How Do Stock Options Work
Buying and selling stock isn’t just limited to putting in orders for whatever the price is at the moment. You can actually take advantage of trading stock options – or a financial instrument that gives you the right to purchase or sell an asset at a future date. Stock options have values just like stocks, but otherwise have differences that make them unique.
Learning how to trade stock options gives traders leverage while reducing risk. Here, we’ll explore those benefits, explain how trading stock options works in the market, and cover other stock options basics.
What Are Stock Options?
As I covered above, a stock option is the right to buy or sell a stock at some point in the future. In other words, it’s a contract between two people to do something with a stock at a future price. This future reference price is called the strike. Since it’s a contract, an option can expire at its expiration date – the point after which the option becomes worthless if it isn’t exercised.
Before we go further, we’ll give you an example. Let’s say you want to buy a certain stock – ABC – in the future. You want 100 shares, and want to buy ABC at $10 (your strike price). Right now, ABC is at $8. You want to wait until the end of the month before you buy, so you buy an option to purchase 100 shares of ABC by the end of the month for $10. This is called a call option – the right (but not the obligation) to buy a stock.
What happens with this contract? Well, if the stock price goes past $10, you’ll profit because you’ll buy 100 shares at $52 – per the terms of your contract – and then sell them for whatever the market price is. If the price is $11 when you sell, you’ll make $1 profit per share, for $100 total.
Of course, in options, when you’re winning someone else is losing. That’s why trading options is called a zero-sum game, meaning you gain at the expense of another trader (and vice-versa). So to make that deal worthwhile for the other person, you pay what is called a premium, or a price per share. The premium could be $0.50 per share, in which case you’d pay the seller a total of $50 for a net profit of $50.
If the stock price never gets past $10, and stays at, say, $9, you of course wouldn’t want to buy because you’d take an automatic loss of $100 when you sold. This is in addition to the $50 premium. At this point, you could let the option expire and you’d only lose $50 in premium.
When you want to sell an option, you create what is called a put option – or a promise to sell the stock at a future date for a future price. In this case, you pay the other trader the premium to purchase the put option from him (making him the ‘seller’ and you the ‘buyer’) and have no obligation to sell the shares if he chooses to exercise the option.
What’s a simple formula for profit off an options trade?
Profit = [(Current Market Price – Strike Price) * Number of shares] – Premium
So, if you have an options contract for 100 shares of ABC at, say, $20 and the current market price after you exercise the option is $25, with a premium of $1 per share, you will make [(25-20) * 100] – 100, or $400.
- When you want to buy shares of a stock, you are purchasing a call option. You have the right to buy the number of shares (called the lot size) at the price before a given expiration date – but you don’t have to if you don’t want to (like if the stock price is lower than the strike price).
- When you want to sell shares of a stock, you are purchasing a put option. You have the right to sell the number of shares at the price before a given expiration date. Whoever sells the put option to you agrees to buy the shares at the strike price, no matter what.
Benefits of Options Trading
All other things considered equal, there is less risk with options than stocks, at least in terms of your exposure to losses. If you buy 100 shares of ABC at $10 – a $1,000 investment – and the price drops to $5, you lose $500 if you had to sell. If you buy a call option for 100 shares of ABC with a premium of $1 per share, you only lose $100 – because you don’t have to actually buy the shares.
Stock options also gives you leverage, or the ability to buy more with what money you have. Small changes in stock price can result in big gains, unlike with stocks. For example, if you put $1,000 into buying 100 shares of ABC at $10, your stake in the investment is $1,000. If the stock goes up a ridiculous 10%, to $11, then you make $100, which is 10% of your initial investment.
Let’s use stock options instead. Let’s say you have a stock option for 100 shares at $10 a share. The price is at $10 a share now, which means the value of your stock is $1,000 (100 x $10). If the stock went up to $11 – 10% of the original value – you’d have a gain of $1 per share, or $100 (which is a gain of 100%). If it went up to $12, that would represent an increase of 20% from the original price of $10. But, to you, that would mean you’d gain $2 per share, for a profit of $200 – which is a gain of 200% from your starting point.
Let’s put it another way. Let’s say you have 100 stock options at $9 a share, and the price is $10 right now. The market value of your shares would be $1,000. It’d cost you $900 to exercise your options and buy 100 shares at $9. The difference between the two costs is $100, or your equity. If the price goes up 10% to $11 per share, your equity would go from $100 to $200 – which is a 100% increase. You’d still have to pay $900, but you’d receive $1,100 in return.
In that case, you’d gain 90% more with stock options than you would with stocks. That is leverage.
Trading on Predictions
Another benefit is that you can trade the market before events actually happen. This is a proactive trading method rather than a reactive one. Trying to get in on stocks before, say, an annual share report is released could open you up to a significant loss if you buy stock and the price dips if the company’s earnings disappoint. Buying options, though, puts at risk only your premium, while giving you upside potential in case you’ve made the right prediction.
Using options to hedge against these kinds of disappointing outcomes if you have open stock positions is another benefit related to the one above. You could buy stock expecting to benefit in a surge in price, but you could also pay a much smaller amount to buy options against your current position just in case you lose the stock battle and your stock falls. This way, your gains and losses would be offset to a significant degree.
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