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 over time.
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 defines 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 – Explaining Calls & Puts
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.
Stock Option Strike Price Explained
The strike price, also known as the exercise price, of a stock option represents the price at which an option contract can be exercised.
For a call option, it signals the share price where the underlying stock can be purchased.
The strike price of a put option represents the value at which the underlying security can be sold.
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. Companies that tend to have a lower price per share usually increment by $2.50 whereas higher priced stocks increment by $5.00. Stock splits and the timing of when option contracts are set also play a factor in how a strike price is set.
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 sale 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.
Valuing the Option Premium
It is important to understand the difference between the strike price of an option and the premium. The strike price always remains static throughout the entire option contract. As mentioned earlier, this is the price at which a stock can be purchased or sold depending on the type of option.
The option premium is the amount of cash that is paid to the seller of the contract. This payment gives the buyer of the option the right (but not the obligation) to buy (call) or sell (put) the underlying stock.
While the premium and strike price represents two different values, the strike price actually helps to determine the premium along with other factors.
For a call option that is out of the money, the higher the exercise price is set the lower the premium. On the other hand, the further an option is in the money the higher the premium. There are also other factors that help determine the premium of an option (like the expiration date), but the strike price is very important.
The premium for put options is also impacted by the exercise price. As a stock trades lower away from the strike price, the premium becomes higher. On the other hand, as the stock increases in value, the premium becomes worth less.
Why Understanding the Stock Option Strike Price is an Essential Concept
The strike price is an important concept to understand for investors looking to trade calls and puts. It simply represents the value in which a stock can be purchased (call) or sold (put) at. The exercise price plays a large role in helping to value an option contract which is referred to as the premium.
What’s “In the Money”?
A call option that is in the money has a strike price that is lower than the current price of the underlying stock. The owner of this type of option would have the right to exercise the contract and purchase shares of the stock for less than the current share price.
For example, a stock trading at $20 may have a call option with a strike price of $15. The owner of the option would have the right to exercise the option and purchase shares of the stock for $15, even though the current price is much higher.
The investor would then be free to sell the stock for the current share price ($20) for a $5 profit or hold it for a longer period of time.
In the Money Puts
An in the money put option has a strike price that is above the current price of the stock. In this case, the owner of the option would have the right to sell shares of the underlying security for more than the current traded share price.
A stock trading at $35 per share that has a put option of $40 would be considered in the money. The owner of the put option could sell back the shares of the stock for a $5 profit per share in this scenario.
Deep In the Money Options
At times, both put and call options can fluctuate between being considered in the money or out of the money depending on where the stock is trading. This is why many options investors search out contracts that are considered to be deep in the money. A deep in the money option is generally considered to be at least one strike price above or below the current share price.
Both put and call options that are deep in the money tend to carry less risk and are valued much higher than contracts with a strike price at or near the share price.
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.
Why is the Expiration Date Important?
The expiration date is an important part of defining a stock option and the value (or premium) that is tied to the contract.
For starters, an investor who has purchased a call or put that lets their contracts expire will have wasted their entire investment. An option that expires without being exercised becomes worthless after the expiration date.
The expiration date also plays a crucial role in helping to set the premium for the contract. For example, an out of the money option (put or call) that has 6 months till expiration is usually worth more than one that has 3 months till expiration.
The option that doesn’t expire for 6 months is considered to be worth more because it has more time to become in the money.
This concept is usually referred to as time value.
As you can tell, the expiration date plays a critical role in determining the premium of an option.
Option Trading Strategies
Any successful investor will include the expiration date into their option trading strategy.
In some cases, there are strategies where the investor looks for options that are set to expire very soon. For example, an investor who sells covered calls will normally pick out options that are set to expire in the next one or two months.
This is because investors are looking for call options that are out of the money but still are close enough to the strike price to hold some value. The main goal of a covered call trader is to actually hold onto their stock while earning the premium that was paid.
Another option trading strategy may target deep in the money call options that have several months to expiration.
The bullish strategy here is to purchase call options on quality stocks that are well in the money that have very little chance of becoming out of the money. The investor then waits for a positive run-up in the stock and sells the call option back for a higher premium than what they originally paid.
The difference in the purchase price and the sale price is the profit earned by the investor. The bottom line here is that the expiration date is a critical piece of data used by the investor to implement their strategy.
Steps to Selling Covered Calls
There are a few important steps that you need to be aware of when selling covered call options. Here is an oversimplified list of steps an investor needs to take in order to successfully implement this basic options strategy.
- Buy the Stock – In order to be “covered” on your trade, you first must own the underlying stock. Remember that for every option contract you sell, you must own 100 shares of the stock. Your broker will not allow you to place the trade without these shares in your brokerage account. A broker will also require special approval in order to trade options, so a standard online brokerage account may or may not offer this feature.
- Find ‘Out of the Money’ Options – It is helpful to look for call options for your stock that are out of the money. A call that is out of the money will have a strike price that is higher than the current share price of the stock. For example, you may find an option for a stock with a strike price of $55 and the share price is currently at $50. This contract would be out of the money until the share price hits $55.01. Once that threshold is passed, then the option contract is considered in the money.
- Look for Soon to Expire Contracts – Another important step that can be used to limit your risk is to look for soon to expire call option contracts. Most investors who sell covered calls don’t actually want to lose the stock and would prefer it to expire without being exercised. Since options are time sensitive, the seller should look to limit the total time the option is open. It is a good rule of thumb to look at call options that expire no more than 2 months out.
- Analyze the Potential Trade – Even though you may have found a call option that is out of the money and expires in less than two months, it is important to analyze the trade. For example, if a potential covered call option trade will only net you $20, then it may not be worth risking your shares. Take the time to calculate how much you will profit from the trade and what would happen if your call option is exercised.
- Place the Sell Order – Once the analysis has been completed on the call option and the trade seems favorable, it is time to place the order. Work with your online discount broker to place a sell order to open transaction.
Final Thoughts on Stock Options Trading
In order to become a successful term-term options trader, an investor must spend the time learning the basics.
The five 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 of 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.