What are Stock Options?

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Every investor wants to earn higher returns. Buying and selling stocks can help investors achieve their goals, but options trading may help you get there faster. These derivatives give you leveraged exposure to stocks and can result in quick gains. However, if you only go into stock options knowing the upside potential, you can end up accumulating losses. This guide will explore how stock options work, some of the best strategies, and insights for investors who want to give stock options a try.

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What are Stock Options?

Stock options are contracts for the right to buy or sell a certain amount of an asset (in this case, shares of stock) at a given price, known as the strike price. These contracts are valid until the expiration date.

Stock option contracts come in lots (groups) of 100 shares, where each contract represents one lot of 100 shares. Most options contracts are “American style” in that they can be used any time up until expiration.

“European style” options can only be exercised at the expiration date. Options contracts come in 2 different flavors: Puts give investors the right but not the obligation to sell a stock. Calls give investors the right but not the obligation to buy a stock.

These examples demonstrate how stock options work:

Put Example

Jon buys one contract for IBM at a strike price of $150 that expires in 3 months. The current price of the stock is $155. If IBM dips below $150 to $145, any time up until expiration Jon can exercise his right to sell 100 shares of IBM at $150.

If he did this when the stock was at $145, he could simultaneously buy 100 shares for $145 and sell them for $150, making a profit of $5 per share.

Call Example

Jon buys one contract of CSX at a strike price of $45 that expires in 1 year. The current price of the stock is $30. If the price of the stock shoots up to $55 on the day of expiration, Jon can exercise his option to buy 100 shares of CSX at $45 and then sell them at $55 on the day of expiration, making a profit of $10 per share.

If a contract reaches expiration and the underlying stock for a put option never falls below the strike, the options contract expires, worthless. Similarly, if a stock never goes above a strike price for a call by expiration, the contract also expires, worthless.

Stock Option Components

Stock options have a few special vocab words to know before trading them:

• Expiration date: The date up until which an option contract is good
• Strike price: Contracted price by which the contract can be exercised.
• Option premium: Cost associated with purchasing or selling an option made up of intrinsic and extrinsic values.
• Intrinsic (in-the-money) value: Value between a stock option strike price and the underlying stock’s price.
• Extrinsic value: Value paid on a contract based on external factors of time and volatility.
• Implied volatility: The expected or forecasted volatility in a stock over a certain number of days.

What’s worth noting is the price you pay for an options contract comes from the intrinsic value plus the extrinsic value. Generally, the more volatility a stock has or the longer you want an option contract to be held open, the more extrinsic value it has.

How to Trade Stock Options

Stock options are traded similarly to stocks. However, the implications of what they mean are very different.

Buying a Stock Option

When you purchase an options contract, you’re said to be long the contract. Being long a call contract is a bet the stock will go up while being long a put is a bet the stock will go down. Your losses are limited to the total price you paid for that options contract known as the premium.

In order to break even, you must be able to sell the options for more than you paid or exercise options that allow you to cover the cost of your premium.

Selling (Writing) a Stock Option

If you short a stock, you could, in theory, lose an infinite amount of money. In some cases, writing options can have the same effect. When you write a call option, you’re providing someone the right to buy stock from you at a designated price, and in return you receive a premium. In theory, the stock could go to infinity, and your losses could be unlimited.

When you write a put option, you are limited to the strike price multiplied by 100 shares of the stock. If you’re interested in opening a brokerage account to trade options, check out Benzinga’s guide to opening a brokerage account.

How to Use Stock Options

Stock options provide a number of valuable ways to invest and manage your portfolio. Here’s how you use stock options:

• Speculation: Stock options themselves can be used as a bet a stock will go up or down in the same way that purchasing or shorting a stock does. However, options limit your exposure and provide leverage in return for a premium.
• Hedge: As noted earlier, options can be used as a type of insurance. Investors often use options as a way to protect stocks within their portfolios.
• Alternative investment: Another way that many investors and traders use options is as an income stream through selling options. There are a variety of strategies that allow investors to collect premiums while managing their risk.

Corporate and Employee Stock Options

Though not often talked about in investing circles, corporate and employee stock option contracts provide a common way for executives and management to receive bonuses. Often CEOs will have option contracts available to them, which incentivizes them to work at increasing the share price of the company.

What is a Call Option?

In the securities market, a call option is a contract that gives you the right, but not the obligation, to purchase a certain amount of a security at a specified price within or at the end of a particular time frame. Also known simply as a “call,” its basic function is to “call” stocks or options away from an option writer or seller if certain conditions are met within or at the end of a specific time frame.

A call has two major components:

• The strike price: This is the price at which your underlying asset can be bought or sold if the option is exercised.
• The expiration date: This is the last day that your option is valid. After this date, the value of your option is 0 because the contract no longer has an enforceable aspect.

