Options can be confusing, complex, and risky. Still, they’re popular among investors who understand their mechanics. Why? Because options can produce gains and income. They’re also widely used to protect against losses in a portfolio.
What are stock options?
Stock options are legal contracts that grant the right to buy or sell a security, like a stock or ETF, at a specific price before a certain date. The contract specifies:
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Whether the contract allows shares to be bought or sold
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How many shares can be transacted under the agreement
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The price at which the shares can be transacted, called the strike price or exercise price
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The expiration date when the contract expires with no value
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Whether the option is American or European, which affects exercise timing (American options can be exercised anytime before expiration, and European options can only be exercised at expiration)
There are two parties to an options contract: a buyer and a seller. The buyer, known as the option holder, purchases the contract by paying a nonrefundable premium to the seller, who is called the option writer. The rights and obligations of option holders and writers differ based on the type of contract. The two main types are calls and puts.
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Call and put options defined
Holders don’t have to exercise their options. For example, the holder of a call option wouldn’t proceed with the transaction if the market price of the stock is less than the strike price. In that case, the better strategy is to do nothing and let the option expire. Alternatively, the holder can sell the option to a third party before expiration.
Option writers have fewer choices. If the holder exercises the option, the writer must fulfill the transaction.
Note that writers can sell covered or uncovered positions. Covered options are backed by owned shares or cash collateral, depending on the contract type. Uncovered, or naked, options are not backed and have much higher risk potential.
Options buying example
To buy or sell an option, you should have a strong opinion about a stock price’s future. Let’s use Apple (AAPL) as an example. Suppose the current share price is $340 and you predict it will rise to $360 in the next month. You could act on that prediction by purchasing a call to buy 100 shares at $350 each.
A reasonable premium might be $5 per share or $500 for 100 shares. Once the premium is paid, three things could happen:
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The stock price could rise above the strike price, which puts the contract “in the money” for the holder. An in-the-money contract is valuable, because it grants the right to buy the stock for less than market value. The holder can sell the contract for a gain or exercise the options and purchase the stock to hold or resell.
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The stock price could rise to the strike price. At this point, the contract is “at the money.”
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The stock price could remain below the strike price. The term for this is “out of the money.”
At-the-money and out-of-the-money contracts are only valuable to investors who believe the share price will rise above the strike price before expiration. If the stock price remains too low, the market value of these contracts declines as the expiration date nears — a dynamic called time decay.
Should the contract expire without value, the holder’s loss is the premium of $500.
How options make money and reduce risk
Holders use options to generate leveraged capital gains, and writers use options to generate income. Both holders and writers may also trade options to protect against potential losses in their portfolios.
Leveraged capital gains
Capital gains occur when an option holder sells an in-the-money options contract for more than the premium paid. Alternatively, the holder can exercise the options and resell the underlying shares for a profit.
Options are considered leveraged assets because holders can transact many shares for a small premium cost. Returning to the Apple example above, it only takes $500 for access to gains on 100 shares of AAPL. If you preferred to buy shares outright, the cash outlay is much higher at $34,000, or $340 per share times 100 shares.
Income
Option writers generate income by collecting premiums.
Selling covered calls is a popular way to use an existing portfolio to produce income. If the underlying security’s price never exceeds the strike price, the writer keeps the shares and the premium. If the share price does rise, the writer’s gain is capped by the strike price. Any gains above that go to the holder.
Hedging
Investors also use options to hedge or protect against losses. Say you worry that a position you own is headed for a correction. You could buy a put option on that security, using the strike price to set a floor for your loss potential on those shares.
Bottom line
Options have a deserved reputation for being complex and risky, but they’re also powerful. You can buy stock options to control large blocks of shares for a budget-friendly price, or write them for extra income on the shares you already own.
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What are options? FAQs
What is the difference between a call and put option?
A call option gives the holder the right to buy shares at the strike price before the contract expires. A put option gives the holder the right to sell shares at the strike price before the contract expires.
What does it mean to exercise an option?
Exercising an option means moving forward with the transaction outlined in the contract. On a call option, this would involve buying shares at the strike price. On a put option, the holder would sell shares at the strike price.
Are stock options and derivatives the same?
Options are a type of derivative because their value comes from another asset. The value of an options contract hinges on the market value of the underlying security relative to the strike price, type of contract, and time remaining until expiration.