contracts and other types of options can have different deliverables, so check the contract specifications.
Now, if I purchased 100 shares of the stock, I would need to put down $5,000 ($50*100). If I want to buy a call option at a $50 strike price with expiration in one month from now, I might only have to pay $2 per share, totaling $200 for one contract (100 shares).
Options pricing is fairly complicated so we will leave that complexity out of this article.
Instead of putting down $5,000 to make my bet, I only had to put down $200. Now, in one month from now, for simplicity, the stock could be at $50 or $60.
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Stock = $50
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If I owned the stock, I would have made $0 in profit because there was no movement
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If I purchased the call option, I would have lost $200 because I paid $200 in option premium to buy the contract and then it expired worthless because I was wrong on my bet
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Stock = $60
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If I owned the stock, I would have made $1,000 in profit ($10 gain * 100 shares). This would be a return of 20% (1000/5000).
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If I purchased the call option, I would have made $800 in profit ($10 gain * 100 shares - $200 premium). Although the net profit was less, my overall return was 400% ($800 profit on $200 investment).
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As you can see in this example, a call option can be a good way to speculate on stocks rather than just buying the stock outright. While options can amplify your profits they can also increase your risk and exposure.
Disclaimer: We are not making any investment recommendations in this article. Please do proper research before making any investments.
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