You can buy or sell a call option. If you buy, you have the right, but not the obligation, to call the notional amount of the option’s underlying asset away from its writer on or before the contract’s expiration date. If you are selling the option, a buyer has the right to call the notional amount of the option’s underlying asset at strike price away from you on or before the expiration date.

Exercising a call option on or before its expiration date by taking delivery of the underlying asset at the designated price is the prerogative of the option’s holder. A buyer may also sell the contract to another person before the expiration date at the market’s going rate for that contract. You can own as many call option contracts as your broker allows.

Example of a Call Option

You may see a call option written in the following format:

WMT240726C00132000

Within this string, you know the option’s strike price, expiration date and which stock it contracts to.

• WMT: shorthand for Wal-Mart (NYSE: WMT)
• 240724: the expiration date of the option, in YYMMDD format
• C: stands for “call.”
• 00132000: the strike price of $132

This option gives a buyer the right to purchase 100 shares of Wal-Mart at $132.00 until July 26, 2024. If a buyer decides to exercise the option when the open market price of WMT is $150, that buyer receives the 100 shares at $132. The shares will appear in the account once they are paid for.

There are other formats to communicate the details of a stock option, but they all contain the same 4 bits of information.

What Makes a Call Option Go Up?

There are exceptions, but most call options go up when the price of its underlying stock goes up. The price of the option tends to rise (or fall) at a faster rate than the stock price.

Call option premium may also increase as the volatility of a stock rises. Volatility can increase a call’s value even if the underlying stock stays flat for the day.

How Does a Call Option Make Money?

The call option has two components to its value: time value and intrinsic value.

• Time value (TV): This is equal to the option premium (current market price) minus the option’s intrinsic value. After the expiration time on the option’s expiration date, the time value of the option is 0.
• Intrinsic value (IV): The price of the underlying asset for delivery on the settlement date of the option.

You can also express the time value of an option as Premium – IV = TV.

The time value of an option generally declines. In order for an option buyer to profit from an option, its IV must increase faster than its TV decreases. Option writers make money when the IV does not increase faster than the TV decreases. This occurs with a call option when the underlying stock falls, trades sideways or rises in value too slowly.

Option buyers have the chance at much bigger profits. Buyers of call options are hoping for a quick rise in the stock price, for example, a jump after a positive earnings call. Call sellers are hoping for a decline, uneventful sideways or slow upward movement in the stock’s price.

Maximum Loss on a Call Option

If you buy a call option, your maximum loss is the amount of premium you spend on the contract. Knowing how much you can afford to lose makes it easier to enter a smaller, less risky position.

If you sell a call option “naked” (without any sort of hedge), your maximum loss is unlimited. Buying 100 shares of the stock and selling a covered call limits your upside and downside. Covered calls do not expose investors to the potential for unlimited losses.

Most Profitable Option Strategy

Here are some basic options strategies using calls only that can be profitable under the right conditions.

Selling Covered Calls

If you own 100 shares of a stock, you can sell a call option giving a buyer the right to call shares away from you. The trick is to sell the call “out of the money” or at a strike price that is above the open market price of the stock. When you sell a call, you take in a premium that you keep if the option expires worthless.

If the stock reaches the option’s expiration date at a price that is still below the call’s strike price, the option will expire worthless. Because the buyer can purchase the stock cheaper on the open market, he will not exercise the option.

The Simple Long Call Strategy

The trick is to limit the time you are in the market to reduce the chance of the market moving against you. You must also be sure that a stock is in an aggressive bull movement. How do you know this? Usually, there has just been some great news about the stock. Trading volume on the stock is up. Pullbacks are limited and short. Finally, don’t get greedy. Exit the trade fast (sometimes within seconds).

The Long Call Spread

If you believe a stock’s price will move up but not by much, you can execute a call spread to define your risk while creating a profit opportunity. A call spread involves buying a call and selling a call at a higher strike price for the same expiration date.

The call you sold will expire worthless, and you keep the premium. The call you bought will be in the money (the stock’s price is higher than the option’s strike price), and you will profit from the intrinsic value increase in the option.

Benzinga Options Newsletter

Options are an integral part of many sophisticated trading strategies that take time to learn and change in real-time. Keep abreast of the latest information in the Benzinga options newsletter and speed up your journey to mastery.

Learn More About Stock Options Now

Although most retail investors consider stock options as one-way bets on a stock, various strategies expand their possibilities. Some investors build entire portfolios of options strategies where they sell options and collect premiums while managing risk.

However, if you own stocks in your portfolio, looking for times of low volatility to purchase protection for stocks or using neutral strategies (like collars for high-dividend stocks) can augment your returns.

Want to learn more about options? Check out Benzinga’s guides to the best options trading platforms, the best options trading books and the best options trading courses.

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The post What are Stock Options? by Jordan Schneir appeared first on Benzinga. Visit Benzinga to get more great content like this.