Trading stock options is one of the most profitable ways to invest in the stock market. It is also one of the riskiest strategies that could wipe out an entire portfolio in a very short amount of time. Buying and selling stock options is certainly not a beginner investing strategy, but is one that could slowly be added to an overall investment portfolio overtime.
As an investor gains experience in the stock market and is looking to add some additional risk, stock options may be a viable investment tool. So what exactly are stock options and how are they different than traditional assets that are bought and sold?
Definition of a Stock Option
According to Investopedia, a stock option is “A privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) a stock at an agreed-upon price within a certain period or on a specific date.”
Based on this definition, there are four key points that investors need to learn when it comes to stock options.
- the right, but not the obligation
- to buy (call) or sell (put) a stock
- agreed upon price
- within a certain period or on a specific date
Each of these points uniquely define how a stock option works and are each explained in more detail below.
Buyers Have the Right but no Obligation
Very few investments give the buyer of an asset (i.e. stock) the right to purchase without any obligation. For example, when an investor purchases a stock, they immediately own the asset until they decide to sell it. There is an obligation to own the stock once the investor places a trade and it is filled.
Buying a call option on the other hand, gives the investor the power (or right) to purchase the same stock at a later date at a predetermined share price. In return for this right, the buyer is required to pay a premium that is then transferred over to the seller of the option. So while the buyer of the option must pay this premium, they are locking in a future price of a stock that may increase or decrease.
Here is an example of how buying a call option works -
Say you are interested in purchasing 100 shares of a hypothetical company known as ABC. While you have the money to invest, you are not sure if you want to completely tie your money up in a single investment. Since shares of ABC are trading over $50 per share, you would need to come up with at least $5,000 to place a buy order to purchase the stock.
Another possible solution to hedge against future prices is to purchase 1 call option (1 option contract = 100 shares of stock) of company ABC. An investor who purchases this type of call with a strike price of $50 is locking in the option to buy 100 shares of the same stock at a future date. At this point, the investor is only out the premium paid to purchase this right and could let the contract eventually expire. There is never any obligation to purchase the stock in this scenario.
Types of Options
While there are plenty of option trading strategies, there are only two types of options which are referred to as calls and puts. Remember that purchasing a call gives you the right to purchase a stock at a fixed price within a set time. A put however gives you the right to sell a stock at a fixed price within a set time.
From the ABC example above, the investor chose to purchase a call option which gives them the right but not the obligation to buy the underlying stock for the agreed upon price. Buying a call option is typically viewed as a bullish strategy where the investor believes the stock price will increase over the next few months.
On the other hand, if an investor becomes bearish on a stock, they could purchase a put option. Purchasing this type of asset gives them the right but not the obligation to sell 100 shares of stock back to the seller for the agreed upon price. This strategy works well when a stock drops in price as the buyer of the option can purchase 100 shares of stock at the current price and turn around and sell them at a huge premium.
Commonly referred to as the exercise price, the strike price is the amount at which an option can be exercised. This fixed price represents the amount at which a stock can be purchased on a call option or sold on a put option. Most of the time, strike prices are found in $2.50 or $5.00 increments, depending on the underlying stock.
In the example above, the investor decided to purchase a call option at a strike price of $50. This price always remains static unlike a share price that fluctuates each trading day. The main purpose of the strike price is to allow an investor to lock in a future purchase price of a stock on a call option and a future sell price on a put option.
Note – The price that an investor actually pays for an option is not the strike price, but is the premium.
Unlike a stock, every option will eventually expire and become worthless at some point in time if it is not exercised. This point in time is known as the expiration date. There are several scenarios that can play out on or before this date, depending on the type of option and the direction the underlying stock is trading.
It is extremely important for new options investors to fully understand the concept around expiration dates. All options have a time value factored in and become less and less valuable as the expiration date draws closer.
In order to become a successful long term options trader, an investor must spend the time learning the basics. The four points listed above are the basic building blocks that define what stock options are. One of the most important things to remember is that purchasing a stock option (call or put) gives the buyer the right to buy or sell a stock with no future obligation. This is much different than what most stock investors may be used to.
A call option is a bullish strategy used to hedge against future share price increases. For those investors who are bearish on a stock, they can trade put options which can help hedge against future decreases in the share price of a stock.
As you can probably tell by now, there are a lot components to learn when it comes to options trading. While they do come with a high level of risk, trading options can be very profitable.
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